Think You Make Too Much to Fund a Roth IRA? Think Again!

In response to the question we pose to new clients — "Are you funding a Roth IRA?" — the most common response from those who aren't is "We can't. We make too much."

Ah! Likely they're not familiar with the magic of the backdoor Roth IRA.

They are correct that, as physicians, they probably earn too much to directly fund a Roth IRA account (for 2021, individual filers earning more than $140,000 are above the income limit; for married filing jointly, the limit is $208,000). But there are no income limits to funding a Roth IRA account using the backdoor method.

What Is a Backdoor Roth IRA?

A backdoor Roth IRA is not a type of account but rather a series of steps that high-income earners need to complete to fund a Roth IRA account. It's a straightforward process that provides significant benefits.

The first step is to open and fund a traditional IRA. If you're under 50, your maximum contribution amount in 2021 is $6000 per year; if you're 50 or above, the amount is $7000. And there's even more you can do if you're married. In that case, you can fund the same amount to an IRA for your spouse, even if they are not gainfully employed — a so-called spousal IRA.

Will I Owe Taxes If I Fund a Backdoor Roth IRA?

The simple answer is no. The money you put into your traditional IRA is after-tax money and will not be tax-deductible. Just move this traditional IRA money to a Roth IRA account and presto change-o. Since you fund your traditional IRA account with after-tax money, no taxes will be due upon conversion. It's like magic!

What's So Great About a Backdoor Roth IRA?

Funding a backdoor Roth IRA for a year or two isn't going to move the needle on your financial plan; the sum of money is too small. However, by funding a backdoor Roth IRA regularly during your career, you can end up with a large bucket of tax-free money. What does this mean? That during retirement, having a Roth IRA will help you reduce tax payments and enable you to keep more of what you've saved.

See my blog on the benefits of tax diversification: Where You Save for Retirement Is as Important as How Much

For example, let's say you fund a backdoor Roth IRA with $6000 per year starting at age 30 and continue annual funding to age 65. We'll assume a 7% annual return. You'll have accumulated nearly $900,000 of tax-free money for retirement.

If you do the same for your spouse, we're talking $1,800,000 of tax-free money!

Can Everyone With Earned Income Fund a Backdoor Roth IRA?

Theoretically, everyone with earned income can fund a backdoor IRA, but it doesn't always make sense. The example above — where you contribute $6000 or $7000 to a traditional IRA and then do the Roth conversion without any taxes owed — applies if you have no other IRA accounts. When you add in more IRAs, the situation changes.

Here's an example using multiple IRAs. Let's say you have a traditional pre-tax IRA worth $94,000, rolled over from a prior employer's 401(k). You want to contribute $6000 to a second IRA account and plan to do the Roth conversion — but the IRS has something else to say about it.

When calculating whether you owe taxes on the $6000 Roth conversion, you have to combine the value of all your IRA accounts, including SEP IRAs and SIMPLE IRAs (note that inherited IRAs don't count for this purpose).

The Pro-rata Rule — and the Consequences for High-Income Earners

In the case above, you must combine the $6000 after-tax IRA contribution with the $94,000 of pre-tax money from your rolled-over account. If you were to do a Roth conversion of $6000, 94% of it ($5640) would count as taxable income. This so-called pro-rata rule is the cream in the coffee. You cannot separate the $6000 in after-tax IRA money from the existing $94,000 in pre-tax IRA money.

The formula for the pro-rata calculation is the total after-tax money in all IRAs, divided by the total value of all IRAs, multiplied by the amount converted. In the above example, if you converted your $6000 traditional IRA contribution, it would mostly comprise the pre-tax portion. As a result, most of the conversion will be taxable to you at your income level.

What does this mean to you? Most practicing physicians are in relatively high tax brackets, making a Roth conversion in the situation above a losing scenario. Better to wait until later on, when you are in retirement and are probably in a lower tax bracket for Roth conversions.

Existing IRAs and the Pro-rata Rule

The pro-rata rule applies to money in IRA accounts, including traditional pre-tax IRAs, SEP IRAs, and SIMPLE IRAs. Is there a way to get around this rule and enable tax-free backdoor Roth conversions? Possibly.

If you have money in any of these types of accounts and are actively employed and enrolled in a 401(k) or 403(b) at work, the money won't be counted for the pro-rata rule if you roll the pre-tax IRA account to your employer retirement plan. Don't have an employer retirement plan available to you? You can open a one-person 401(k) plan for yourself, roll the IRA money there, and you'll be good to go with your tax-free backdoor Roth IRA.

All examples are hypothetical and are for illustrative purposes only. No specific investments were used in these examples. Actual results will vary.

Disclaimer: The above article is intended for informational purposes only. Please consult a legal or tax professional regarding your situation.

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About Dr Joel Greenwald

Joel S. Greenwald, MD, is a graduate of the Albert Einstein College of Medicine in Bronx, New York, Joel completed his internal medicine residency at the University of Minnesota.

He practiced internal medicine in the Twin Cities for 11 years before making the transition to financial planning for physicians, beginning in 1998.

Joel's wife is a radiation oncologist, making him all too familiar with the stress of medical practice.

Knowing firsthand the challenges of practicing medicine, Joel's passion is making the lives of physicians easier by helping relieve them of financial worries.

Connect with him on LinkedIn or on his website.

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