Category: KB Healthcare Consultants
Many physicians would like the opportunity to contribute to a Roth IRA (“Roth”) but are precluded from making direct contributions because of income limitations. There are a couple of ways to overcome this perceived impediment; one is the “Back Door Roth” strategy.
Roth IRA – The Basics
The Roth IRA is a wonderful retirement strategy, because the earnings grow tax free and distributions (after a relatively short time) are withdrawn tax free. Unlike traditional IRAs, the initial contribution to a Roth IRA is never tax deductible, but in a traditional IRA, the earnings are taxable when withdrawn. Therefore, a traditional IRA generally receives a tax deduction at the front end and the Roth at the back end. Roth IRAs also have more favorable required minimum distribution (RMD) rules, which makes them desirable to affluent individuals.
If you have funded some other retirement vehicle and are over the income limit for additional deductible (traditional) IRA investments, you can consider making a non-deductible IRA, and then flip that non-deductible IRA into a Roth. Any individual is eligible to convert or rollover from a traditional IRA account to a Roth and the transaction can be undertaken regardless of adjusted gross income (AGI); however, the transaction may be taxable.
Steps to a Backdoor
How do you avoid paying taxes on the transaction? You “backdoor” the contributions using the following steps:
Taxation of IRAs with Both Deductible and Non-deductible
IRAs - Beware!
Even if you have a combination of deductible and non-deductible IRAs in your portfolio and you wish to convert the non-deductible IRAs to Roths, you will likely have a taxable event. All of your IRA accounts are combined when computing the taxable income on a rollover to a Roth account For example, if an individual has $100,000 in a traditional IRA account and $50,000 in a non-deductible account with a basis (meaning that you funded a non-deductible IRA with post-tax dollars) of $25,000, the taxable amount to consider is $125,000 ($100,000 plus $50,000 minus $25,000.) If only the non-deductible account is to be rolled to a Roth, the basis must be spread proportionately to all IRA accounts. In order to roll the non-deductible account of $50,000 (one-third of total IRA funds), the basis allocated to that transaction is only $8,333, or one-third of the total basis. The taxable amount is $50,000 minus $8,333.
It’s clear that the first step of rolling over the traditional IRA accounts will go a long way to limiting or eliminating your taxable income.
Accounts that your traditional IRA can be rolled into include:
IRS ROLLOVER CHART LINK