Do you think $2 million in the bank is a lot for retirement? Depending on the state you live in, your tax liability could potentially cut that amount in half. High-income retirees in the most tax-friendly states can expect to owe at least 37% to the government. In metropolitan areas such as Los Angeles and New York, this amount exceeds 50%.
No one wants their retirement nest egg cut in half, and our lawmakers understand that to some 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 singles earning over $144,000 and married couples earning over $214,000.
Private practitioners with annual incomes below these amounts should undoubtedly pay the maximum annual allowance of $6,000 ($7,000 for those age 50 and older) directly into a designated Roth IRA account. But what about dentists whose annual income exceeds this threshold? Luckily for them, there is a legal loophole under current IRS guidelines that allows them to procure exactly the same benefits given to the middle class, for now anyway. We will talk later about his possible disappearance.
Invest your money wisely
Known colloquially as the Roth IRA backdoor, it’s not so much an account as a way to intelligently access an account through conversion. In three steps, any employee, regardless of income level, can contribute to a Roth IRA that will generate tax-free income throughout retirement and beyond. To begin the process, simply fund a traditional IRA with the maximum amount allowed, usually $6,000, but with after-tax money. (Normally, you would fund such an account with pre-tax income for immediate tax deduction.) Second, convert the funds into a Roth IRA, preferably immediately. The third step? Invest the allowance.
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This last step is perhaps the most critical. It should go without saying, but without investing money, the Roth IRA is of no benefit to you. It’s about growth and the protection of the resulting revenue from taxation. In addition, the investment must be made after conversion to avoid paying taxes on potential earnings.
You are now ready to invest. Where to start ? The majority of experts recommend diversification, and fortunately a variety of low-cost, broad-market index funds exist to help achieve this goal. Generally, the earlier you start the process, the more aggressive you can be when selecting your specific assets. I recommend consulting a financial advisor to fully explore the options that are best for you.
Once you’ve started the process, make it an annual tradition. The easiest route is to do the conversion all at once, usually every January. Also, to report that your contributions are in fact non-deductible, you will use tax form 8606 when filing your return for that particular year. If you already have a traditional IRA established, you can still perform the backdoor conversion. However, you will need to report any income from the funds before they are converted. Consult with your tax professional to ensure that all past income is properly documented to avoid possible penalties.
Once your Roth IRA is 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 following their conversion. Some notable exceptions to this rule come into play if you become disabled or die, leaving your account to your beneficiaries. Note that a new five-year clock is attached to each annual conversion until you reach age 59½, at which point they all automatically disappear and you will have unlimited access to the original contributions.
As for the earnings? It’s a whole different story. A second five-year rule prohibits investors from withdrawing any income on amounts converted over the past five years, regardless of age. In other words, although you can withdraw all initial contributions after age 59.5, you must wait at least five years before you can withdraw income from their respective contributions. In the event that you have made your final contribution at 59½, then at 64½ your entire balance will be available to you without penalty. If you decide to make retirement contributions, consult a tax professional to find out what funds you can safely access without penalty.
Many advantages to this strategy
Although it sounds a bit complicated, the benefit of having a dedicated retirement income stream from a Roth IRA is enormous. Besides the incredible tax benefits, Roth IRAs don’t require minimum withdrawals at age 72, an unfortunate caveat of traditional IRAs. The absence of required minimum distributions allows greater flexibility in asset preservation and management. You can easily save these funds for much of your golden age or even leave them to your heirs. Also, because withdrawals aren’t considered taxable income, they don’t take into account whether you pay Social Security taxes or what extra you might pay for your health insurance premiums.
Sounds almost too good to be true, doesn’t it? This is not the case, at least for now. Although it seems safe for now, lawmakers are well aware of the smart device and they have understood some billionaires who allegedly misused it. Pending legislation known as Secure Act 2.0 may eventually close this gap. Only time will tell. However, most experts agree that even if new legislation is passed, it will not be retroactive. Conversions made today will likely be grandfathered. Thus, it is incumbent on all high earners to take advantage of this exceptionally lucrative strategy as soon as possible.
All investments involve an element of risk. It is best to consult an advisor for a comprehensive approach. You can 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 originally appeared in the November 2022 print edition of Dental economy magazine. Dentists in North America can take advantage of a free print subscription. Register here.
