How To Properly Execute The 'Backdoor' Roth IRA Strategy for Medical Providers

Introduction:

The Backdoor Roth IRA is a hot topic within the medical community. The idea of building tax-free retirement assets is enticing, especially for high-earners.

In searching for resources for my clients who were interested in pursuing the strategy, I came across a lot of articles explaining the concept of the Backdoor Roth IRA, but very few who actually outlined the specific steps one should take in order to execute the strategy effectively.

In this article, we'll delve into the mechanics of this approach, exploring how it works and why it can be a valuable addition to your investment toolkit.

Understanding the Backdoor Roth IRA:

The Backdoor Roth IRA strategy is a workaround for high-income earners who are otherwise restricted from contributing directly to a Roth IRA due to income limitations based on your Modified Adjusted Gross Income.

However, the Backdoor Roth IRA strategy allows these individuals to contribute indirectly by utilizing a two-step process: making a nondeductible contribution to a Traditional IRA and then converting it to a Roth IRA.

Benefits of the Backdoor Roth IRA Strategy:

1. Tax-Free Growth: Once the funds are in the Roth IRA, any future earnings and withdrawals are tax-free, providing a powerful tool for tax-efficient wealth accumulation.
2. No Required Minimum Distributions (RMDs): Unlike Traditional IRAs, Roth IRAs do not mandate RMDs during the account holder's lifetime, offering greater flexibility in managing retirement assets.
3. Diversification of Tax Treatment: Incorporating Roth accounts into your retirement portfolio allows for tax diversification, giving you the ability to manage tax implications strategically in retirement.

Considerations and Potential Pitfalls:

1. Pro Rata Rule: It's crucial to be aware of the pro-rata rule, which considers all Traditional IRA assets when converting to a Roth IRA. This can complicate matters if an individual has pre-existing Traditional IRA balances with deductible contributions.
2. Tax Implications: While the initial contribution is nondeductible, any gains in the Traditional IRA at the time of conversion are subject to income tax. This can be minimized if the Roth IRA conversion is done shortly after the contribution is made to the Traditional IRA (e.g. the next day).

Step-By-Step Guide for Completing the Backdoor Roth IRA Strategy

Step 1A: Determine if you can execute the Backdoor Roth IRA Strategy

When determining if the Backdoor Roth IRA, it’s easy to forget about the pesty Pro Rata Rule. The Pro Rata Rule basically says that you can’t pick and choose what IRA dollars you convert to Roth, it’s got to be an aggregation of all of your pre-tax IRA assets.

Ex. If you have $200,000 of pre-tax dollars inside a Traditional IRA and you make a $7,000 non-deductible contribution to the Traditional IRA with hopes of converting the entire amount to Roth Tax-Free, you won’t be able to. You would only be able to convert roughly 3.5% of the $7,000 tax-free, the rest would be taxable ($7,000/$207,000= ~3.5%).

That’s why The Backdoor Roth IRA is best for those who don’t have pre-tax IRA assets (assets held in pre-tax 401(k)s or 403(b)s aren’t considered in the pro-rata rule).

If you have a small amount of pre-tax IRA dollars, you can either consider converting them to Roth (and paying income taxes on the conversion) to ‘empty out' your Traditional IRA for executing the Backdoor Roth IRA in the future

NOTE: If you have a large pre-tax IRA, you may want to consider a rollover into an Employer plan (if your employer allows incoming rollovers) or avoid the Backdoor Strategy altogether and work on another way to save money like a Brokerage Account.

Step 1B: Determine your Modified Adjusted Gross Income (MAGI)

A majority of Americans will be able to contribute to a Roth IRA without needing to use the Backdoor strategy since the income eligibility thresholds are high.

Your MAGI is essentially your gross income minus some key deductions. Here’s a great article by NerdWallet on how to calculate your MAGI.

For most people, calculating your MAGI consists of taking your gross income minus any pre-tax retirement contributions and/or Health Savings Account/Flexible Spending Account Contributions.

For reference, if you are Married Couple that files your taxes Jointly, your Roth IRA eligibility starts to phase-out at $230,000 of MAGI (here’s a reference of the 2024 Tax Numbers).

Let’s say you and your partner have a gross income of $280,000 but each contribute to your 401(k) up to the annual max of $23,000 and you also max out your HSA at $8,300. Your MAGI would be $225,700, thus making you eligible for a Roth IRA without needing to use the Backdoor strategy. ($280,000-$46,000-$8,300)

Let’s use the same example but increase your gross income to $350,000. Your MAGI would be approximately $296,000, making the Backdoor Strategy necessary if you want to contribute funds to your Roth IRA.

Step 2: Traditional IRA Contribution

Contribute to Traditional IRA:

• Make a contribution to a Traditional IRA (2024 contribution limit = $7,000 or $8,000 if over age 50).

Step 3: Roth Conversion

Convert Traditional IRA to Roth IRA:

• Execute the conversion of the non-deductible Traditional IRA contribution to a Roth IRA. This can be done within the same tax year.
• When executing the Backdoor Roth IRA, it’s recommended that you don’t invest the funds until you complete the conversion process and the funds are in your Roth IRA. If you invest the funds in your Traditional IRA before converting to Roth, any gains you make in your Traditional IRA will be treated as income once converted.

Step 4: File Form 8606

Complete Form 8606 - Part I:

• Submit Form 8606 along with your tax return if you file your own taxes. If you’re working with a tax preparer, they should complete Form 8606 for you.

Sections to Complete:

[The following is instructions for completing Form 8606 for Tax Year 2023 assuming you have NO pre-existing pre-tax IRA assets, you're under age 50, and made your Traditional IRA contribution before 12/31/2023]

• Line 1: Enter the total amount contributed to the Traditional IRA.
• Line 2: Should be $0 (assuming you had no money in a Traditional IRA as of 12/31). If you do have pre-existing Traditional IRA assets, refer to the pro-rata rule. Be sure to work with an accountant before executing the Backdoor Roth IRA if you have pre-existing Pre-tax IRA assets (Traditional IRA, SIMPLE IRA, SEP-IRA, etc.).
• Line 3: Add lines 1 and 2.
• Line 4: Should be $0 unless you made the contribution for the prior year between 1/1 and 4/15 of the current year.
• Line 5: Subtract Line 4 from Line 3
• Line 6: Should be $0
• Line 7: Should be $0
• Line 8: Enter the amount you converted from your Traditional IRA to Roth. Should be $6,500
• Follow instructions on Form 8606 for Lines 9-13
• The remaining Lines in Part I Should be $0

Form 8606 - Part II

• Line 16: Enter the number from Line 8
• Line 17: Enter number from Line 11
• Line 18: Assuming the form is done correctly, Line 18 should show a taxable amount of $0 on the conversion (thus completing the Backdoor Roth IRA Strategy).

Form 8606 - Part III

• For purposes of completing the Backdoor Roth IRA Strategy, Part III of Form 8606 doesn’t need to be completed.
• Be sure to still review Part III of the form to make sure none of the questions apply to your situation. ?

Step 7: Keep Records

1. Maintain Detailed Records: Keep thorough records of your Traditional IRA contributions and conversions is crucial for future tax filings and to demonstrate the tax basis of your Roth IRA. When it’s all said and done, there’s 3 forms that you should keep for your records pertaining to the Backdoor Roth IRA.

1. Form 5498 (from Traditional IRA) – Usually isn’t sent out until May/June so it doesn’t need to be filed with your tax return. ?
2. 1099-R (from Traditional IRA) – IRS form that IRA distributions are reported on.
3. Form 8606 – Used to report non-deductible contributions and Conversions from Traditional IRA to Roth IRA.

Get in touch with me:

If you have questions on how to build a retirement plan that fits your goals, feel free to reach out to me at [email protected] or schedule a meeting with me at https://www.advancedpracticeplanning.com/contact.

If you want financial tips and strategies that you can implement in your daily life, feel free to sign-up for my weekly newsletter:

https://www.advancedpracticeplanning.com/financial-soap-notes

Disclosures:

The information provided in this article is for educational purposes only. It is not intended as financial advice, legal, or tax advice, and no content within should be construed as such. The content is based on general financial principles and concepts, and individual financial situations may vary.

Readers are encouraged to consult with a qualified financial, legal, tax or any other professional needed to address the personalized advice regarding their specific financial circumstances. Any action taken by readers based on the information presented in this article is at their own discretion and risk.

The author and publisher of this article make no representations or warranties with respect to the accuracy, applicability, or completeness of the information provided.

This article does not endorse or promote any specific financial products, services, or companies. It is the responsibility of readers to conduct their own research and due diligence before making any financial decisions.

About The Author

Caleb Pepperday, CFP?, ChFC? provides Fee-Only Financial Planning and Investment Management Services for medical professionals. Advanced Practice Planning, LLC is based in Missoula, MT, but primarily works with clients in a virtual capacity nationwide. As a CERTIFIED FINANCIAL PLANNER? and fiduciary, Caleb Pepperday works to create financial plans for medical professionals with their best interest in mind. As a Fee-Only financial planner, Caleb Pepperday is only compensated through the investment management or financial planning fees that you pay him directly and never earns a commission. Caleb Pepperday primarily focuses on working with mid-career Physician Assistants/Physician Associates (PA-C), Certified Registered Nurse Practitioners (CRNP), and Certified Registered Nurse Anesthetists (CRNA), but has clients in a variety of professions (particularly relating to the spouses of Advanced Practice Providers).