At some point you may have thought “Should I use a Roth account for my investments?” The answer is yes; here are six ways to get started.
Generally it’s to your advantage to choose a Roth account over a traditional account if you think that you’ll pay higher taxes when you withdraw the money than you do now. When you contribute to a Roth account, you do not get an upfront tax deduction now in exchange for not paying taxes on the contribution or any gains when you withdraw the money in the future. If you’ve made the decision to Roth your investments, here are 7 ways you can get there:
Path #1: Contribute to a Roth IRA directly
You might think that physicians cannot contribute directly to a Roth IRA account, but that’s not necessarily true. It depends on your income — specifically what the IRS calls your modified adjusted gross income (MAGI). For 2015 if you are married and your MAGI is less than $183,000 then you can contribute the maximum $5,500 to a Roth IRA.
To find an estimate of your MAGI, go to line 37 on the first page of Form 1040 of your 2014 federal income tax return. That shows your adjusted gross income (AGI). There are a few adjustments to the AGI to derive your MAGI, but the AGI is a pretty good estimate for most people.
What types of emergency physicians (EPs) does this apply to? First are current residents who are not graduating this year. If you’re in this category you’ve got an opportunity to directly contribute to a Roth IRA and that opportunity will likely go away when you make more income. The second are current residents who are graduating this year. If you are in this group you’ve got to be careful because your income bump later in the year might disqualify you from contributing to a Roth IRA. The third are emergency physicians who work part time and who will make less income than the average EP. This group includes older EPs who are winding down their careers. In that case you can contribute $6,500 to a Roth IRA.
Path #2: Contribute to a Roth 401k or Roth 403b in an employer sponsored retirement plan
If you are an employee and your hospital or has a 401k or 403b plan, check to see if your plan allows you to designate your contributions to the plan (known as employee elective deferrals) as Roth 401k. Under age 50 you can contribute a max of $18,000 out of your paycheck to the Roth 401k or Roth 403b. Above age 50, you can contribute $24,000 this year.
What’s nice about the Roth 401k/403b — unlike the Roth IRA — is that there are no income restrictions on who can contribute. You could make $1 million of income (I know that’s wishful thinking for an EP) and still contribute to the Roth 401k. Of course you’ll pay thousands of dollars more in taxes this year, over $7,000 if you’re in a combined federal and state income tax bracket of 39%.
You do run into a complication later on — which is that just like a traditional 401k, you’ll be required to take distributions form the Roth 401k account at age 70.5 even though you don’t pay taxes on the Roth 401k/403b withdrawals. You can avoid this by rolling over your Roth 401k to a Roth IRA when you retire.
Path #3: Contribute to a Roth 401k in an individual 401k plan
This is similar to Path #2 except that it applies to independent contractors who’ve set up an individual 401k plan. Most custodians now have the Roth 401k option for individual 401k plans. Under age 50, the maximum contribution to an individual 401k plan is $53,000 in 2015. Over age 50, it’s $59,000. That’s assuming you make sufficient income to support that contribution.
Realize that in this setup, you can designate a portion of that total as an employee contribution and the rest as an employer profit sharing contribution. It’s only the employee contribution of $18,000 (or $24,000 if above age 50) as Roth 401k. You cannot designate the employer contribution to the Roth 401k. Instead the employer portion must go to the pretax traditional profit sharing account.
Path #4: Convert your traditional IRA to Roth IRA and pay taxes
Let’s say you take a year “off” and work part time for one year before going back to full time work the next year, or suppose your spouse loses his/her job and generates no income for a year. In this case you might fall into a lower income tax bracket this year than next year. If so, you can convert all or part of your traditional IRA or SEP IRA this year to a Roth IRA. To do this you open a Roth IRA account and specify the dollar amount you want to convert to a Roth IRA on a Roth conversion form. Assets are then transferred form your traditional or SEP IRA to your Roth IRA. Assuming that all of the converted money was pretax, then you’ll pay taxes in the year you convert.
Path #5: Convert your traditional IRA to Roth IRA and pay no taxes
If you have a $0 balance in all traditional IRA and SEP IRA accounts combined, you can make a nondeductible (post tax) contribution to a traditional IRA and then convert that nondeductible money to a Roth IRA. In this case because you are converting post tax money to a Roth IRA, you will not owe income tax on the conversion.
While this sounds pretty easy, there are large number of pitfalls that can screw up this strategy, including rollovers from outside accounts, not accounting for all of your IRA balances, not filling the appropriate tax forms and many others. So tread carefully and know what you’re doing before attempting this.
Path #6: Convert your traditional 401k to Roth 401k or Roth IRA and pay taxes
Suppose you are an employee and made contributions previously to only your traditional 401k account on a pretax basis. Now you regret that decision and you wish you could have changed that to the Roth 401k. Recently the IRS started allowing “in plan Roth conversions.” This means that even if you are actively employed you can convert pretax money from your traditional 401k to your Roth 401k.
Be careful here. Remember that you’ll owe tax on the conversion because your converting pretax money to a Roth 401k. The tax must be paid outside of your 401k account and cannot come from withholding taxes on the conversion.
When you leave an employer you also have the option of rolling over your pretax traditional 401k into a Roth IRA and owing taxes in that process.
As you can see you can use one method or a combination of methods to get to the Roth structure, but be warned that mistakes can be costly and in some cases can’t be undone.