Written by Josh Lantz, CRPC®/ Chief Investment Officer, Financial Advisor

Roth IRAs can be great savings vehicles for doctors. They allow your money to be contributed after taxes, grow tax-deferred, and be withdrawn tax-free when used correctly. In this article we’ll cover:

How to fund a Roth IRA using the Backdoor Roth strategy
How the taxes work
How the pro rata rule works
Who can use the Backdoor Roth strategy
Who should use the Backdoor Roth strategy
Where you can setup the accounts for the Backdoor Roth strategy
How a Roth IRA is different than your options at work

1. How to fund a Roth IRA using the Backdoor Roth strategy

Many doctors make high incomes. Under IRS rules, those high incomes preclude them from directly funding their Roth IRAs each year. In 2023, when you make over $138,000 (single filer) or $218,000 (married joint filer) you are restricted from directly contributing to a Roth IRA via phase out rules.

In fact, if you make over $151,500 (single filer) or $228,000 (married joint filer) you are prohibited entirely from directly funding any amount in a Roth IRA.

Doctors can still sometimes contribute to a Roth IRA via the Backdoor Roth IRA strategy.

In 2023, you can contribute $6,500 each if you’re under the age of 50 and $7,500 each if you’re older than 50. To get around the income restrictions properly, you directly contribute to what’s called a non-deductible IRA first. You can do this because there’s no income restriction for funding a non-deductible IRA. This is an IRA that you fund with after-tax dollars.

You notify the IRS you funded this non-deductible IRA with after-tax dollars each year by asking your tax accountant to fill out IRS form 8606. This is a vital step to avoid double taxation and it’s often missed.

Once the non-deductible IRA is funded with your contribution you should invest your money, wait an amount of time so they are not considered the same transaction, then do a Roth Conversion of the non-deductible IRA.

A Roth Conversion does not have an income limit associated with it. It takes IRA money and converts it into Roth money. In the case of the Backdoor Roth strategy: when you convert, you already funded the contribution with after-tax dollars, therefore you won’t pay tax on that amount. You will however, pay taxes on any gain between funding and converting.

Example: you contribute $6,500 dollars on 1/10/23 and invest the next day. It grows to $6,600 dollars by the time you do the Roth Conversion on 2/11/23. You should only pay ordinary income taxes on the gain of $100 dollars in this scenario. You’ll pay when you file your taxes in mid-April 2024 for calendar year 2023.

Here are the steps of the Backdoor Roth strategy:

Fund non-deductible IRA up to contribution limit
Notify your tax accountant so they fill out IRS form 8606
Invest the non-deductible IRA and wait
Do a Roth Conversion of the entire non-deductible IRA

2. How the taxes work

Money is contributed after taxes, grows tax-deferred, and is withdrawn tax-free, assuming it’s held at least five years within the Roth IRA and withdrawn after age 59 ½.

Each year the IRS determines contribution limits, which is the new money that can be deposited into the account annually.

In the case of the Roth IRA, money is contributed after-tax. That means you get no tax deduction for your contribution. You’re basically shifting money from your checking/savings account at a bank to a Roth IRA for its future tax benefits.

Once invested inside the Roth IRA, it grows tax-deferred. That means you’re not paying any taxes on that money over time. That’s even the case if you sell/change around your investments inside your Roth IRA and/or earn dividends or income from your investments. This is an underestimated feature of the Roth IRA.

For comparison, if money was held in a non-retirement account like a brokerage, part of the investment would be eroded over time from taxes. It’s estimated 0.80% to 2.00% of the annual returns are eroded due to ongoing taxation. For this reason, a Roth IRA should outpace the returns of a brokerage account after taxes. Let’s look at an example:

Assume both the investments in the brokerage and Roth IRA earn 8.00% gross returns. In the brokerage account you’ll face the tax erosion of 0.80% to 2.00%. Therefore, you’ll get net returns of 7.20% or 6.00%. If you project those end balances contributing $6,500 for thirty years here’s the result:

As you can see, you are almost $100,000 ahead of the brokerage account, by choosing the Roth IRA, when your tax erosion is only 0.80%. However, if your tax erosion is a full 2.00%, then the Roth IRA beats the brokerage account by over $220,000.

Lastly, money is withdrawn tax-free from a Roth IRA in retirement. This is what everyone loves about Roth IRAs--even if income taxes go higher in the United States, your money is still withdrawn tax-free from the account.

3. How the pro rata rule works

The pro rata rule does not apply to a direct Roth IRA contribution. However, it does apply to anyone using the Backdoor Roth IRA strategy who happens to have a balance in their Traditional IRA, SEP IRA, or SIMPLE IRA at the end of the year.

It’s very common for doctors to have a Rollover IRA. This is money from a former employer that they rolled over from a 401k/403b into a Traditional IRA. Or maybe they had self-employment income and thus contributed to a SEP IRA. Having a balance in the Traditional IRA, SEP IRA, or SIMPLE IRA usually makes it cost prohibitive to perform a Backdoor Roth.

If you use the Backdoor Roth strategy and you have an existing balance in a Traditional, SEP, or SIMPLE IRA, you can face double taxation on your Backdoor Roth contribution.

What does that look like? The portion that is distributed tax-free is your after-tax amount divided by the Traditional, SEP, and/or SIMPLE IRA pre-tax balance. The portion that is taxed as income is the difference. Here’s an example:

You do a $6,500 Backdoor Roth. That’s your after-tax amount you distribute for the year. However, you have a $50,000 Traditional IRA from a rollover. The $6,500 divided by $50,000 is 13% tax-free. The difference is 100% less 13% or 87% taxable.

Math:

$6,500 / $50,000 = tax free distribution %

100% - Tax free distribution % = taxable distribution %

Taxable distribution % x $6,500 = unnecessary taxable income

Math:

$6,500 / $50,000 = 13%

100% - 13% = 87%

87% x $6,500 distribution = $5,655 of unnecessary taxable income

If you were in a 24% marginal tax rate, you’d pay 24% x $5,655 or $1,357.20 in unnecessary taxes due to the pro rata rule.

The easiest way to avoid this is skip doing a Backdoor Roth if you have a balance in a Traditional IRA, SEP IRA, or SIMPLE IRA. Alternatively, you could consider a Roth Conversion (Taxable event) of your IRA, SEP IRA, or SIMPLE IRA. This is a good option, depending on the balance size of your account. Or you might consider only funding a non-deductible IRA. Make sure to talk through those strategies with your advisor if you’re in this situation.

Keep in mind, retirement accounts are owned individually. It’s possible to have one spouse that has a Traditional, SEP, or SIMPLE IRA who shouldn’t use the Backdoor Roth strategy and the other spouse who has a $0 balance in their Traditional, SEP, and SIMPLE IRAs who can use the Backdoor Roth strategy.

4. Who can use the Backdoor Roth IRA strategy

Anyone with earned income can use the Backdoor Roth strategy. Even if one spouse earns all the income, the non-earning spouse can also fund a Backdoor Roth. Here's the catch, the earning spouse must earn at least the amount of the contributions.

This is easy for doctors to do given they have such high incomes. Their incomes are way above the contribution limits of $6,500 each ($7,500 if over 50).

5. Who should use the Backdoor Roth IRA strategy

Every doctor who doesn’t have a Traditional IRA, SEP IRA, or SIMPLE IRA balance should consider using the Backdoor Roth strategy.

Doctors should already max out their 401k, 403b, or other work retirement plans--it’s essential for every doctor to retire at a reasonable level.

After maxing a 401k, 403b, etc., there are very few options to save in a tax-advantaged way for a W2 employee doctor. The Backdoor Roth strategy provides an, otherwise unavailable, opportunity for doctors and other high earners to save additional tax-free money for retirement.

6. Where you can setup the accounts for the Backdoor Roth strategy

You can setup the accounts at any custodian that provides Traditional IRA and Roth IRA accounts for investments. Typical choices are TD Ameritrade, Schwab, and Fidelity.

Setup and implementation will require some paperwork and working with the custodian. Given the added steps of the Backdoor Roth strategy (e.g. IRS form 8606, multiple step process), a lot of doctors seek the help of a professional to delegate the setup and implementation. We take care of this for our clients.

7. How a Roth IRA is different than your options at work

A Roth IRA is a different contribution plan and thus has a different contribution limit than your work accounts. It is permissible to stack a Roth IRA on top of your Roth accounts at work.

You might have a Roth 401k or Roth 403b at work. That’s fine. You can contribute $22,500 in 2023 to those plans ($30,000 if over 50). Those contribution amounts are separate to the Backdoor Roth IRA contribution limit of $6,500 ($7,500 over 50). Potentially you could fund $29,000 in both a Roth IRA plus your Roth 401k/403b ($37,500 over 50).

Therefore, you can contribute to both a Roth IRA via the Backdoor Roth strategy and any Roth options at work under current IRS rules.

The Backdoor Roth strategy can save you thousands on taxes over time relative to a brokerage account. Make sure this year you consider contributing via the Backdoor Roth strategy to boost your long term savings and lower your future tax bill.

Josh Lantz, CRPC®/ Chief Investment Officer, Financial Advisor With over a decade of financial planning experience, Josh has worked on more than 450 doctors’ financial plans. “It’s very hard to find a doctor’s situation I haven’t seen before,” says Josh. This is only a snapshot of the expertise Josh brings to MD Financial. He was recently recognized in Medical Economics for Financial Adviser for Doctor’s in 2017-2018, as well as Dental Products Report’s Best Financial Adviser for Dentists in 2019. In 2022, Josh was recognized as a Five Star Wealth Manager Under age 40. He can be reached at Josh@mdfinancialadvisors.com.