The Optometrist's Guide to Roth IRA and How to do a Backdoor Roth
Written/Updated By Dr. Dat Bui OD. November 10,2021 with 2022 IRS Tax Codes
Chapter 1: Why is the Roth IRA so Awesome?
A fully funded Roth IRA should be a goal for every optometrist, every year. We are going to give you the basics of why we love the Roth IRA so much, and why it should be a part of every high-earning professional portfolio.
Anyone with earned income (regardless of 1099 or W2) can open a Roth IRA via Vanguard or Fidelity and can contribute $6,000 each year for 2022 (as well as another spousal IRA $6000 for your spouse if you want). The great thing about a Roth IRA is that you have access to a variety of great and cheap choices of mutual funds, unlike those automatically chosen within your 401K by your employer. Also, a Roth IRA is extremely easy to set up!
Since you contribute to a Roth-IRA with after-tax money, the contributions can NEVER be taxed again (because you already paid taxes to Uncle Sam). Your capital gains (or how much your investment funds grow in profit) will also come out TAX-FREE. This is the principal reason why the Roth IRA is so awesome - because it doesn’t have to pay the typical income tax upon withdrawal, unlike those in a traditional 401K or even the 15% long-term capital gains tax in a typical Taxable Brokerage investment.
"Since you contribute to a Roth-IRA with after-tax money, the contributions can NEVER be taxed again (because you already paid taxes to Uncle Sam). Your capital gains (or how much your investment funds grow in profit) will also come out TAX-FREE. This is the principal reason why the Roth IRA is so awesome - because it doesn’t have to pay the typical income tax upon withdrawal, unlike those in a traditional 401K or even the 15% long-term capital gain tax"
Traditional Individual Retirement Account (Trad-IRA)
Roth Individual Retirement Account (Roth-IRA)
Any earned-income individual (W2 or 1099)
Can contribute up to $6,000 Pre-tax Deductible dollars (Extra $1,000 catch-up for >Age 50). Will have Modified Adjusted Gross income (MAGI) limit if Optometrist already have a main employer retirement plan like 401K or SIMPLE IRA
Single: Max MAGI income= $78,000 (start to phase out contribution level at $68,000)
Married filing jointly: Max MAGI income = $129,000 (start to phase out contribution level at $109,000)
All withdrawals are taxed at income rate after 59 ½ but additional 10% Penalty imposed if withdrawal made prior to retirement age
Easy to set up with great fund choices
Able to withdraw without penalty due to hardship such as disability and high medical expense
Able to withdraw without penalty for qualified Higher education (You, your spouse or your children or grandchildren)
- Able to withdraw without penalty up to $10,000 per spouse for 1st home purchase (you, spouse, grandparents or children/grandchildren)
- Low contribution Limit
- Most ODs' income will be too high or they will already have a main Employer retirement account
Any earned-income individual (W2 or 1099)
Can contribute up to $6,000 Post-tax Deductible dollars (Extra $1,000 catch-up for >Age 50), also additional $6,000 Spousal Roth IRA (non-working)
Single: Max MAGI income= $144,000 (start to phase out contribution level at $129,000)
Married filing jointly: Max MAGI income = $214,000 (start to phase out contribution level at $204,000)
Contributions (what you put in) can be withdrawn at any time, without taxes or penalty. If you withdraw earnings (a.k.a. gains) before age 59 ½ then they will be taxed as income tax rate +10% penalty. Otherwise, withdrawal on gains will be tax-free after 59 ½
- Easy to set up with great fund choices
- Tax-free Growth
- Able to withdraw CONTRIBUTIONS Anytime (since it is funded with post-tax already) with tax or 10% Penalty PRIOR TO 59 1/2
- Able to withdraw EARNING without penalty due to hardship such as disability and high medical expense (After 5 years)
- Able to withdraw EARNING without penalty for qualified Higher education like for you, your spouse or your children or grandchildren (After 5 years)
- Able to withdraw EARNING without penalty up to $10,000 per spouse for 1st home purchase for you, spouse, grandparents or children/grandchildren) (After 5 years)
- Low contribution Limit
- Max Income limit, but able to do Backdoor Roth IRA
- 5 years Withdrawal Rule:The first Roth IRA five-year rule is used to determine if the earnings (interest) from your Roth IRA are tax-free. To be tax-free, you must withdraw the earnings: (1) On or after the date you turn 59 (2) At least five tax years after the first contribution to any Roth IRA you own
Example: Dr. McLovin is one lazy 30-year-old when it comes to retirement investing and only contributes $6000 each year to his Roth IRA out of his huge paycheck. If he is planning to retire at 65 years old and assuming an 8% growth each year, his total contribution (how much he put in) will only be $210,000 but his gains will be a WHOPPING $906,612.
This allows Dr. McLovin to retire a millionaire (Total net worth of $1,116,612) by doing the bare minimum (see how little effort it takes to be rich??).
Okay, so lets talk about the tax implications! Since it is in a Roth IRA, that $906,612 is all yours! Uncle Sam can’t touch it.
But if this was in a Traditional 401K, you would have to put taxes BOTH on the contribution and gains. Therefore, assuming you are at the lowest Tax Bracket of 15% in retirement, and you pull out all the money slowly over time, your overall tax bill on the total $1,116,612 within the traditional 401K, would have an estimated tax bill loss of $167,491 to Uncle Sam.
What about Withdrawals for Contribution & Gains in a Roth IRA?
While you can withdraw the Roth IRA contributions at any time WITHOUT penalty or taxes, there are some strict rules of your GAINS WITHDRAWAL.
5-year Rule: You can only withdraw your gains 5 years after you open your Roth IRA account.
Example: Dr. Cornea have $40,000 in his Roth IRA as of 1/2021 that he open up in 1/2017, 4 years ago.
- $24,000 Contribution
- $16,000 Profit
Remember that he can withdraw that $24,000 contribution anytime (post-tax), BUT if he want to use withdraw that $16,000 to help his kid's college education. He would have to wait until 1/2022 (5 years) to withdraw it to avoid the income tax + 10% penalty. This is why it is recommended to open up the Roth IRA ASAP to allow for the clock to run down.
Note: If you made a Roth IRA contribution in February 2022 and assign it for 2021 Tax year (Remember you have up until April 2022 Tax Deadline to make any Roth contribution for 2020), you will have to wait until 1/1/2026 to withdraw any Roth IRA earning.
Similar to other retirement accounts, you still have to wait until they are 59 ½ years old to withdraw any gains and avoid the 10% penalty.
What are Some Exceptions to Avoid the 10% Penalty for Gain Withdrawal?
- Hardship periods such as disability and high medical expense.
- Higher Education Schooling (can be applied to your spouse, or children/grandchildren).
- Up to $10,000 per spouse, for a first-time home purchase (can be applied to your grandparents or children/grandchildren as long as it is their 1st home purchase).
Also, many doctors want to retire as early as 50 years old but cannot access their Trad-401K or IRAs until 59 ½, so a great strategy is to spend any tax-free Roth IRA contributions to fund their retirement from 50 to 59 ½ year old without the 10% penalty. Then after 59 ½ they can tap the fund in their traditional 401K funds.
CAUTION: Remember that you must be aware of the 5 year withdrawal Rule (see above)
Lastly, while we strongly DO NOT recommend this route since the funds in your Roth IRA should only be reserved for retirement, some investors can use their Roth IRA as a source for additional emergency funds in a dire financial situation such as a life-saving medical operation.
What is the Back-Door Roth IRA?
You might be asking, “Wait guys! Most doctor salaries are way above the $144,000 limit (2022) and cannot qualify for a Roth IRA! So why are we even talking about this?”
You are absolutely correct!
To qualify for a Roth IRA in 2022, you need to have a modified adjusted gross income of under $144,000 (start to phase out contribution level at $129,000) for single individuals, and for married filing jointly, the max income is $214,000 (start to phase out contribution level at $204,000). So how do many high-earning professionals get around this??
There is a wonderful IRS loophole called the BACKDOOR Roth IRA. It is basically for the high earning professional whose income is above the MAGI Roth IRA Limit and wants to open a Roth IRA. There are many online tutorials on how to do this, but you can basically open a Traditional IRA (ex: via Vanguard) and deposit the full $6,000 max amount. Then, the next day, you convert it to the Roth IRA. You simply repeat this each year.
How does Pro-Rata Rule affect me if I have any existing IRAs?
We won’t go into much detail, but basically the IRS requires you to perform a calculation end of the year, where they will treat all your existing IRAs (such as SEP, SIMPLE, Traditional IRAS) as ONE BIG IRA account. This can complicate things when you try to do a backdoor Roth conversion.
Your Roth IRA will be taxed on the “pro-rata” percentage of all your total pre-tax IRA balances to the total of all your IRA balances.
So here are two solutions if you want to attempt the backdoor Roth IRA
(1) Convert ALL IRA accounts to your Roth IRA, and willingly pay the huge tax bill at the end of the year
- Remember, with Roth, you pay taxes now to avoid the taxes due on any gains in the future. Afterwards, you technically only have one Massive Roth-IRA, then you can do the backdoor Roth IRA.
- Example: If you only have a trad IRA, You can convert that Trad IRA into a Roth IRA, then moving forward, fund just the Roth IRA (Tax Event). We always recommend doing this step sooner than later to reduce tax paid on growth
(2) Rollover ALL IRA accounts into your Solo-401K
- If you were or currently are a 1099 independent contractor, then having an existing Solo 401K is the best route (vs a SEP or SIMPLE IRA). Why? Because as your income grows, you will eventually be faced with doing the backdoor Roth IRA. Therefore, if you have an existing solo-401K, it is easy to rollover all IRA accounts into your Solo 401k
- Caution: Before you proceed with rolling over your SIMPLE IRA to a Solo 401k, first confirm that it has been at least two years since you first contributed to it. 2 Year Period is needed to avoid 25% penalty
- Note: SEP IRA, there is NO waiting period to rollover a SEP IRA into a new Solo 401K
In Summary, it is extremely complicated - so DO NOT attempt the backdoor Roth IRA if you have other existing IRAs, like a SIMPLE or SEP IRA.
"IRS treats all your existing IRAs (such as SEP, SIMPLE, Traditional IRAS) as ONE BIG IRA account. This can complicate things when you try to do a backdoor Roth conversion due to the Pro-Rata Rule. Do NOT attempt the Backdoor Roth IRA if you have any existing IRAs"
What About my Spouse? And What if My Spouse Has an Existing IRAs?
Remember that an IRA is an individual Retirement Account, which means one for you and one for your spouse! Yup, that is $6,000 per person, for a total of $12,000 if you are filing jointly. Even if your spouse has no earned income (Stay at home parent), they can still do a spousal Roth IRA, up to $6,000.
IMPORTANT: You can still do a backdoor Roth IRA as a high-income doctor (assuming you don't have any existing IRAS like SIMPLE), even if your spouse has an existing SIMPLE, Traditional or SEP IRA.
The bad news is that your Spouse CANNOT do a backdoor IRA, unless they do an IRA rollover into an existing Solo 401K, or simply convert all IRAs to their Roth IRA (tax bill on the gains) prior to attempting the backdoor Roth IRA.
Why is This Even Legal?
Some financial experts argued that it is just a way for the IRS to track their budget, but Congress officially blessed the backdoor Roth IRA for everyone back in 2018.
The Roth IRA is a powerhouse when it comes to all these different tools and is a great way to diversify your retirement tax.