Guest columnist Dr. Ronald Dritz invites young anesthesiologists to join him for a series of articles focusing on the lifecycle of financial health. In this installment, he explains why the Roth IRA is an increasingly popular retirement savings account that offers particular advantages as part of a long-term financial portfolio.
Roth IRA accounts were established as part of the 1997 Taxpayer Relief Act. Named after the primary sponsor of the legislation, Senator William Roth Jr. (R-Del), Roth IRA accounts are funded with after-tax dollars, accrue earnings tax free, and are tax free on withdrawal — provided certain rules are followed.
There are two basic ways to fund a Roth IRA, either through direct contributions or through conversion of funds from a traditional IRA or 401(k) account. As discussed in a previous blog, direct contributions are subject to phase-out provisions at taxable income levels above which direct contributions are not allowed.
Conversion of funds from either an IRA or 401(k) into a Roth IRA are allowed at any taxable income level with no limit on the amount of the conversion. However, when funds are converted, they will incur a tax liability as income in the year of the conversion. It is imperative to consider the management of this tax liability to reap the fullest possible benefit from a Roth IRA conversion. But before we dive into Roth IRA conversion strategies let’s first understand some basic rules that govern these accounts.
The Five-Year Rule
The Five-Year Rule is actually two separate rules, one covering Roth IRA contributions and one covering conversions. A Roth IRA account must be opened and funded ($1 is sufficient) to start the five-year rule clock running for Roth IRA contributions and the clock starts on January 1st of the year of the contribution. So, a contribution made on December 31, 2025, will set the clock to start counting from January 1, 2025.
Additionally, contributions can be made up until Tax Day of the following year and still set the clock running to January 1st of the previous year. Any funding, either from a direct contribution or a conversion, will start the five-year clock. Also, once the five-year clock is started it will cover all subsequent contributions.
Despite the Five-Year Rule, you can withdraw your Roth IRA contribution at any time without incurring either a penalty or a tax liability. However, if you withdraw any earnings on the contribution the earnings will be subject to taxation and, if you are under the age of 59½, a 10% penalty. The IRS designates withdrawals as contributions first, then earnings. So, if you made a $6000 contribution and earnings accrued making account value $7000 you could withdraw $6000 at any time without taxation or penalty. If you withdrew the entire $7000 within less than five years after account inception the $1000 earnings would be subject to income tax and, if you are under age 59½, a 10% penalty.
For IRA or 401(k) to Roth IRA conversions there is an entirely separate Five Year Rule. This distinction is often not made and has led to considerable confusion and, unfortunately, loss of funds. Here are the differences:
- When making a Roth IRA conversion, a five-year clock starts running on January 1st of the year of the conversion for EACH conversion. A second Roth IRA conversion the following year starts a separate five-year clock for that conversion.
- Unlike Roth IRA contributions, where the contributed amount can be withdrawn at any time without tax or penalty, Roth IRA conversions, neither the converted amount nor the earnings can be withdrawn in under five years without incurring a tax liability and, if you’re under age 59 ½, at 10% penalty. So, if you convert $10,000 from your 401(k) to your Roth IRA then withdraw any or all that amount in under five years, you will pay a 10% penalty on the converted amount if you’re under age 59 ½, and tax on the earnings. If you are over age 59 ½ there will be no penalty on the converted amount, but the earnings will be subject to taxation.
Required Minimum Distributions (RMDs)
For those born in 1960 or after, RMDs are not required until age 75. Since this blog is for younger anesthesiologists with the RMD requirement possibly decades away, I will be brief. RMD withdrawals are required annually after age 75 on traditional IRA accounts but not on Roth IRA or Roth 401(k) accounts. Further, RMD withdrawals cannot be used as part of a Roth IRA conversion. This offers an additional advantage for Roth IRA accounts. Calculate the required RMD withdrawal here.
IRA or 401(k) to Roth IRA Conversion Strategies
If you decide to convert funds from a traditional IRA or 401(k) into a Roth IRA, it is important to consider certain strategies to maximize the benefits offered by Roth IRAs.
- Fill out your tax bracket. Let’s say you have a taxable income of $330,000 and are filing jointly. You are in a 24% tax bracket. The 32% bracket does not kick in until you reach $394,600. Therefore, you could consider converting up to $64,600 and still pay 24% tax. Any portion of a conversion over that amount would be taxed at 32%.
- The earlier you convert, the longer those funds have to grow. Since withdrawals (over age 59 ½ and after the five-year holding period) are entirely tax free, Roth IRA accounts should be the last ones tapped for income to maximize their tax-free growth.
- To maximize the value of a conversion be sure, to the maximum extent possible, that you pay your tax liability with outside funds. If you use a portion of the converted amount to pay the tax you will dilute the future earnings within the account. This is important. In #1 above, the tax liability on the $64,600 conversion at 24% is $15,504. If the tax is paid by deducting that amount from the conversion the earnings on the $15,504 will be lost. That amount earning 6% per annum will be worth $124,032 if held for 36 years!
- If you are in a lower income year, take advantage of a lower tax bracket and use the year to be more aggressive with a Roth IRA conversion.
- If you have invested assets in your IRA or 401(k), consider a down market as an opportunity to convert assets “in kind.” That is, if you’re holding a S&P 500 ETF in your 401(k), converting that asset when the value has dropped will lower the tax liability.
Roth IRAs are a great tool to employ as part of an overall investment strategy. If properly used, they can greatly enhance the value of your portfolio and give greater flexibility to your investment decisions.
Ronald Dritz, MD, FACA, practiced anesthesia for twenty-eight years in northern California. He held numerous positions of leadership including Chairman of Anesthesia, President of the Medical Staff, hospital and health system board membership and served as Finance Chair of an IPA medical group. He is happily retired and lives with his lovely wife in Emeryville, California.
The ASA Committee on Young Physicians is pleased to present this monthly article series on personal finance. These articles are not written by hedge fund managers or real estate tycoons but by practicing physicians. Some have business degrees and some do not – but every contributor is an anesthesiologist who has some guidance to offer the rising generation of attending physicians. It is not the intention of the committee to offer definitive financial advice, but rather some pearls of wisdom to consider while developing a personal fiscal plan.
#CommitteeonYoungPhysicians
#PersonalFinances