IRAs: Types and Strategies For High Income Earners

When investing for retirement, there are several decisions that will determine how successful your plan is. Three of the most important decisions are how much to save, your asset allocation (choosing which investments to hold and in what proportions), and which accounts you use. This article will focus on the account side – specifically individual retirement accounts, or IRAs – as opposed to employer-sponsored retirement accounts like 401(k)s and 403(b)s. We will provide an overview on the differences between the main IRA types, their income restrictions and strategies cardiologists can use to take advantage of favorable tax legislation.

You can think of an investment account like a bucket that holds your investments and determines how these are taxed, how much you can contribute into them, and which types of securities you can hold within them. The two most common types of individual retirement accounts, or "individual retirement arrangements" as the IRS titles them, are traditional IRAs and Roth IRAs. Traditional IRAs are pre-tax retirement accounts and share the same tax characteristics as 401(k)s and 403(b)s with tax-deductible contributions, tax-deferred growth, and distributions taxed as ordinary income. Roth IRAs are post-tax retirement accounts, which do not offer tax deductible contributions, but do provide tax-deferred growth and qualified withdrawals result in tax free income. As most employer-provided retirement plans allow large pre-tax contributions, it can be beneficial to contribute to a Roth IRA to build a source of income that will not be taxed. The IRS imposes different restrictions on these accounts for high income earners.

The ability to directly contribute to a Roth IRA is restricted based on an income range that most cardiologists will be above after training. Traditional IRAs also have an income limit, which restricts deducting contributions from income to lower taxes (most cardiologists will also be above this). However, there is currently not an income restriction on converting traditional IRAs, and other pre-tax retirement plans, to Roth IRAs. This allows for a strategy that is sometimes called a "Backdoor Roth IRA," which allows high income earners to get money into a Roth IRA indirectly via a nondeductible IRA.

To implement this, you will need both a traditional IRA and a Roth IRA. You will first make your contribution to your traditional IRA and not take the tax deduction (because your income will likely be too high and the goal is to get your money in the post-tax Roth IRA). You now have after-tax money in a traditional IRA, called a nondeductible IRA. You will then convert the balance in your nondeductible IRA to your Roth IRA. That's it. Once your money is in a Roth IRA, it is like you made a direct contribution and qualified distributions will not be taxed.

There are a few items to be aware of with this strategy. First, this can backfire and result in additional taxes owed if you have pre-tax money in an IRA. We would also recommend making the entire year's $5,500 IRA contribution and Roth conversion at one time. If there is any growth between these two steps, then you could owe additional taxes. You will also want to complete Form 8606 when you file your taxes, as this establishes a tax cost basis for your nondeductible IRA contribution.

On a different note, it may make sense to convert the pre-tax balance of a previous employer's retirement plan to a Roth IRA in the year you transition from fellowship to your attending position, depending on your situation. Keep in mind you will have to claim the amount converted as income, but this amount will then not be taxed again. In most cases, converting during your transition year will result in lower taxes than waiting to convert when you have a full year of attending income.

If you have questions on IRAs or other investment-related matters, we would encourage you to seek guidance from a financial advisor who is familiar with the specific situations of cardiologists and other medical professionals.

Michael Merrill and Marshall Weintraub are financial advisors with the independent financial services firm, Finity Group, LLC. To ask them questions or arrange a consultation, email them at Office Address: 4380 SW Macadam Ave, Suite 245, Portland, OR 97239. Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Finity Group, LLC and Cambridge are not affiliated. Financial Advisors do not provide specific tax advice and this information should not be considered as such. You should consult your tax advisor regarding your specific tax situation. For a Roth IRA, earnings withdrawn prior to reaching age 59½ and/or not meeting the five-year holding period may be subject to a 10 percent penalty in addition to income tax. After-tax contribution amounts are generally returned income tax free.

This article was authored by Michael Merrill, CLU, ChFC and Marshall Weintraub.