PracticalDermatology

Tax diversification is a planning concept that we stress when working with dermatologists and other physicians. This concept may be especially important for 2021, as we anticipate tax hikes to be coming, especially for those taxpayers who earn more than $400,000, a group which includes many dermatologists.

Essentially, tax diversification means building assets in a variety of “buckets”,, each of which will be taxed differently when liquidating for retirement. One such “bucket,” which is often under-utilized, is the “tax-free” bucket—assets that will come to the physician tax-free in retirement. Roth IRAs can play an important role in this asset group but may seem to be off limits for many higher-income earners because of strict income caps on contributions to these accounts. However, even if your income disqualifies you from being able to contribute to a Roth IRA, the backdoor Roth IRA strategy can provide a way for you to take advantage of these accounts and help you achieve better long-term tax diversification.

The Appeal and Limitations of a Roth

With a Roth IRA, you get no up-front tax deduction, as you do with a traditional IRA, 401(k) retirement plan or other tax-deferred account. However:

• You pay no tax on either principal or earnings when you withdraw your money (although you must be at least age 59½ and have had the Roth for five years).
• There is no required minimum distribution, or age when you must withdraw money—an appealing option for those who want to leave the money to heirs.

The trouble has been, of course, that Roth IRAs technically are only available to those whose annual income is below certain levels. In 2021 those limits are:

• $207,999 or less for married couples filing jointly
• $139,999 or less for single filers

A backdoor Roth IRA circumvents those income restrictions. The most recent tax reform legislation confirms that backdoor Roth IRAs are an allowable transaction. Taxpayers who had shied away from using backdoor IRAs for fear of running afoul of the IRS now have a clear path to using this strategy to create Roth IRAs.

Backdoor Roth IRA: How it Works

So how does a backdoor Roth IRA work? Instead of contributing to a Roth IRA directly—which you may not be eligible to do because of the income restrictions—you make a nondeductible contribution to a traditional IRA. No income restrictions apply to your right to put money into a traditional IRA.

Nondeductible means you are using money left over after you pay your income taxes. The tax impact is a wash because you would not have been allowed to deduct a direct contribution to a Roth IRA, anyway. Both are so-called after-tax contributions.

After putting the money into a traditional IRA, you convert or transfer it to a Roth IRA. You can contribute up to $6,000 a year to a traditional IRA, or up to $7,000 if you are age 50 or older, and you can convert the money at any time.

Still, remember to follow certain rules:

• You must have earned income. Otherwise, you are not eligible to make a nondeductible contribution to a traditional IRA. But there is a helpful exception to that rule: For married couples filing a joint return, the backdoor Roth IRA can be doubled by having a nonworking spouse also contribute to his or her own IRA. The working spouse must have enough earned income to cover the contribution for the nonworking spouse.
• You cannot convert money to a backdoor Roth IRA if you are over 72 years of age. If a worker is contributing for a nonworking spouse, the nonworking spouse also must be younger than 72.
• Obey the IRS’s pro-rata rule in calculating tax on the conversion amount. The pro-rata rule is a rule that dictates the taxation of an IRA distribution when the IRA owner has any IRA containing after-tax amounts. The rule states that, in general, an IRA distribution will consist of the same proportion of pre-tax and after-tax amounts as the IRA owner has in his or her IRA(s). Furthermore, for the purposes of this rule, all of a taxpayer’s traditional IRAs—including SEP and SIMPLE IRAs—are looked at as a single IRA.

The crux of the calculation is this: You pay taxes in proportion to the original account’s pretax contributions and earnings. Suppose you kick in $6,500 to a nondeductible traditional IRA. In addition, you also have an IRA worth $93,500, funded entirely with deductible contributions. As a result, 93.5 percent of any conversion would be taxable.

If you have no other IRAs, the calculation is simple. Better yet, the conversion will be tax-free because the amount converted will consist only of after-tax, nondeductible money.

An Effective Strategy

A Backdoor Roth IRA can be an effective strategy for dermatologists looking to build assets for retirement and achieve tax diversification in their overall portfolios. A professional financial advisor can help you understand the related IRS rules and successfully implement this strategy. The authors welcome your questions.

The authors have recently completed Wealth Planning for the Modern Physician. To receive free print copies or ebook downloads of this book or Wealth Management Made Simple, text PRDERM to 844-418-1212, or visit www.ojmbookstore.com and enter promotional code PRDERM at checkout.

David Mandell, JD, MBA, is an attorney and author of more than a dozen books for doctors, including Wealth Planning for the Modern Physician. He is a partner in the wealth management firm OJM Group (www.ojmgroup.com), where Bob Peelman, CFP® is a partner and Director of Wealth Advisors. They can be reached at 877-656-4362 or mandell@ojmgroup.com.

Disclosure: OJM Group, LLC. (“OJM”) is an SEC registered investment adviser with its principal place of business in the State of Ohio. SEC registration does not constitute an endorsement of OJM by the SEC nor does it indicate that OJM has attained a particular level of skill or ability. OJM and its representatives are in compliance with the current notice filing and registration requirements imposed upon registered investment advisers by those states in which OJM maintains clients. OJM may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. For information pertaining to the registration status of OJM, please contact OJM or refer to the Investment Adviser Public Disclosure web site www.adviserinfo.sec.gov.

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This article contains general information that is not suitable for everyone. Information obtained from third party sources are believed to be reliable but not guaranteed. OJM makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.