Do you think $2 million in the bank is a lot for retirement? Depending on the state where you live, your tax liability could potentially reduce that amount by half. High-income retirees in the most tax-friendly states can expect to owe a minimum of 37% to the government. In metropolitan areas such as Los Angeles and New York City, that amount hovers above a whopping 50%.
Nobody wants their retirement nest egg cut in half, and our lawmakers understand this to a certain extent. Roth IRAs have long been the crown jewel when it comes to earning tax-free income in retirement. Specifically designed for the middle class, these investment vehicles appear off limits to single earners making more than $144,000 and jointly filing married couples making more than $214,000.
Private practitioners with annual incomes below these amounts should without a doubt contribute the maximum yearly allotment of $6,000 ($7,000 for those aged 50 and older) directly into a designated Roth IRA account. But what about dentists with yearly incomes above this threshold? Fortunately for them, there is a legal loophole in accordance with current IRS guidelines that allows them to procure the exact same benefits afforded to the middle class—for now anyway. We’ll talk more about its possible disappearance later.
Cleverly invest your money
Known colloquially as a backdoor Roth IRA, it’s not so much an account as a means to cleverly access an account via conversion. In three steps, any income earner, regardless of earning level, can contribute to a Roth IRA that will yield tax-free income throughout retirement and beyond. To begin the process, simply fund a traditional IRA with the maximum allowable amount, typically $6,000, but with after-tax money. (Normally, you would fund such an account with pretax income for an immediate tax deduction.) Secondly, convert the funds to a Roth IRA, preferably immediately. The third step? Invest the allocation.
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That last step is perhaps the most critical. This should go without saying, but without investing the money, the Roth IRA is of zero advantage to you. It’s all about growth and protecting the resultant proceeds from taxation. Furthermore, the investment must happen after the conversion to avoid paying taxes on potential earnings.
Now you’re ready to invest. Where might you begin? The majority of experts recommend diversification, and thankfully a variety of low-cost, broad-market index funds exist to help achieve this goal. Typically, the earlier you begin the process, the more aggressive you can be when selecting your specific assets. I recommend consulting with a financial advisor to fully explore which options are best for you.
Once you’ve started the process, make it a yearly tradition. The most straightforward route involves performing the conversion all at once, customarily every January. Also, to report that your contributions are in fact nondeductible, you’ll use Tax Form 8606 when filing your return for that particular year. If you already have an established traditional IRA, you can still complete the backdoor conversion. However, you will have to report any earnings from the funds prior to their conversion. Consult with your tax professional to ensure all previous earnings are properly documented to avoid possible penalties.
Once your Roth IRA has been established, there are two rules regarding withdrawals. The first stipulates that you will not be able to access your deposited funds without penalty for the first five years after their conversion. Some notable exceptions to this rule come into play if you become disabled or you pass away, leaving your account to your beneficiaries. Note that a new five-year clock is attached to each yearly conversion until you reach the age of 59½, at which point they all automatically drop off and you’ll have unlimited access to the original contributions.
As for the earnings? That’s a different story altogether. A second five-year rule prevents investors from withdrawing any earnings on sums converted within the past five years, regardless of age. In other words, while you can withdraw any and all original contributions after 59½, you must wait a minimum of five years before you can withdraw earnings from their respective contributions. In the event you made your final contribution at 59½, then at 64½ your entire balance will be at your disposal penalty free. If you decide to make contributions into retirement, consult with a tax professional for guidance on which funds you can safely access without penalty.
Many advantages to this strategy
Even if it seems a tad complicated, the upside to having a dedicated stream of income in retirement from a Roth IRA is enormous. Aside from the incredible tax advantages, Roth IRAs do not necessitate minimum withdrawals at age 72, an unfortunate caveat of traditional IRAs. The lack of required minimum distributions allows greater flexibility with regard to asset preservation and management. You can readily save these funds for well into your golden years or even leave them for your heirs. Also, since withdrawals are not counted as taxable income, they don’t factor into whether you pay taxes on Social Security or the extra you might pay for your Medicare premiums.
It almost sounds too good to be true, doesn’t it? It’s not––at least for the time being. While it looks safe for now, lawmakers are well aware of the clever device, and they’ve caught on to some billionaires who have allegedly abused it. Pending legislation known as the Secure Act 2.0 could ultimately close this loophole. Only time will tell. However, most experts agree that even if new legislation is passed, it won’t be retroactive. Conversions made today will likely be grandfathered. Thus, it behooves all high-income earners to take advantage of the exceptionally lucrative strategy as soon as possible.
All investments involve an element of risk. It’s best to consult with an advisor for a comprehensive approach. You may contact us at (973) 422-9140 or [email protected]. My staff and I would be more than happy to assist you.
Editor's note: This article appeared in the November 2022 print edition of Dental Economics magazine. Dentists in North America are eligible for a complimentary print subscription. Sign up here.
