How A Roth IRA Can Save You Over $500,000

March 2015 ISSUE March 1, 2015
Retirement Plans IRAs (Roth, SEP, SIMPLE, etc.)
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Roth IRA Tax Benefits

Roth IRA earnings can be withdrawn tax-free any time after the later of age 59½ and at least five years after opening the Roth IRA. Also, amounts contributed to Roth IRAs (principal) can be withdrawn tax-free at any time. Moreover, neither Roth IRA earnings nor withdrawals are subject to the 3.8% Obamacare payroll tax on personal investment income (i.e. interest, dividends, capital gains, rental income, etc.).

In addition to these tremendous income and payroll tax benefits, there are also estate tax advantages. No distributions from Roth IRAs are required beginning at age 70½ as with traditional IRAs. Accordingly, the doctor need not tap into his Roth IRA during his lifetime, but can pass the balance down to his children, who can stretch out distributions over their lifetimes, allowing tax-free compounding to continue for decades.

Can You Fund a Roth IRA?

Virtually every doctor and spouse can fund a Roth IRA, either directly or indirectly. Doctors can make contributions directly into a Roth IRA if their Modified Adjusted Gross Income (MAGI) is below $116,000 in 2015 and $117,000 in 2016 (single), or $183,000 in 2015 and $184,000 in 2016 (married). Higher income doctors can make indirect, or “back door” contributions to a Roth IRA, which we first recommended back in 2010.  [Paragraph updated March 2016 with 2016 income limits.]

Under this approach, the doctor and spouse make the maximum annual contribution ($5,500 per spouse if under age 50; $6,500 per spouse if age 50 or older) into a non-deductible IRA and thereafter convert those contributions into a Roth IRA. This conversion is tax-free if handled as discussed below. Doctors should note that President Obama’s 2016 budget proposes to eliminate these “back door” Roth IRA contributions, although Congressional passage is unlikely this year.

Doctors who follow our recommended strategies for Roth IRA conversions can achieve federal income tax savings of over $500,000 as shown on the next page. With potential savings of this magnitude, it’s imperative that all doctors take maximum advantage of Roth IRAs.

Maximizing Tax-Free Roth Conversions

Most doctors have one or more IRAs that contain not only after-tax IRA contributions, but also earnings and rollovers from prior retirement plans. Brett Miller, CPA, CFP®, a wealth manager with McGill Advisors, Inc., has helped dozens of doctors achieve tax-free Roth conversions, using the following five-step process:

  1. Calculate the cumulative amount of after-tax contributions that have been made to the doctor’s IRA. Tax laws require doctors to keep a running record of their non-deductible IRA contributions and report them to the IRS on Form 8606 attached to their annual federal income tax return. If the doctor lacks these records, he may be able to obtain this information from his investment advisor. Otherwise, the doctor must simply estimate his prior non-deductible contribution.
  2. Once the doctor has confirmed his total cumulative non-deductible contributions, he should roll over the remaining taxable portion of his IRAs into a qualified retirement plan, such as a 401(k) or defined benefit plan in which he is participating. This leaves only the non-deductible contribution amounts in the IRA. The ability to roll the fully taxable portion of an IRA into a retirement plan is not automatic. Rather, the retirement plan document must allow this option. Accordingly, the doctor must contact his retirement plan advisor to assure that his plan allows this, or if not, is amended to allow it.
  3. Convert the regular IRA containing only after-tax non-deductible contributions into a Roth IRA. Since the doctor’s tax basis is equal to the cumulative amount of the contributions, there will be no tax due on this conversion.
  4. Thereafter, the doctor and spouse should make the maximum contribution to their non-deductible IRAs each year.
  5. Immediately thereafter, the doctor and spouse should convert these amounts tax-free into their Roth IRAs each year.

Low Cost Roth Conversions Following Practice Sale

Most doctors with whom we consult receive all of their practice sale proceeds in cash at closing. After paying the taxes on the sale (mostly at favorable capital gains rates), we recommend that the doctor live off the after-tax sales proceeds first, which usually last 5-8 years depending on lifestyle. As a result, the doctor usually has very little taxable income during these post-sale years, until he begins withdrawing mandatory distributions from his taxable IRA beginning at age 70½. This provides a tremendous opportunity to convert substantial amounts from his regular taxable IRA into his Roth IRA at extremely low income tax rates.

For example, a doctor sold his practice at age 62 and was able to live off the after-tax practice sale proceeds for eight years until age 70. During this time period, he had no other income.

Following the practice sale, the retirement plan was terminated and his share of the proceeds rolled over into his regular IRA. His goal was to accumulate a $1,000,000 Roth IRA balance by age 70, starting from zero. Accordingly, this required him to convert $97,211 annually ($8,100.92 monthly) to achieve that goal, based on a 6% return.

The $97,211 Roth conversion was fully taxable. However, a portion of this income was offset by the doctor’s personal exemptions for himself and his spouse ($4,000 each in 2015) and $32,000 in itemized deductions (state income taxes, property taxes, home mortgage interest, and charitable contributions). He owed $7,659 in federal income taxes annually on the remaining $57,211 of taxable income, or a total of $61,272 over the 8-year period.

Future Tax Savings in Retirement

While the doctor was impressed by the minimal taxes paid on his post-sale Roth IRA conversions, he still wanted to know how much his future tax savings would be. The tax savings are summarized by the chart below, assuming that the doctor had $4,000,000 in total IRA balances at age 70, which were withdrawn in equal monthly payments over a 30-year period, at a 6% investment return.

If the doctor had not undertaken the Roth IRA conversions, the entire $4,000,000 would be held inside his taxable IRA. Based on a 6% investment return, the annual distributions over the next 30 years would be $287,784. However, since the doctor had accumulated $1,000,000 in his Roth IRA, only $3,000,000 was still held in his taxable IRA, requiring a pay-out of $215,838 over 30 years at a 6% return. Accordingly, because of the Roth IRA conversions, the doctor would withdraw $71,946 less in taxable IRA proceeds each year during retirement.

Based upon $40,000 in deductions and personal exemptions, the doctor would owe income taxes of $57,298 if all of his IRA funds were held inside a taxable IRA, but only $36,285 annually since $1,000,000 of his IRA proceeds were held inside a tax-free Roth. As a result, income taxes were reduced by $21,013 a year, or $630,390 over this 30-year period. Subtracting out the $61,272 in taxes paid on the Roth IRA conversions from ages 62-70 provides net federal income tax savings of $569,118 for this doctor.

A. Reduced Income Taxes on IRA Distributions

B. Taxes on Annual Roth IRA Conversions (Ages 62-70)

C. Total Income Tax Savings over 30-year Period

The actual tax savings may be higher than that shown, if future federal income tax rates increase. Moreover, state income tax savings may also be realized. Finally, if a doctor does not withdraw all of his Roth IRA funds during this lifetime, and passes the balance to his children, the tax savings will be substantially increased since they will withdraw the proceeds over their life expectancy.

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