Few doctors and other HIPs (High Income Professionals) qualify to contribute directly to a Roth IRA. In 2017, you are prohibited from doing so if:
- MFJ – your AGI (Adjusted Gross Income) is above $196k
- MFS – your AGI is above $10k
- Single – your AGI is above $133k
The workaround is to contribute to a nondeductible (“n/d”) TIRA (Traditional IRA) and then convert to a Roth IRA. That is possible for anyone with earned income and is a tax-free transaction if you do not have pre-tax TIRAs in your name, as we discussed in a previous blog post.
Once you’ve made it past these hurdles, the question becomes: when should I go through this two-step process? This matters because a n/d TIRA has a distinction that the Roth does not have: any growth in a n/d TIRA will be immediately taxed at your top marginal rate when it comes out of the account, i.e. when you convert it to a Roth IRA. In other words, a n/d TIRA is the one account you don’t want to grow.
Therefore, you should convert your n/d TIRA to a Roth IRA as soon as possible after contributing to it. Because of the “step transaction doctrine“, however, many advisors recommend waiting a few days, weeks, or even months before converting. I’m not one of those people – if this doctrine is ever applied, I don’t happen to believe it will matter how long you wait if you’ve been converting to a backdoor Roth like clockwork every year. It will be pretty obvious what you and millions of other investors have been doing. Caveat emptor.
So when do you complete step 1, the n/d contribution? My preference is on the first business day of the year. That will not always work for you but, because the market is up on average, about 70% of each day it is open, the odds are in your favor.
The only time I recommend not following this logic is when you have a pre-tax IRA that you will not be able to empty (according to the instructions in this post) until the following year. In that case, you should wait until the last business day of the year and convert the first business day of the next year. This will mean your money is sitting idle for the least amount of time.
Example: You have a $10,000 TIRA (pre-tax) and will be starting a part-time locums gig in 2018, when you plan to open a SOLO-401k. Here are the steps to follow:
- You should contribute to a n/d TIRA on 12/29/17.
- You should convert it to a Roth IRA on 1/2/18. You should also contribute to your Roth for 2018 and convert it on 1/2/18.
- You have until 12/31/18 to: 1) open your SOLO-401k and 2) roll your $10k pre-tax TIRA into your 401k.
By the way, there may be a few cents of interest when you convert. Just move it all and forget about it – the IRS won’t expect you to report it or track it.
The Pro-Rata Rule for Backdoor Roth IRA’s