I like to consider my options for investing in stock and mutual funds as buckets: taxable, tax-deferred, and tax-advantaged. The one bucket that is most misunderstood by high-income earners is the Roth IRA.
What is a Roth IRA?
The Roth IRA is an individual retirement account that allows your investments to grow tax free. This means that if you put $5,000 into the account and it grows to $10,000 by the time you withdraw the funds, you pay no taxes. That’s right. If $5,000 grows to $5,000,000 within the Roth IRA, you still don’t have to pay taxes on the gains upon withdrawal!
Obviously there are a few stipulations regarding the Roth IRA. You can only contribute up to the annual limit, which is $5,500 for 2015 ($6,500 if you are over age 55). The amount that you do contribute to the Roth IRA must come from after-tax dollars, meaning that there is no federal tax deductions allowed from investing in this vehicle.
To invest in a Roth IRA, simply choose a custodian to hold your investments. Most banks and brokers offer IRA/Roth IRA contributions. I use E*Trade, but Fidelity, Vanguard, ScotTrade, and dozens of other online brokers all offer IRAs. You can even open accounts at most of these brokers without ever needing to speak to a person!
Isn’t There an Income Limit To Qualify For A Roth IRA?
Yes and no. Technically the phase-out for a direct Roth IRA contribution starts at $112,000 for single filers and $178,000 for married couples. However, it is well-known that you can bypass this limit. You can contribute to a Traditional (Non-Deductible) IRA, and then make a Roth IRA conversion.
Typically, I go through the following steps:
- Contribute the maximum IRA limit into a Traditional IRA through my custodian.
- Wait a week or two, and then submit a request to convert the Traditional IRA to a Roth IRA. I have never had any funds in a Traditional IRA at the end of the year, so I do not have to pay taxes on any conversions.
- Whenever I file my taxes, I submit Form 8606 to document the Traditional to Roth IRA conversion.
I have had multiple financial advisors pitch me their ability to help me invest in a Roth IRA no matter what my income is, as long as I agree to enlist their “professional services”. Fortunately for you that now that you’ve read this blog post, you won’t fall prey to bogus sales tactics.
Why should I even care about a Roth IRA if I can only contribute $5,500 a year?
It is true that the contribution limit for Roth IRA is minuscule compared to the expected amount that you should invest given that you are a high-income earner. Understand that your investment portfolio should consist of as many buckets as possible to diversify your options. As a doctor, you should have enough disposable investment income to maximize all of your buckets that you end up having to invest the rest in a taxable account. A Roth IRA is more advantageous than a taxable account. You don’t get taxed on the gains if you withdraw after 59 1/2 years old.