Roth IRAs: Everything a Doctor Needs to Know Before Investing
By Katherine Vessenes, JD, CFP®, RFC
Founder, MD Financial
If you have been following our articles, you know we have been discussing Roth 401k/403bs, IRAs and Roth IRAs. A lot of our doctors are confused about how they work and when they can use them. You can get more information on Roth 401k/403bs here and more on IRAs here. Today, we are going to address what doctors need to know about Roth IRAs.
Roth IRAs first became available in 1997 and were named after the late Senator William Roth from Delaware. The word “Roth” has become synonymous with a tax-free investment.
Here are a few basics about Roth IRAs:
1. You, or your spouse, must be working in order to contribute. The rules apply to “earned income.” If all of your income is passive, from investments or trusts for example, you won’t qualify.
2. All contributions to Roth IRAs are made after tax. This means you cannot take a tax deduction for investing into a Roth IRA, like you can in a traditional IRA.
3. The contributions go in after taxes, grow tax-deferred until age 59 ½. After 59 ½ you can withdraw your earnings, and the original investment tax free, or you can leave them in the account and they will continue to grow tax free.
4. Your contribution is limited to your earned income or the annual IRS contribution limit, whichever is lower. This year that will be $5,500 for doctors who are under 50, and $6,500 for those who are over 50. This amount is increased periodically to keep up with inflation.
5. You can make a contribution up to April 15th of the following tax year (Dec. 31st if doing Back-Door Roth.) Meaning that if you are reading this in 2018, you could contribute up to April 15th of 2019. If you believe the market is going up, we recommend investing as early in the year as possible to avoid paying taxes on the gains of your investment. If you are worried about a down or choppy market, you might want to wait as long as possible to invest, believing you would have a little more upside potential.
6. Once you reach the age of 70 ½, you are no longer eligible to make a traditional IRA contribution even if you are working. However, you can make a Roth IRA contribution after the age of 70 ½ assuming you, or your spouse, are still working.
7. Doctors have to be careful about investing directly into a Roth, because the IRS has limits on whether you can directly invest, depending on your income. Married doctors, filing joint tax returns, must make less than $189,000 this year in order to qualify for a direct contribution. Single doctors need to make less than $120,000. As a result, in our practice, it is usually just residents and fellows who can make direct contributions.
8. Roth IRA accounts are held at custodians. This could be a bank, like Bank of America or Wells Fargo, or an investment company/brokerage firm like Fidelity, Vanguard, or TD Ameritrade, to name just a few.
9. Just like an IRA, you are able to select any investments that your custodian offers inside the Roth IRA. The common investment options include basic cash or money market accounts, annuities, stocks, bonds, mutual funds and real estate funds. The choices can get more exotic with some custodians and might include precious metals such as gold or silver or stock in closely held companies.
10. Transactions in the Roth IRA are not subject to any tax while still in the account. This includes interest on the bonds, dividends on the stocks, or capital gains.
11. You can have more than one Roth IRA account and it is not unusual for us to see doctors with numerous ones held at different institutions. We don’t recommend this because it becomes more difficult to track them and to manage the investments. Usually it is best to combine all of your Roth IRAs into one account and use a consistent investment philosophy on all your investments.
12. Unlike IRAs, you are not required to make minimum distributions once you turn 70 ½. In fact, you are not required to make any distributions at all.
13. It is possible to have both a Roth IRA and a Roth 403b/401k at work. If you are under 50 and maximizing both plans, then you could be setting aside $18,500 dollars. If you’re over 50 you could set aside $24,500 in 2018 ($18,500 + $6,000 catch up) per year to grow tax free.
Here are a few ways to get funds into a Roth IRA:
1. The easiest, unfortunately rarely works for our attending physicians and dentists: If you are married, filing joint returns, and make less than $189,000, then you can make a direct Roth Contribution. If you are single, the cut off is $120,000 in 2018.
2. If you have an existing IRA, you can do a Roth conversion. This means moving the funds from the IRA to a Roth IRA. This will trigger income taxes (but not the 10% penalty) on all the funds that are converted. The taxes are due on April 15th of the year following the conversion. You can convert an unlimited amount using this technique, but you also have to be prepared to pay the taxes the following April. This is a common strategy when we believe you’re in a lower tax bracket this year than the future. We often can do this in stages to avoid a huge tax bill in one year for doctors with large IRAs.
3. A common strategy with our doctors, is to do a Back-Door Roth contribution. In this case, assuming your income is over the limits, we would first create a non-deductible IRA, or one that is invested after taxes have been paid. We would then convert it to a Roth IRA. Assuming it is done correctly, there would be no more income taxes due. This technique only works in certain cases:
This works great when you do not have any funds in an IRA, SEP IRA, or SIMPLE IRA that has not been taxed. The reason is, most CPAs believe you cannot have an existing IRA, SEP IRA, or SIMPLE IRA, which has not been taxed, and use this strategy. If you do, the IRS required a “pro rata” calculation on the after-tax IRA amount converted which means those funds are taxed twice! Something that completely obliterates the reason we want to do this in the first place. So, when clients have small, IRAs that have never been taxed, we recommend converting them first before doing a Back-Door Roth.
If you follow our articles, you know I firmly believe, there are pros and cons to every investment, including a Roth IRA. Here are a few items all physicians and dentists should consider before using investing in a Roth.
Starting with the positives:
1. The earnings or growth inside the Roth IRA are not taxable unless withdrawn before age 59 1/2. This can be a significant advantage, as it leaves more funds growing without the headwind of taxes.
2. A Roth IRA is sometimes protected from creditors, which is an important consideration for our doctors who are concerned about asset protection strategies. The levels of the protection vary from state to state.
3. The best reason to use a Roth is tax free income in retirement. We believe it is crucial to plan to have some income that is tax free.
4. The Roth IRA is one of the few tax shelters left. Almost all of the others have been disallowed by Congress!
5. You can transfer a Roth IRA at death to your heirs without any income taxes, unlike a traditional IRA.
6. These can be a great gift for your children or grandchildren if they have earned income.
A few years ago, we had a plastic surgeon from Detroit who had triplets. Before they were 6 months old, they had already earned money staring in some ads. We recommended taking their pay and opening a Roth for each of them. Let’s assume they each made $5,000 for the photo shoot, and they make 7.2% per year on their investments. Using the Rule of 72, that $5,000 will grow to $1.28 million, tax free, by the time they are 80! A very nice gift.
On the negative side:
1. Withdrawals before age 59 ½ are subject to ordinary income tax rates in the year of distribution, along with the 10% penalty previously discussed. This makes them relatively illiquid.
2. You cannot borrow from a Roth IRA. If you do, it is considered a taxable event.
3. Unless you are converting an existing IRA to a Roth, you can only invest a limited amount each year: $5,500 for doctors under 50 and $6,500 for those who are older. For most of our clients this is just a drop in the bucket for what they will need in retirement.
4. If you do convert your IRA to a Roth and you are under the age of 59 ½, the taxes will have to come from another account. After you are over the age of 59 ½, you can deduct the taxes from the IRA as you convert.
If you are thinking about doing a Back-Door Roth or a Roth conversion, we strongly recommend getting some good advice to avoid the IRS pit-falls and penalties.
Takeaway: If you can tie up funds until retirement, then a Roth IRA might be a great choice for you to get tax free income in retirement.
© Katherine Vessenes 2018.
Katherine Vessenes, JD, CFP®, RFC is founder of MD Financial, a concierge financial consulting and wealth management firm for physicians and dentists across the country. She can be reached directly at 952-388-6317 or Katherine@mdfinancialadvisors.com.
If you’d like to hear our corresponding podcast on Roth IRAs, click the link below.