Roth IRAs have a lot of advantages with regards to investing, tax reduction, asset protection, and estate planning. Even high-earners should be grateful to Senator William Roth who was the sponsor of the legislation that established Roth IRAs back in the 1990s.
The Basics
Anyone with earned income can open a Roth IRA and contribute up to $5000 per year. If income is sufficient, one can also open a Spousal Roth IRA and contribute another $5000. If you’re over 50, those limits are raised to $6000 per year. There is a contribution income limit, meaning if you make more than $120K (single) or $179K (married), you can’t contribute to a Roth IRA. However, there is no income limit to Roth IRA conversions, so that leaves the option for a Backdoor Roth IRA wide open for most physicians.
You contribute to a Roth IRA with after-tax money, but it is never taxed again. You don’t pay taxes on capital gains and dividends as the money grows, and it comes out tax-free in retirement. You generally can’t access the money before age 59 1/2 (see the exceptions here), but unlike a 401K or traditional IRA, there are no required minimum distributions beginning at age 70.
Investing Advantages
Roth IRAs are tax-protected. This allows you to invest in tax-inefficient investments, like REITs, TIPS, taxable bonds, and peer to peer lending. You can also buy and sell investments to rebalance, or simply change your portfolio without tax consequences. Unlike a 401K, you are essentially unlimited in the investments you can choose for a Roth IRA. So you can choose the best investments. If you go to a low-cost provider such as Vanguard, you’ll almost always pay much less in fees with a Roth IRA than with your 401K. In investing, you get (to keep) what you don’t pay for.
Tax Advantages
I already mentioned that you get to save a lot of taxes with a Roth IRA since after the initial contributions, it is never taxed again. The fact that both pre-tax (like traditional IRAs and 401Ks) and post-tax investment accounts are available allows you to diversify your taxes, minimizing the taxes you pay over your lifetime. For instance, a resident ought to preferentially use an after-tax investment and an attending ought to preferentially use a pre-tax investment. Roth conversions can be done during years of low income, and then in retirement, tax diversification allows you to minimize the taxman’s bite. In addition, practicing physicians ought to continue to make Roth IRA contributions via the Backdoor Roth IRA, as long as they can max out their tax-deferred options like 401Ks first.
Asset Protection
Many of the steps you do to facilitate estate planning, reduce taxes, or protect your assets have nasty side effects. For instance, some asset protection techniques increase your tax bill or hurt your estate planning efforts. Tax reduction techniques can often hurt your investment return. But with a Roth IRA, you get all these benefits without side effects. Roth IRAs are generally protected from your creditors in most states. Many states offer unlimited protection of a Roth IRA.
Estate Planning
A Roth IRA is so good for estate planning that many people preferentially try to leave their Roth IRA to their heirs rather than any other assets. Not only is the money completely tax-free to your heirs, but the IRA can be “stretched” by your heirs, possibly allowing more than a century of tax-free growth. The assets do count toward the estate tax exemption limit (currently $10 Million for married taxpayers), but as long as it remains at least that high, it really isn’t much of an issue.
Thanks to maxing out my Roth IRAs in residency and during military service, some Roth conversions, and continuing to use backdoor Roths, fully half of my retirement portfolio will never be taxed again. If you want a great start tfor your next egg, I can think of no better vehicle.
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What happens if the clowns in congress decide to tax withdrawals of Roth IRAs at some point? It’s not like they haven’t changed the rules regarding taxation before [Social Security income used to be tax free]. I’d rather take my tax break now with a defined contribution plan. At least I know what tax break I am really getting.
actually you dont know what tax break you will be getting. I wouldnt be surprised that in the future that taxes for all classes are higher and thus you could accidentally defer into the exact same tax rate or possibly even a higher rate. Now personally im betting that wont happen but i think its possible.
Great post. I had looked into this topic a couple of years ago when the income limitation for conversion was lifted. For estate planning purposes, transferring a Roth IRA to your beneficiaries on your death can be a very valuable decision. The beneficiary receives an asset which will grow at a compounded rate tax-free for his lifetime, and any withdrawals made will be completely tax-free. One point of clarification should be made though… the transfer of the Roth to your heirs is not tax-free. Unfortunately, the Roth IRA is still subject to Inheritance Tax (here in PA) and Federal Estate Tax at the owner’s death. Even with the double-taxation, this is still far better than a traditional IRA or 401(k) transfer to heirs.
Mark and Rex- Remember that with a Roth IRA you save on taxes at your marginal rate, then pay taxes at your effective rate in retirement. So tax rates need to go up quite a bit (or you need A LOT of retirement income) to be hosed with a pre-tax investment. For an attending, deferring tax now is probably the right move. But when you’re choosing between a taxable account and a backdoor Roth, you probably ought to go with the Roth every time. But yes, there is a risk that Congress can change the rules.
RheumDoc- You’re right that a stretch Roth IRA can be subject to estate/inheritance taxes. But unless you have more than $5 Million (single, $10 million married) it won’t be subject to federal inheritance taxes. State inheritance taxes vary, and some states have only a $1 Million exemption which would catch many docs, so it is quite possible that the estate will owe taxes on a stretch IRA left behind. If it is smart, it’ll pay those taxes out of another pot of money and preserve the Roth benefits as much as possible.
In the article, you should mention the backdoor roth for the individuals making the physician salary. I believe taxes will be higher in the future due to government debt.
I’m a resident getting ready to make the transition into attendinghood, and I was curious about the backdoor IRA conversion. If you set up a SEP IRA and then a post-tax backdoor IRA conversion, do you have to pay tax pro rata as if you had a “traditional” IRA? Is an SEP IRA counted as the same as a traditional IRA in this case?
Yes, a SEP-IRA counts as a traditional IRA for roth conversion purposes. You need to get rid of it by either converting the whole SEP to a Roth, or rolling it into a 401K or perhaps even your own solo 401K.
I’ve added a link in the post to my page on Backdoor Roth IRAs.
Hi White Coat Investor,
Thanks for the info, Roth IRAs are my favorite savings tool because they are so flexible and they have so many tax benefits. One of the benefits of a Roth IRA is that you can take out up to $10,000 without paying any tax or penalty. However, there are some rules to follow in order to get the tax-free, penalty-free treatment, so make sure you do your homework before you take a withdrawal.
All the Best