WCI #7: Backdoor Roth IRAs and Why You Should Be Funding Them

This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here's your host, Dr. Jim Dahli.

No more wading through dozens of books at the library, scrolling through hundreds of blog posts on dozens of blogs, or checking in daily with online forums trying to gain a financial education the way the hobbyists do for a fraction of the price of hiring a professional financial financial planner. The Fire your financial advisor online course will take you from feeling anxious and having no plan to having a written financial plan. You can follow the rest of your investing career as a professional and a retiree. This course is the material that should have been taught to you in college, medical school or residency, but never was. Fire your financial advisor also has a version eligible for CME credit. Get your financial life in order today. Go to whitecoatinvestor.com courses to sign up. You can do this and the White Coat Investor can help.

Thank you for what you do. You're probably commuting into your job or maybe commuting home after a hard day and sometimes it feels like you're not really making much of a difference. But I can assure you you are. I had a patient last night who was pretty ill when she came in. She'd apparently turned down the medics when they tried to bring her in two days earlier and by the time her roommate finally drug her in, she had kidney failure and hyponatremia and some dead bowel. But you know what? At midnight I call in the surgeon and anesthesiologist and they come in and take care of her. Even though they weren't sure they were going to be paid, they weren't sure they were going to be able to make a difference. But there they were taking good care of her. And that's the sort of thing that we do as high income professionals and it really makes a difference in the lives of others. We've been having a lot of fun with this podcast. It's something that obviously we've never done before around here at the White Coat Investor, but it turns out that it really is reaching a different audience than those who will read the blog or read the newsletter or participate on the forum. Thanks a lot especially for all the great feedback we've been getting. Remember that the good ratings go to your podcast provider and all the bad feedback comes to us via email. Also, be sure to send any questions you want addressed on the show to editorhitecoatinvestor.com or via Twitter tocinvestor. Or you can even send it in a Facebook message if you like. Be sure to let me know your name and location. Or if you prefer just that you want to be anonymous with your question. We've been podcasting now for about 10 days and we've had 19,000 downloads of the podcast, so that's been pretty exciting for us. We've been gotten a lot of great feedback as well that has taught us a lot more about podcasting that we didn't even know. For instance, we were told that we needed to get a de Esser. I didn't even know there was such a thing as a de Esser, but apparently you you can have too many S's and too much of an S sound coming through in your podcast. And so we're trying a few different things with the microphone today to see if we can get rid of that. If not, I think we're going to have to buy some expensive equipment to get rid of those S's. I'm also being told to slow down and vary my pacing more. Yet then I get other emails from people who say, oh, I like listening to your podcast at 1.5 times speed. Well, if you want me to if you like listening at 1.5 times speed, why don't I just speak at 1.5 times speed? Anyway, I'll try to vary my pacing a little bit more. Other readers tell me I need to use she at least as much as I use he, so I'm going to try to do that today. Yet other readers tell me I shouldn't use the word stupid but should still let my personality shine through. So I'm going to try not to say stupid nearly as much as I usually do. One advisor wrote in and said I shouldn't be so hard on advisors and tells me that it's a lot harder to be a do it yourselfer than I say it is. Well, that may be true, but you've got a little bit of a bias in saying that. Other people are asking for me to share the name and location of people who write in with questions. And so we'll try to do that when the person is willing to share it. And then of course we're going to try to read the sponsor ad at the same time as the podcast, rather than pre recording it or recording it afterward and inserting it in. Hopefully this will all make for a much more enjoyable podcast for you to listen to, but we'll continue to make improvements as we go. Today's subject is going to be the backdoor Roth ira, which is a pretty awesome trick if you've never heard of it. The best thing about it is it improves your Roth or tax free to tax deferred ratio of your assets in retirement. It's wonderful when you're retired to have both tax free and tax deferred assets because you can choose preferentially which one to pull money from and basically set your own tax rate in retirement wherever you want it to be. If you want the rate lower, you pull the tax free money out. If you want the rate a little higher, or if you just want to, you know, max out that bracket that you're in, you might pull a little more from the tax deferred side, but the backdoor Roth IRA allows physicians and other high income professionals to continue to get money into a Roth account during their peak earnings years without having to miss out on the super valuable tax deferred deductions available in a typical 401k. The reason the backdoor Roth IRA works is because of some legal changes that were made by Congress in 2010. Prior to 2010, a high income professional with a retirement plan at work, which is most doctors, could not deduct a contribution to a traditional ira. They also could not contribute directly to a Roth ira. In addition to that, they could not convert tax deferred money to, to Roth money because their income was too high. And so before that time, basically you tried to get as much as you could into a Roth IRA as a resident because you knew once you became an attending, you wouldn't be able to put any more in there. But in 2010, Congress changed one of those three rules. You still couldn't deduct a traditional IRA contribution and you still couldn't contribute directly to a Roth ira. But you were allowed to convert money from, from a traditional IRA to a Roth ira, no matter how high your income. And that change in law is what allows for the backdoor Roth ira. And here's how you do it. First, you contribute to a traditional IRA. That can be as much as 5,500 per month or per year. Excuse me, if you are under 50, and if you're over 50, it's $6,500 per year. You can also do one for your spouse, whether your spouse has earned income or not, as long as you have enough earned income to cover the contribution. So that's another 5,500 or 6,500 for your spouse to a separate traditional IRA in their name. Then the next day you can convert it to a Roth IRA because you never got a deduction for that traditional IRA contribution. The conversion to the Roth IRA is totally tax free. So that's a pretty cool trick there. Basically, you end up with the same end result as if you had contributed directly to a Roth IRA, but but you're able to do it legally. Step three in this process is to get rid of any SEP simple or traditional IRAs you may have by December 31st. It isn't the account you need to get rid of as the money in the account. And the reason for that is something called the pro rata rule. And I'll explain a little bit more about that in just a second. Finally, the last step is to make sure that you or your tax preparer fill out the tax paperwork correctly. The tax form on which you report all this stuff is Form 8606 and it's not that complicated. If you just follow the instructions, you can work your way right down it. I even have examples on the site on a blog post entitled Backdoor Roth IRA Tutorial which will tell you exactly how to fill out this form, whether you're using tax software or whether you're using paper. But make sure that that tax paperwork is filled out correctly. You should not be paying taxes twice on that $5,500. But I've seen a lot of tax preparers that have made that mistake. So be sure to look at the bottom of that form and make sure there wasn't any tax due on your backdoor Roth ira. The pro rata rule basically says that when you pull money out of a traditional ira, it comes out pro rata or in proportion with tax deferred versus post tax money. Because that money you're putting in to do a backdoor Roth IRA is post tax. But if you already have a bunch tax deferred money in there, pulling it out is going to give you a problem. The IRS doesn't let you just pull out the post tax money. You have to pull it out in proportion. And what that does, if you put 5,500 into a traditional IRA that already has a bunch of tax deferred money in it, then you may end up having to actually pay money on the conversion and leaving a bunch of the post tax money in the traditional IRA that you wouldn't want to do. So that's why you've got to get rid of that SEP simple and traditional IRA by the end of the year. And that's just a relic of the way they've made the form 8606 and the way your tax bill on the conversion is calculated on it, it's unfortunate. But that's one downside of doing this via the back door and the way to work around it is to get rid of that money. There's two ways to get rid of it. One, you can pay the taxes and just convert the whole thing to a Roth ira. And that's pretty easy to do if it's a relatively small IRA. If you only have a $5,000 traditional IRA, maybe you just want to pay the taxes and move that into your Roth IRA too. But if you have a $500,000 traditional IRA, that's probably not going to be such a wise idea in that sort of a situation. What you want to do is to roll that money into an individual 401k or your 401k at work. If you have a 401k at work, that's really easy. You just got to fill out a form and they'll take the money from your traditional IRA and put it in your 401k. If you don't have one at work or a 403B, you may have to get a little bit more creative. You may have to become self employed. That's not that big of a deal because you don't need much self employment income. $10 is probably enough. And you can get that from online surveys if you want. But if you have some self employment income, that that allows you to get a federal employee identification number and open an individual 401k, even if all you ever do with it is just roll in that traditional IRA you're trying to get rid of. Keep in mind that if you open an individual 401 at Vanguard, which is my usual default mutual fund provider, they don't allow you to do rollovers. So if you need to do a rollover into an individual 401, you might want to look at another individual 401 provider, such as Fidelity or, or E Trade. Now, a lot of people worry about what's called the step doctrine. And this is an IRS doctrine that basically says if the sum of a bunch of steps that are legal is illegal, then the whole process is illegal. And some people worry that this doctrine is going to be applied to the backdoor Roth ira. I think that's unlikely. And the reason why is I'm now in my eighth year of doing a backdoor Roth IRA from 2010 all the way to 2017, and I broadcast it widely on the website, as do thousands and Thousands of other high income professionals who are doing this every year. And yet I haven't heard of a single one who the IRS had a problem with and applied this step doctrine to, although it's called the backdoor Roth ira. Like it sounds like some tricky scheme that the IRS doesn't know about. They're very well aware of this. This has been written about in the Wall Street Journal and Forbes and hundreds of Internet forums. This is not being done in the dark. And besides, you fill out Form 8606 every year and tell them what you're doing. So it's not like the IRS doesn't know what you're doing. And both IRS and Congress seem just fine with it. As soon as I hear about somebody that has the step doctrine applied to their backdoor Roth ira, you'll be the first to hear about it. Some advisors have recommended you actually wait a period of time in between the contribution and, and the conversion steps in order to make it not look like a step doctrine issue. They say wait a few months or even a year. Michael Kitchies, who does a lot of blogging for financial advisors, recommends a year. But it really seems silly to me to do that because you're just going to go back the next year and do it again. So if the IRS comes and asks you, hey, what are you doing here? And you say, you know, I'm doing a, I didn't know I was going to do a backdoor Roth IRA when I made that contribution initially. That's why I waited a year. And then they see that you did it again the next year and the next year and the next year, you know, it's not going to be a very convincing argument. So that's why I just convert mine the next day. And if Congress wants to change the rules, we'll play by the new rules. If they don't, we'll continue doing this. A lot of people worry that Congress will change this to outlaw the backdoor Roth ira. And I suppose that's possible that they could. But it seems just as likely to me that they allow high income professionals to contribute directly to a Roth IRA as change it in any other direction. So there's really a lot of different ways it could be changed. But this is the way the law stands right now, so that's the way we should do our backdoor Roth IRA contributions. Remember that with the backdoor Roth ira, you're not comparing it to contributing to a tax deferred account because you cannot deduct the contribution you make to a traditional ira. So what you really should be comparing it to is having that $5,500 in a taxable account. And obviously if you have an option between a taxable account and a tax free account, the tax free account is going to be a no brainer every time. In addition, in most states, a retirement account like a Roth IRA receives significant asset protection from your creditors. Plus the estate planning with it is far easier. You can just name a beneficiary, and as the law currently stands, that beneficiary can even stretch withdrawals from that account over decades. And so it's really far preferable to have the money in a backdoor Roth IRA than in a non deductible traditional IRA or in a taxable account. There's another backdoor Roth IRA idea floating around out there that's been called the mega backdoor Roth IRA. And if your 401k allows it, this can be a slick trick as well. Basically, a 401k is allowed to have $54,000 a year if you're under 50, put into it as a combination of employee and employer contributions. Some employers allow you to make post tax, not Roth, but post tax contributions to your 401k. If they also allow you to take those post tax contributions and either pull them out and convert them to a Roth or convert them to a roth inside that 401k, then you are eligible for what is called the Mega backdoor Roth ira. This could work out to allow you to put as much as $54,000 a year into a tax free account, never to be taxed again. So be sure to look at the rules for your 401k to see if that is an option for you, if that's something you would be interested in. For most physicians in their peak earnings years, they should still be using a tax deferred account just because of the ability to put money in at their high marginal tax rate while in their working years and be able to pull it out and fill the brackets in their later years after they've retired or cut back on work. The right answer for most people when they're weighing between a tax deferred option and a Roth option if you're in your peak earnings years, is to use the tax deferred option. But for some people, if you're interested, the Mega backdoor Roth IRA can allow you to get an awful lot of money in a hurry into a Roth account. Alright, let's move on to a couple of questions I've gotten recently. The first comes from a resident, he says. I'm a third year resident heading for a $250,000 a year hospitalist job. I have no loans thanks to my mother who used her life savings to pay for my med school. I grew up in $150,000 house and I'm looking at a physician loan to buy a $500,000 house in a nice part of town. We won't have a down payment due to wedding costs and we'll probably use a physician mortgage to get it. My mom needs a new townhome and I want need have to buy it. It looks to be about $200,000 to $300,000 for this cost. She can't afford a mortgage nor will a bank give her one because she's retired. I said that I would be happy to pay, just that she would have to pay the 20% or whatever down and I would pay the monthly costs from there until I can ultimately give her the 20% back she paid. How can I get loans on both houses at the same time? Signed your Disciple well, shoot. If you're going to sign an email to me as my disciple, I've got to write you back and help you. Actually, this is why I do this though. I honestly love helping doctors with their financial questions, especially anybody who had described themselves as a disciple. I think it's great that you don't have student loans. That puts you ahead of most of your peers when it comes to your net worth. However, even without having student loans, I still wouldn't Buy a house for yourself for six to 12 months into your new job. You want to make sure the job likes you and you like it, then buy the house. Seriously, just rent. You can rent something nice in a nice neighborhood, but I'd probably just rent something small and avoid getting doc itis. Then at that point, if you need a physician mortgage, go ahead and use one, but you quite likely may have a 20% down payment by that time. I think it's super nice of you to buy your mom a house. I don't know where she lives now and how desperate the situation is to get her out, but I'd probably put it off for a year at least. In the meantime, she can come live in the mansion with you. Keep in mind that you're still broke even without student loans. You basically have no net worth and so income is not wealth and future income certainly isn't wealth. You just can't afford a $300,000 gift at this time. You can tell because you need to finance it. That's what Tells you you can't afford something. But just because you can't afford it now doesn't mean you can't very soon. If it's a big priority for you. And I think for a lot of doctors, this sort of a gift is a big priority. It's possible, in fact, that you could even buy her a house before you buy yours. I just think you're trying to do too much too soon. But give it a couple of years and sure go for it. If you still decide to go for it despite that advice, I think you're probably going to run into issues getting a loan on both houses at the same time. You can't get a doctor loan on a house you're not in, but with her 20% down payment, especially if they don't know it's a gift, you can probably get a conventional loan. Your terms won't be as good if they know you won't live in it, though. I think maybe one possible option for you would be to buy the little townhouse six months out of residency with the doctor loan, live in it yourself for six months, then buy your fancy doctor home six to 12 months later with or without a doctor loan. And then when you move into the big mansion, your mom gets the town home. There's lots of ways to skin this cat, but I think the key is going to be to drag your feet. Don't try to do this as a resident or a very brand new attending. If you can drag your feet out a year or two, you're going to be in a much, much better financial position to be able to do everything you want to do. Another listener writes in saying, I'm a pathologist in Texas, three years out of residency making $330,000 a year. I have a mortgage of $310,000, student loans of $260,000, two car payments and about $100,000 saved. My family is growing and we are quickly outgrowing our 2,000 square foot house. I have an opportunity to buy a really great house in the neighborhood for 600,000. It is worth almost 700,000. I can get a physician loan with 0 down at 4.2% with no PMI through the same bank that I have my existing mortgage with. I realize that the smartest thing to do is to pay student loans off as fast as possible, but I'm tired of grinding. In my mind, I feel like I can afford this new house and still pay extra toward my loans. So my question is, is this a stupid idea now? Remember the guy writing in said stupid, not me. So don't give me any bad feedback about using stupid again. Personally, I wouldn't buy a bigger house until the student loans are gone and the car's paid off. I don't think even a really good deal on a house would change my mind on that. Remember that just because you can afford to make payments doesn't mean you can afford something. This writer seems overly comfortable with debt. The current house is reasonable, but the fact that the cars aren't paid for and you still owe $262,000 in student loans after earning almost a million dollars since leaving residency is not reasonable. I mean, the net worth here three years out of residency is still something like minus $160,000. I mean, nobody wants to grind forever. But you can grind now or you can grind later. And if you decide you're going to spend a bunch of money you don't have yet, it might mean that you'll be working for five years later, five years longer at the end of your career. But I'm a little bit biased. My five siblings and I were raised in a 2000 square foot house and I certainly don't need the 4400 square foot house I have now for my family of six. In fact, it's a little bit of a pain to clean the extra floor we don't even need downstairs unless we have guests. What I do wish I had though is a little bit more space in my garage. Funny how you can never have enough room in the garage, isn't it? I agree that the right decision is to pay off the student loans as fast as possible, then upgrade the house. And I wonder if this person writing in was really expecting me to recommend something other than that. Life's fun though. You get to make your own decisions. Just remember that you can't escape the consequences of them.

No more wading through dozens of books at the library, scrolling through hundreds of blog posts on dozens of blogs, or checking in daily with online forums, trying to gain a financial education the way the hobbyists do, for a fraction of the price of hiring a professional financial planner. The Fire your financial advisor online course will take you from feeling anxious and having no plan to having a written financial plan. You can follow the rest of your investing career as a professional and a retiree. This course is the material that should have been taught to you in college, medical school, or residency, but never was. Fire your financial advisor also has a version eligible for CME credit. Get your financial life in order today. Go to whitecoatinvestor.com courses to sign up. You can do this and the white coat investor can help.

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