Every now and then, Congress tosses doctors and others with high salaries a bone. Physicians are phased out of many of the loopholes in the tax code, such as the ability to make contributions to a Roth IRA or deduct their contributions to a traditional IRA. But starting in 2010, Congress changed the rules. There is no longer an income limit on converting a non-deductible traditional IRA to a Roth IRA. This is a great way to save some money if you are already maxing out your other retirement plans or if you simply want to have some tax diversification of your retirement assets. There’s only one small catch. First an example, then the catch.
Our hero the physician decides on January 2nd to put $5000 into a traditional IRA for himself and another $5000 into a traditional IRA for his wife. His income is too high to be able to deduct these contributions from his taxes. So the next day he converts the traditional IRAs to Roth IRAs completely tax-free. His income is too high for him to make a direct contribution into an IRA, but there’s no limit on conversions! And since he couldn’t deduct the contribution anyway, he might as well get the advantage of never paying taxes on that money again available through the Roth IRA.
Now the catch. If you have any other traditional IRAs, this can really screw up the conversion due to the pro-rata rule. This basically says that if you have both pre-tax traditional IRAs (includes SEP-IRAs and SIMPLE IRAs) and non-deductible traditional IRAs, you must convert them “pro-rata.” So if you have a $20,000 pre-tax IRA and a $5000 non-deductible IRA, and you convert $5000 of it to a Roth IRA, you’ll end up having to pay taxes on $4000 of that conversion. You only want to do that if you’re in a low marginal tax bracket (which most physicians aren’t.) So you must somehow find a way to isolate that non-deductible IRA. The easiest way to do this is to roll it into a 401K if possible. (Most 401Ks allow this.) Traditionally, financial advisers have recommended that you roll your 401Ks over to IRAs every time you change employers to take advantage of lower fees and better investment choices. The Backdoor Roth IRA shows at least one reason why it might be better to leave the money in the 401K.