Most physicians should max their backdoor Roth IRA every year, as well as their spouse’s. If done correctly, a physician could build a substantial post-tax nest egg within their retirement portfolio.
If you consider that many physicians are limited to the annual employee contribution limit on their 401(k) ($19,000 in 2019), it’s crucial to find other tax-advantaged ways to set money aside for retirement. The backdoor Roth is probably the next-best strategy to implement.
Here are the steps you need to follow:
Step 1: Roll any tax-deferred IRAs over into an employer-provided retirement plan
This is important to do to avoid taxation on the eventual Roth conversion. The types of IRAs you want to roll over include Traditional, Rollover, SEP and SIMPLE IRAs. Just about every modern 401(k) or 403(b) will accept rollovers of pre-tax IRA money. Contact your retirement plan administrator or Human Resources to learn more about starting the rollover process.
If you are 1099, then you can set up your own solo 401(k) at a custodian like Vanguard. Then you can roll your IRAs into that.
Once your pre-tax IRAs all have a zero balance, then you are ready to move to the next step. It’s ok to keep a balance in your Roth IRA, if you have one.
Step 2: Make a non-deductible contribution to a traditional IRA
For 2019, the maximum contribution is $6,000, with a $1,000 catch up for anyone 50 and over. You can use an existing IRA you had set up in the past, or open a new one. Just transfer the money from your checking account to the IRA, and you’re good.
The contribution is considered non-deductible because most physicians make too much money to qualify for a tax-deductible contribution. That’s ok though, because this means the eventual conversion will not be taxable (since it’s already been taxed). However, you will need to keep track of the fact that it’s a non-deductible contribution, because your custodian won’t. We’ll talk about how to how to do this in Step 5.
Also, I don’t recommend investing your contribution, since you’ll soon be converting it. The best way to keep the accounting clean throughout this process is to convert the same exact amount that you contributed in the first place. So keep it in cash, until after you’ve converted to a Roth.
Step 3: Convert your traditional IRA to a Roth IRA
You will need to have a Roth IRA set up for this. Again, you can use a pre-existing Roth IRA, even if it has a balance. That won’t interfere with anything you’re doing. But if you don’t have a Roth IRA, you’ll need to set one up, which is pretty easy to do. It should be at the same custodian as your traditional IRA.
How long you wait between contribution and conversion is a topic of debate.
Michael Kitces argues that for you to be totally safe, you should wait a year between contribution and conversion. The reason being, that while the two-steps of a back-door Roth Contribution aren’t illegal, the combination of both done in rapid succession could be perceived as a way to circumvent the law, which could get you in trouble with the IRS and/or Tax Court.
A blog at Ed Slott and Co says that a one month waiting period is recommended and sufficient to prove that the transactions are separate.
Then you have Jim Dahle at White Coat Investor, who dared the IRS to audit him on the back-door Roth IRA (even though he converts it the day after making his contribution), to no avail.
It’s up to you how you want to go about it, but for further consideration, Congress appeared to bless the back-door Roth IRA process, no matter the waiting period.
Once you’ve waited to the point you’re comfortable with, move forward with the conversion. Technically speaking, you are converting the balance in your IRA (which you just contributed) to a Roth IRA. And since the balance in your IRA is post-tax, the conversion will be non-taxable.
What this actually looks like will depend on your custodian. Vanguard and Betterment make it really easy to do, typically just the push of a button. Other big investment houses like Schwab or Fidelity might require you to call customer service or submit a signed form, to convert the IRA. If you don’t know what to do, it’s best to call the customer service number of your custodian to find out.
One last note here. Your custodian may tell you that the conversion is a taxable event. That’s because they want to warn you, in case you’re uninformed. But what they don’t know is that you made a non-deductible contribution, and therefore the money sitting in your IRA has already been taxed. As long as you have followed the steps correctly, converting the IRA won’t be a taxable event, despite what your custodian is telling you. Just make sure that you rolled all your other pre-tax IRAs over to your 401(k), first.
Step 4: Invest
Once you’ve completed the conversion, then you are free to invest the Roth IRA according to your investment strategy. Since the money in the account and all the future earnings will never be taxed again, you have pretty good incentive to be aggressive, to try to grow it as much as possible. But make sure you seek qualified advice, if you’re unsure what you’re doing in this area.
Step 5: File form 8606
To keep track of how much of your traditional IRA contributions are non-deductible, you need to file form 8606 every year. This is also important when you convert your IRA to a Roth IRA, as it will show that the amount being converted is post-tax, thus not requiring additional taxation. Your accountant should be taking care of this for you, but make sure you discuss it with them beforehand. Many accountants today are not aware of the back-door Roth IRA strategy, even though they’ve been in the business for many years.
To help make your accountant’s job easier (or your own if you file your own taxes), you will want to make the contribution and conversion in the same tax year. According to this recommendation, most physicians will tend to contribute and convert early in the year like in January, or at the end of the year in November or December (a great year-end tax move!). It’s just a matter of preference.
If done in the same calendar year and tax year, Form 8606 is easy to fill out. Lines 1, 3, 5, 8, 9, 11, 13, 16 and 17 all contain the contribution/conversion amount. This amount would be $6,000 in 2019 if you max your contribution (and are under 50). All the other lines are zero.
If you’re married, make sure you duplicate the same process for your spouse.
That’s all there is to it! Good luck!