Backdoor Roth: Standard and Mega

INTRODUCTION

This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high-income professionals stop doing dumb things with their money since 2011.

Tyler Scott:
Hello, everyone, and welcome to Episode 430 of the White Coat Investor podcast. Today's episode is called Backdoor Roth, Normal, and Mega.

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My name is Tyler Scott, and I am one of the friends of WCI here standing in for Jim today and excited to talk to you about some Backdoor Roth questions, both the traditional version and the mega backdoor Roth at work.

Before we get started on that, let me just first say thank you so much for all that you do out there. We know that our target audience is those wearing the white coat, the physicians and dentists, but we know that's not our only audience. We know there's all kinds of you out there doing important work, making sacrifices to make our community better. We see you. We appreciate you. We are grateful for what you do.

And wherever you're listening today, whether you're in the car or you're on a jog at the gym or if you're at work, thank you for taking time to spend time with us and for making contributions to our community here in the White Coat world and our community at large, making society a better place through your efforts.

QUOTE OF THE DAY

Our quote of the day today is from Susie Orman. “A big part of financial freedom is having your heart and mind free from worry about the what ifs of life.” And that is so true. Money is many things. And one of the things when utilized best is the ability to utilize our bandwidth for the things that bring us the most joy and to have peace of mind about what's going on in our life gives us the choices to do what we want with our time and to feel less stress. I agree with Susie on that one.

All right. Without further ado, let's get started on our questions and take our first question off the Speak Pipe.

COMMON BACKDOOR ROTH IRA MISTAKES

Speaker:
Hi, Jim. I was hoping you could help me with my first time doing a backdoor Roth IRA. I contributed $7,000 to a traditional IRA with part of it coming from my bank and part of it coming from a taxable brokerage account that we decided to convert into the Roth IRA this y ear.

Before it all got there, I did earn 33 cents of interest and that did get rolled over into the Roth IRA. There was $7,000.33 converted from a traditional IRA to a Roth IRA. I called Vanguard to see how I could fix that extra 33 cents. And they said that the conversion from a traditional to a Roth is does not have a limit.

I'm a little confused, but he reassured me that it would be a 33 cents taxable event, but otherwise there wouldn't be any penalties. I was hoping you could confirm that and help me understand if there's anything I need to do to retract that extra 33 cents that again was contributed to a traditional IRA and then rolled over to a Roth IRA. Thanks.

Tyler Scott:
Wonderful. Great question. A really common question. First, congratulations on doing your first backdoor Roth contribution. That's so fun. And the fact that you've educated yourself to the point of being able to even ask this question is a great sign for your financial future.

Also, I understand your concern here. You want to do this the right way and follow all the rules, not just to stay out of trouble, but also to do the right thing. One thing I appreciate a lot about our WCI community is a consistently high ethical standard. I'm continually impressed and inspired by the questions we get to demonstrate people's commitment to integrity and the value we all place on doing the right thing, even when no one may be paying attention.

And believe it or not, the IRS is often not paying attention when it comes to some of these details. That doesn't mean we shouldn't all seek to abide by the laws of the land and uphold the rules, even when the rules may be bizarre and the referee is asleep.

Let's talk about this really common question related to the backdoor Roth IRA mechanics and why there's nothing to worry about in this case. If you want to read about this on the blog, Jim has a post called “Pennies and the Backdoor Roth IRA” that will talk you through it all.

The steps for a backdoor Roth IRA are really quite simple, but it generates a lot of questions, which I think is totally reasonable because the whole backdoor Roth IRA concept is not at all intuitive. It would all be easier if we didn't have to use the so-called backdoor. If we could just make direct front door contributions to our Roth IRA, that would be awesome and we wouldn't get all these questions. But we can't, or at least most of us can't.

The U.S. Congress has decided that if you make too much money, you can't contribute to a Roth IRA. Well, how much is too much? In 2025, if you're single and your modified adjusted gross income or MAGI is more than $165,000, you can't make any direct contributions to a Roth IRA. If you're married, filing a joint tax return and have an MAGI of $246,000 or greater, you can't make direct Roth IRA contributions. Sad news for most listeners of this podcast.

The good news is that there's a loophole, a workaround for this income restriction. In my opinion, the loophole makes absolutely no sense. It's not intuitive or logical at all, but I love it because it means my wife and I and all of my clients can maneuver our Byzantine tax code to get money into our Roth IRAs each year via this we lovingly call the backdoor Roth IRA.

That term is totally made up by the way. If you search the IRS website for backdoor Roth, nothing is going to come up. It's just a conceptual term to describe the following steps of the loophole.

Step one, make a non-tax deductible contribution to a traditional IRA. Leave the money in cash. Don't invest it yet. Step two, convert those non-deductible dollars from the traditional IRA to the Roth IRA. Step three, invest the money in the Roth IRA according to your written investment plan. And four, fill out form 8606 completely and correctly and file it with your tax return each year. That's it. That's the loophole. Those are the steps.

This caller knows all that and is just getting caught up on step two. She made the maximum allowable contribution to the traditional IRA for 2025, which is $7,000, and she left it in cash. Good job. Then a day or two later, she converted the entire balance of the traditional IRA to the Roth IRA, which was $7,000 and 33 cents. Again, good job. She's just tripped up on the 33 cents.

First, where did the 33 cents come from? It is interest. Remember how we said to leave the money in the traditional IRA in cash? Well, at most brokerages like Vanguard, Fidelity, and Schwab, the cash earns a decent interest rate. Right now, that's between 4% and 5% a year. Well, on $7,000, the daily equivalent of 4% to 5% was 33 cents in this case.

Well, now what? The 2025 limit is $7,000, and she is worried about breaking some kind of rule for exceeding that limit. I get this question from clients all the time. It just begs the question, “What limit?” This is where people get caught up. The limit is for the contribution, not for the conversion.

The Vanguard rep who talked to her on the phone said as much. There is no limit on how much you can convert from your traditional IRA to your Roth IRA in a given year. If you've listened to this podcast much, you already know this in the deep recesses of your brain somewhere because you've heard the questions we get on the podcast all the time from people considering doing a Roth conversion.

Often, these people are approaching retirement and have cut back at work. Maybe they're already in retirement, or other people are in a low-ish tax bracket for some reason like taking a sabbatical, going back to school, being in training, or something like that.

These people want to take advantage of their low tax bracket by moving money from a pre-tax account like a 401(k) or rollover IRA to their Roth IRA. Well, this is a taxable event because the money is being moved from a pre-tax universe to a post-tax universe. Given that taxes will be owed on the conversion of this money to the Roth IRA, people call in and ask us, “Hey, how much should I do as a Roth conversion, or when should I consider a Roth conversion?”

All of this is to say that the Vanguard rep was right that there is no limit on how much you can convert to your Roth IRA at any time. If you want to move $5 million dollars, no one's going to stop you. You just need to understand how much in taxes you're going to owe on that conversion.

Well, that brings us back to our 33 cents. In the back to our Roth steps, given that step one was to contribute $7,000 of non-deductible after-tax money, do we owe any taxes for moving that post-tax money to a post-tax account like a Roth IRA? No, we don't. Did we break any rules by contributing more than the annual $7,000 limit? No, we did not.

But if we have any earnings on our $7,000 between the time of the contribution and the conversion, do we owe taxes on those earnings? Yes, we do. Is there a limit on how much we can convert to our Roth IRA? No, we just covered that. There's no limit on the conversion amount.

Can we convert $7,000.33 to our Roth IRA without breaking any rules? Yes, absolutely. It just begs the question, how much do we owe in taxes on that? Well, $7,000 was a tax-free conversion because it was already after-tax dollars, but we do theoretically owe ordinary income taxes on the 33 cents of growth. I say theoretically, because in reality, we don't report cents on our tax returns. So, when you fill out Form 8606, 33 cents rounds down to zero.

In this caller's case, there is no tax due for the $7,000.33 conversion. But what if it was 87 cents or $5 or $20 of interest that had accumulated? You just owe taxes on that growth amount. If your marginal tax rate is 40% and you convert $7,005, you owe $5 times 40%, which equals $2 of taxes. No big deal, right? Didn't break any rules. The backdoor Roth police aren't coming to your door. You just have to pay your taxes on the extra amount that you converted due to growth.

Alternatively, you can leave the 87 cents or the $5 in the traditional IRA, but that will complicate your or your CPA's task of filling out Form 8606. And it'll make you subject to pro-rata calculations on future backdoor Roth conversions. I've already talked too long about this simple question, so I'll spare you a discussion about line six of Form 8606 and the pro-rata rules. You can go read all about that on the blog.

But for now, suffice it to say that it's much easier and cleaner to get your traditional IRA down to zero bucks before December 31st each year. That leads me to a final point. In the caller's case, she was able to see the 33 cents of interest before she completed her conversion, which is actually kind of nice. At least she knew it was there.

The more annoying version of this problem I see all the time with clients is they put $7,000 in the traditional IRA on January 2nd, they convert the entire balance on January 4th, and that balance still shows as $7,000. And so, they think they're good to go. But then when they send me their account balances in June for our annual meeting, I see the traditional IRA has $1.68 in it. And I tell them, hey, you should clean this up or your Form 8606 will be a little wacky and the pro-rata rules can apply down the road. And then they say, “Wait, what the heck? I converted the entire balance of the traditional IRA. And when I was done, there was no money in there. Where did this $1.68 magically come from?”

The answer is that it was an interest payment made in arrears. Often these brokerages don't make daily interest payments, but they do it weekly or monthly. On January 9th, they look back and say, “Well, how much did Joe have in his account last week on January 2nd? Looks like he had $7,000 in there. We owe him $1.68.” Then they put the interest payment in long after you think you've emptied out the account. So, look out for that. I always log into my traditional IRA on like December 1st each year, just to make sure it's at zero.

In short, don't worry if you convert a little over the $7,000 contribution limit in a given year, you'll owe a little tax on that. Just make sure to get your traditional IRA to zero by the end of the calendar year so your paperwork is easy. This is the easiest of the backdoor Roth IRA mistakes to fix.

A COMMON BACKDOOR ROTH IRA MISTAKE

Okay. Let's listen to a question from Gabriel, a new attending who made another common backdoor Roth IRA mistake. This one is a little more complicated to clean up than the last one.

Gabriel:
Hello, Dr. Dahle. My name is Gabriel. I'm an allergist. I recently started working as an attending in Seattle, Washington. My question is regarding an excess contribution for a Roth IRA. I contributed to a Roth IRA for this tax year and realized my income will be above the limit for contributing to a Roth IRA. Now I'm looking into removing the excess contribution or recharacterizing it into a traditional IRA. I don't have a traditional IRA at this point.

If I recharacterize it into a traditional IRA, I was wondering if I would be able to immediately afterwards do a backdoor Roth conversion, or if I should just remove the contribution first and then later on attempt the backdoor Roth conversion. It seems like it should be straightforward to just do the recharacterization to a traditional IRA and then do a backdoor Roth but I want to make sure I'm not missing something. Thanks for your help.

Tyler Scott:
All right, Gabriel. Great question. And another common problem we see with backdoor Roth. Again, like the last question, let me say good job on making use of this loophole and great job on paying attention to the rules and self-policing when you got it wrong.

The misstep Gabriel made here is one of benevolent exuberance. He was in such a good habit of funding his Roth IRA early in the calendar year as a resident and was so excited about funding it again in this last year of training that he made a direct contribution without thinking about the totality of his 2025 income.

This excitement has not been a problem for him in the past because as a resident, his annual income was below the limits we mentioned in the last question. Gabriel didn't ever need to use the backdoor Roth loophole as a resident. But now with a partial year of resident income and a partial year of attending income, he realized after the fact that his 2025 income will exceed the limits for direct Roth IRA contributions.

In his exuberance to fund his Roth IRA earlier this year, he didn't pause to realize that even though he was a poor resident at the time of the contribution, that when taking the entire year into account, he would make too much money for that direct contribution and now he needs to fix his ineligible or excess contribution.

This happens so often, I've written a blog post about it. It's called Backdoor Roth When Your Life Is In Flux. Jim has a post about it. It's called IRA Recharacterizations: I Should Have Backdoor Rothed. So go read those. And in my post, I point out a few common scenarios where you will find yourself wishing you had used the backdoor loophole.

The most common situation is Gabriel's, someone in their final year of training. You're so accustomed to being low income that you don't pause to realize that by the end of the year, your income will exceed the limit.

Another situation is getting married to another earner. Let's say you're a first-year resident making $60,000 and you make your direct Roth IRA contribution in January and then marry an attending in July. Well, guess what? Your tax filing for that year is going to be married filing jointly and your combined household income is going to be way above the income limits. And now your Roth IRA contribution way back in January needed to have happened via the backdoor loophole, even though you made the direct contribution when you were a well-meaning low-income single person back earlier at the start of the year.

Similarly, those that divorce a non-earner can be in the same boat. Consider a married earner with an MAGI under the married filing jointly direct Roth IRA income limits, but above the single income limits. $200,000 works as a good example.

Our married earner has become accustomed to making a direct Roth IRA contribution for themselves and their stay-at-home spouse each January. By the end of the year, the couple is divorced and both spouses are filing their taxes as single or head of household.

The non-earner has no problem here because they have a MAGI of zero, but our earner who thought they were making an eligible direct Roth IRA contribution suddenly finds themselves with an MAGI that exceeds the limit for a single or head of household filing.

Another situation where I see this a lot is with clients related to student loan optimization when they're pursuing Public Service Loan Forgiveness. For complex reasons that transcend today's episode, just know that it can make sense for some couples to file their taxes separately, even though they're married and living together. And this is so they can make the lowest possible student loan payments while one or both of them pursue forgiveness of their loans.

The MAGI limit for direct Roth IRA contributions begins to phase out between zero and $10,000 of income for married people filing separately. And let's agree that staying below $0 of income is mathematically challenging for a household. So, consider a couple who are under the married filing jointly income limits for direct Roth contributions, and they make their maximum Roth contribution each year in January.

Well, in March of the following year, like 15 months later, they meet with Andrew at Student Loan Advice and learn they need to file their taxes separately for both the previous tax year and for the tax years to come. They have unexpectedly and unknowingly found themselves with ineligible contributions to the Roth IRA from both the one they did a couple months ago and the contribution they made 14 or 15 months ago. Now they've got two years of ineligible contributions.

This happens all the time with the demographic of clients I work with. This accidental direct Roth IRA contribution mistake can also happen to people who just end up making more money in a year than they expected to. This actually happened to me a few years ago when I switched from dentistry to financial planning. I had every reason to believe that the first year of being in this new job that it would be a low income year for us as I got my feet underneath me and I built my client base. I made a direct Roth IRA contribution for me and Megan in January of 2022.

It was to my great surprise and delight that it didn't take me nearly as long as I thought to hit my stride in this new world. And we ended up surpassing the MAGI limit for direct Roth IRA contributions by the end of 2022. Oops, that was a happy oops, but still an oops. And so, it can happen in years where you just make more money than you thought.

I've also seen it happen for those losing qualifying widow or widower status. This one's much more rare, but it does happen. What you need to know here is in the year of your spouse's death, you can still file your taxes married filing jointly. And for the next few years after that, you can file as a qualifying widow, assuming you don't remarry, have at least one child you claim as a dependent and pay for more than half the cost of keeping up a home. Then after those two years, you have to start filing your taxes as single or head of household.

Well, qualifying widow has the same income limits as married filing jointly for direct Roth contributions. In that tax year where you lose qualifying widow status, if your MAGI is below the widow limit, but above the single limit, you can find yourself having accidentally made an ineligible direct Roth IRA contribution.

The point is there are lots of ways where Gabriel's question is relevant. It's not just for those finishing training, though that is the most common demographic who makes this mistake.

Okay, Gabriel, what are you going to do to fix this? First, don't stress too much. It's not that big of a deal to fix the error and you're on the right track. The solution is to recharacterize your Roth IRA contributions into traditional IRA contributions, and then start the backdoor process from there.

To recharacterize is to say, “Oops, my bad, that's not what I meant to do. Let's turn these Roth dollars back into traditional IRA contributions.” There's just a couple things to be aware of, a couple pitfalls with IRA recharacterizations. First, just know this is going to require calling the custodian of the Roth IRA, being on hold, filling out paperwork, and navigating a bureaucratic process that will eat up some of your time and raise your blood pressure a little.

Next, know that any growth that occurs on the original ineligible direct Roth IRA contributions, from the date of that contribution to the date of the recharacterization, that growth will be taxable income to you at your marginal tax rate as ordinary income. This can result in a few hundred dollars of taxpaying load.

And then finally, the deadline to complete a recharacterization is October 15th of the year following the ineligible contribution. Gabriel, if you made your ineligible contribution earlier in 2025, you have until October 15, 2026 to do the recharacterization.

Just note that if you made an ineligible Roth contribution in early 2025 for the 2024 tax year, because remember you have until April 15th to do your Roth contribution for the previous year. If that happens, the deadline to fix the error via recharacterization would be October 15th of this year of 2025. And if you miss that deadline, you must remove the entire Roth IRA contribution along with any growth and pay a 6% penalty on the amount removed.

Gabriel, get your recharacterization done on time. Get those dollars into a traditional IRA. It sounds like you need to open a traditional IRA first. Then just use those dollars to start the backdoor process from there.

Moral of the story to everyone listening is, when in doubt, just use the backdoor loophole. There's no penalty for using it if you don't have to. Most of you need to get good at doing it anyway, and you can save a lot of hassle when life changes unexpectedly as life is wont to do.

All right, next we're going to move from standard backdoor Roth questions to the world of the mega backdoor Roth. And I'm going to try something a little different with these three questions. And before I say what that different thing is, let me acknowledge that I know all of you listening are already disappointed that I'm not Jim and that he's out today.

But just know he's asked me to be here because while he loves this work and intends to keep doing it, he may not want to do it at this same pace forever. With that in mind, the WCI team is curious to see if people like me, the so-called friends of WCI, can pick up some shifts here and there to lighten Jim's load and help him find the work-life balance that we all need.

Further, the White Coat team has given us guest hosts some license to be ourselves and do things a little different than just try to be mini Jim, which would be a fool's errand anyway.

With that in mind, instead of reading or listening to the questions and then responding to them in a classic way, for the next few, I'm going to offer up a kind of primer. I'm going to talk about the topic first and then use the questions to test our knowledge. I want you listening out there to learn a little about the topic first and then maybe be able to pause the recording and take a stab at answering the questions on your own based on what we've just talked about. Think of it as a see one, do one, teach one opportunity for all of us.

As always, if you like it or hate it or hate or like anything associated with the podcast, email Megan at [email protected] and tell her what you think. She listens to all that feedback. They talk about it as a team and we try to make this a better experience for you.

MEGA BACKDOOR ROTH STRATEGY

With that preamble, let's talk about the mega backdoor Roth strategy. The big picture goal with the mega backdoor Roth is to use up all the tax protected space the IRS offers you each year in your 401(k) or 403(b).

This limit, known as the 415(c) limit, increases each year with inflation. The limit for 2025 is $70,000 for those less than 50 years old. The 415(c) limit for those 50 and older this year is $77,500. I just went to Jim's surprise 50th birthday party here at the house a couple weeks ago and I said, “Congratulations on being healthy enough to still play hockey. And for the $7,500 extra you get to sock away this year in the 401(k).” Catch up contributions in your 401(k) and IRA are the best part of turning 50 if you're a financial planning dork like me and Jim.

Okay, the first thing you need to know with the mega backdoor Roth is that your 401(k) or 403(b) has to allow for this strategy and most plans do not. Maybe 10 or 15% of my clients have this option and they're all either in a custom solo 401(k) or a 401(k) or 403(b) provided by Fidelity. I'm not saying Fidelity is the only one that offers it, that's just me reporting from the streets. All the “regular” W2 folks that have access to this, they all happen to have a Fidelity employer sponsored plan.

For this to work, the 401(k) or 403(b) has to have three sub-accounts. A pre-tax bucket, a Roth bucket, and an after-tax bucket. Note, do not confuse the terms after-tax and Roth. Too many people conflate the concepts of after-tax and Roth in this conversation. Those are very precise terms with very different meanings in this case.

If you call up some staffer at Fidelity and ask, “Does my 401(k) allow for after-tax contributions?” They're very likely to say, yes, your plan does allow Roth contributions. Boo! Hiss! I hate that. That's not what I asked. I know my plan allows for Roth contributions. I need to know if the plan allows for after-tax contributions, which is an entirely different thing. Then you ask for a higher level account manager and eventually you get someone who knows what you're really asking for.

Your plan has to have these three sub-accounts. Pre-tax, Roth, and after-tax, and it has to allow for you to make after-tax contributions to the after-tax bucket. Then the plan must allow for you to convert the dollars in the after-tax bucket either to A) the Roth sub-account in the 401(k) or B) to your own Roth IRA.

When we move money from the after-tax 401(k) bucket to the Roth 401(k) bucket, we call that an in-plan conversion. Makes sense, right? You converted the money inside the plan. When we move money from the after-tax 401(k) bucket to our own Roth IRA, we call that an in-service distribution. Makes sense, right? We distributed money from the plan even though we're still in service to the employer. We didn't leave. We didn't get fired or quit or change jobs.

That's the lay of the land, but why are we even talking about this again? Remember the goal for me at age 41 is to get $70,000 in my 401(k). So, let's see how I can do it. Where is that $70,000 going to come from? The first $23,500 this year goes in as an elective employee contribution. I make that contribution on a pre-tax basis and most of you listening probably do, too.

The next slice comes as an employer match. I'm a W-2 employee for my financial planning firm and I get a standard 4% match. That's another $6,500 or so for me. That's also a pre-tax contribution for most of you listening out there. So far that's $30,000 that we've got in the 401(k) for me all pre-tax. That's great. But I still have $40,000 of room left until I hit the 415(c) limit of $70,000 for this year.

How do I fill up that $40,000 worth of space? The answer is I make use of the mega backdoor Roth strategy. If my plan allows for it, I can contribute $40,000 on an after-tax basis. I can then have the plan convert that $40,000 right away to the Roth sub-account inside the 401(k) via an in-plan conversion or I can use an in-service distribution and transfer the $40,000 to my own Roth IRA. And there, boom, I did it. I made full use of the 415(c) limit this year. Awesome. High fives all around, right? Amazing.

I just gave an example of the most common use case for the mega backdoor Roth. That case is a W-2 employee whose own maximum employee elective deferral contributions plus their employer match equals less than the annual 415(c) limit.

The next most common use case is for self-employed people with a solo 401(k). For these folks, the basic ideas are still the same. They start by making their maximum elective employee deferral contribution of $23,500. Next is their employer contributions. Well, they are their own employer.

How much can they put in the 401(k) from the employer side? The answer for sole proprietors and LLC owners is 20% of your net business earnings. For S-corp owners, the answer is 25% of your W-2 salary from the S-corp.

The big point here is whether or not a self-employed sole proprietor and LLC owner can max out their 415(c) limit from just normal employee and employer contributions is a function of their net business earnings.

For an example, if an LLC owner has net business earnings of $150,000, they can contribute 20%, which is $30,000 as an employer contribution. Combine that with their $23,500 of employee contributions, and they've put in $53,500. Well, bummer. That's $16,500 short of the 415(c) limit. Sad emoji there. We're bummed about that.

But wait, all is not lost. The mega backdoor Roth can still ride in on a white horse and save us here. If you've set up your solo 401(k) to allow for after-tax contributions and in-plan conversions, you can contribute the other $16,500 to hit the 415(c) limit. Awesome. Happy emoji.

Now, what if our LLC net business earnings are $400,000? Well, 20% of that is $80,000. Can we put the entire $80,000 in as an employer contribution? No. No, we can't. That's more than the $70,000 415(c) limit. So, how much can we put in? Well, we already did the $23,500 of employee contributions. That leaves us with $46,500 to put in as the employer. Yay. Happy times. We filled up the 415(c) limit. No mega backdoor Roth needed in that case.

Well, what about all you S-corp owners out there who are excited about taking part of your income as a K-1 distribution so you can reduce your FICA taxes? What does that math look like for you? Remember your employer contributions to your solo 401(k) are 25% of your W-2 salary.

Now, as we said a minute ago about our LLC and sole prop friends, all is not lost if your salary is too low to max out your employer contributions. You can still max out your solo 401(k) by making after-tax contributions and converting those to the Roth sub-account if you've set up your 401(k) accordingly.

Note that cookie-cutter, off-the-shelf plans from Fidelity and Schwab don't allow for this. So, you'll want to set up a custom solo 401(k) with one of the providers we list on the Recommended tab on the website under Retirement Accounts and HSA.

Okay, we just fleshed out the next most common use case for the mega backdoor Roth, the self-employed person that has inadequate W-2 salary from their S-corp or inadequate net business profits from their LLC to max out their annual 415(c) limit. Another use case is for the W-2 employee that has a self-employed side hustle. We'll tackle that one in our last question here in a few minutes.

This is a good time for some disclaimers. I'm giving really broad and general advice here. I am not a CPA, let alone your CPA. The actual mechanics and details of this stuff are complex and not a DIY project in my opinion. You should work closely with a tax professional and, dare I suggest, a financial planner to make sure you know what your net business profits are, what a reasonable salary is for the job in your city, and all the myriad complexities that surround this world, like the wildly confusing QBI deduction, just to name one example.

Another short aside here for my S-corp friends out there, I know that you and your CPA are super stoked about getting your salary as low as possible to reduce your Social Security and Medicare tax as low as you can get it. I love that for you.

This is just an invitation to make sure of two things. One, don't take a salary so low as not to be able to pass the reasonable compensation standards set by the IRS. There's not much guidance from the IRS about how they define reasonable, but from cases in the tax courts, we know that one definition of reasonable is how much you would need to pay someone to hire them for this job. If you're a 1099 anesthesiologist and your S-corp salary is $90,000, that's pretty sketchy and super scary, in my opinion, and I think you should be setting money aside to cover the very plausible audit and penalties that'll come with it.

Number two invitation here is don't get so fixated on driving your FICA taxes down with that super low salary that you miss the opportunity to max out your solo 401(k) with pre-tax dollars from the employer side. Saving $4,000 of FICA taxes at the cost of deferring $20,000 of income taxes is not necessarily the most optimal long-term strategy.

This is one of the most common misses I see with S-corp clients and their approach to taxes. Again, every situation is different and this should all be worked out in great detail with your accountant every year as the math and the rules are constantly evolving.

MEGA BACKDOOR ROTH MECHANICS

Okay, with all that framework in mind, let's tackle our first mega backdoor Roth question together. This one comes in via email. “A couple weeks ago, you talked about setting up mega backdoor Roth 401(k). You mentioned there had to be three sub-accounts, one pre-tax, one post-tax, and one Roth. Then you outlined the steps of contributing to the post-tax account and converting it to the Roth account.

For 1099 people who set up their 401(k)s through an outside party – I used my solo 401(k) that I know you used before, Jim – Can you just write a check from the business to the Roth 401(k) sub-account and not have the after-tax sub-account? I met with my accountant and she said you can contribute the employee and employer contributions directly to the Roth 401(k). She said that is not a mega backdoor Roth when you do it like this.

I guess my question is, what's the difference? Why do we need the extra sub-account and the extra step? What's the difference between mega backdoor Roth and just contributing directly to the Roth 401(k) as an employee and employer?”

Okay, good question. Let's tackle those questions one at a time. Okay, friends out there listening, why do we need the extra sub-account and the extra step? Short answer, because that's the only way for some self-employed people to max out their 415(c) limit.

Do we have enough information from this particular emailer to know if he needs the after-tax sub-account and associated mega backdoor Roth strategy? No, we don't know. We don't have enough information.

What additional information do we wish the emailer had included to help us give a more precise answer? Pause for you to think about it. Yes, good. We wish we knew how old this person was, because that impacts their total contribution for the year. Are they 50 or older? We wish we knew what type of business entity they had. As we just pointed out, the math is different for LLC folks and S-corp folks. And third, we wish we knew what their net business profits were if they ran an LLC, or we wish we knew how much their salary was if they ran an S-corp.

What can we say to this smart, albeit incomplete question? What would you say if someone asked you this at a dinner party? I might say, well, if you make enough via salary or net business profits to contribute the 415(c) limit for your age without needing after-tax contributions, then awesome. You don't need the extra sub-account and the extra step.

Alternatively, if you don't make enough, then you do need after-tax contributions and the sub-account and the step. That's for you and your accountant to figure out at the end of the year once all your salary or profits are known.

Okay, next question from the emailer was, what's the difference between the mega backdoor Roth and just contributing directly to the Roth 401(k) with employee and employer contributions?

Well, this is kind of a different version of the same question, right? What's the difference? The difference is whether or not you make enough to fill up the 415(c) limit without making after-tax contributions or whether you need the mega backdoor steps to get there.

Now, to be fair, there's some additional color here I didn't speak to earlier that the emailer may be referring to. Note that they mentioned Roth employee and Roth employer contributions. Employee contributions have long been allowed to be either pre-tax or Roth, but the Secure 2.0 Act now allows for employer contributions to be either pre-tax or Roth. Prior to the law being passed, all employer contributions were pre-tax.

The emailer may be asking or making the point that, assuming they make enough, they can just get $70,000 of Roth contributions into the 401(k) without mega backdoor steps. And that is a good point. After Secure 2.0, you don't have to use after-tax contributions to the Roth. You don't have to do that maneuver if you want to make $70,000 of Roth contributions.

Now, that said, I have not seen many plans out there in the wild that actually allow for this yet. Just because the Secure 2.0 Act allows it does not mean that any plan you encounter is going to actually have that set up, and I haven't seen any yet.

Okay, do you guys want to hear what Jim's email response was to this person? Of course you do. So let me just read what he emailed them back. Okay, Jim said, “Yes, both the employee contribution of $23,500 and the employer contributions, 20% of net income, can now be Roth. Whether that's enough for you to get $70,000 in there or not, I don't know. Depends on how much you make. If so, no point in doing mega backdoor Roth contributions. If not, then you will still need that third sub-account.

But it's not a huge deal to have a third sub-account. It's not like MySolo 401(k) charges you extra for that or something. Every one of our employees has a third sub-account, and nobody has any money in theirs for longer than a day.” That was Jim's much shorter answer than mine.

Okay, let's go to the Speak Pipe for the next question. Well, this isn't really a question, per se. It's a comment that is applicable to our conversation. Maybe it'll help codify some of our learnings so far. So, let's hear Brian's comment.

COMMENTS FROM A LISTENER ABOUT MEGA BACKDOOR ROTH

Brian:
This is a comment on the podcast that dropped Thursday, June 12. One of the questions was from a gentleman who was trying to figure out if his plan had an after-tax option that could then be used to fund a mega backdoor Roth. Two questions that he should ask his benefits team were if the plan actually allows post-tax contributions and if those contributions can be rolled into the Roth portion of the 401(k).

Another question to ask would be if the plan allows in-service distributions if it does not allow in-plan conversions to the Roth portion. Some plans, mine included, do not allow direct conversions of after-tax 401(k) money to the Roth option, but they do allow in-service distributions. They can then be sent to an IRA and then converted to Roth from there. Hope that helps. Thanks.

Tyler Scott:
Obviously no question there from Brian, but I play this for two reasons. First, Megan has been thinking about the idea of not just soliciting Speak Pipe questions from all of you, but asking for your comments as well. You are a smart, engaged, diverse, and well-spoken bunch out there and we think including your perspectives, opinions, and ideas could add valuable color and texture to the podcast.

The idea is that just like Brian, you leave a Speak Pipe in reference to a specific question on a specific podcast episode and offer your two cents. The Speak Pipes are still limited to 90 seconds, so we're not looking for a soliloquy here, but we're interested in your commentary. We don't claim to know everything and we certainly can't speak to every cultural, geographic, gender, career, or personal perspective on a topic.

So, let's give it a try. If you notice something we missed, something we glossed over, something you have a different perspective on, something you think we could have explained better, or maybe most interestingly something you disagree with, drop us a Speak Pipe at www.speakpipe.com/whitecoatinvestor and if we get some good comments, we'll start mixing them into the episodes.

Let me use this mega backdoor Roth topic to give an example of the kind of Speak Pipe commentary I would leave based on Megan's new invitation. If I were a listener over the last couple years, there's one thing I've noticed as I've listened to Jim talk about the mega backdoor Roth steps. And he kind of wonders out loud why people say mega backdoor Roth IRA, even though an IRA is rarely involved in this process, given that the strategy must always start in an employer provided retirement account like a 401(k).

I always find it weird and mildly annoying that everyone says mega backdoor Roth IRA. And my theory is that we as a financial community got so accustomed to saying backdoor Roth IRA, that when we add the mega, we can't help but saying mega backdoor Roth IRA. And the IRA at the end is just this compulsory habit that we can't seem to drop.

So, here's an example of what my Speak Pipe commentary might sound like, taking Megan up on her offer for you all to call in and offer your two cents.

“Hi, Jim. My name is Tyler. I'm a 41 year old former dentist and current financial nerd here in Salt Lake City calling with a comment regarding episode 402, where you addressed a question about the mega backdoor Roth IRA.

In the episode, you wonder aloud why this technique is called the mega backdoor Roth IRA when it predominantly occurs in a 401(k) or 403(b) and rarely involves an IRA at all. I share that wonderment with you. Since we agree there is no formal or legal term known as mega backdoor Roth IRA, I suggest that you, me and all of us stop using the term mega backdoor Roth IRA to universally describe this idea and simply say mega backdoor Roth.

We can then use this term to describe the concept of moving after tax contributions immediately over to Roth accounts in order to max out our annual 415(c) limit in employer-sponsored retirement accounts.

From there, we can say mega backdoor Roth 401(k) or mega backdoor Roth 403(b) for situations that allow in-plan conversions. Or less commonly, we can say mega backdoor Roth IRA only when an IRA is actually involved via in-service distributions. Thanks for all you do and thanks to the entire White Coat team.”

Okay, that's my example of my Speak Pipe comment. And if this sounds appealing to you, send some in and we'll see if this can become a thing.

Now, let's connect all this back to Brian's comment based on what I just said. Let's listen to Brian's Speak Pipe again and ask yourself the question, “Does Brian know what he's talking about? Is Brian offering a thoughtful, correct, actionable comment here about the mechanics of the two options on how to make a mega backdoor Roth?” Let's publicly test Brian. Thanks, Brian, for being an unwitting experiment.

Brian:
This is a comment on the podcast that dropped Thursday, June 12. One of the questions was from a gentleman who was trying to figure out if his plan had an after-tax option that could then be used to fund a mega backdoor Roth. Two questions that he should ask his benefits team were if the plan actually allows post-tax contributions and if those contributions can be rolled into the Roth portion of the 401(k).

Another question to ask would be if the plan allows in-service distributions if it does not allow in-plan conversions to the Roth portion. Some plans, mine included, do not allow direct conversions of after-tax 401(k) money to the Roth option, but they do allow in-service distributions. They can then be sent to an IRA and then converted to Roth from there. Hope that helps. Thanks.

Tyler Scott:
Okay, friends, does Brian know what he's talking about? Did he describe the two mechanics of the mega backdoor Roth well? He did. He knows what he's talking about. He described the ways you can get money into the after-tax bucket, first finding out if it's even an option, and then once it's there, you can do an in-plan conversion or an in-service distribution. So, well done, Brian. Thanks for your comment, and let's see if we can get more of those from you guys.

Okay, now some of you may be thinking at this point, what's the big deal about moving the after-tax money to the Roth account anyway? Why not just leave it in the after-tax bucket? That's a reasonable question.

The answer is that if we leave the money in the after-tax bucket, we will owe taxes on all the growth on the investments at ordinary income tax rates, and that's no fun. But if we move the money into the Roth sub-account in the 401(k) or to our own Roth IRA, we don't owe any taxes on the growth of the investments.

That's why it's really nice if you can work with your 401(k) provider to set up automated immediate transfers from the after-tax sub-account to the Roth sub-account. That way, the after-tax contributions are made each pay period and then immediately moved to the Roth account. This ensures all the growth on the investments is certain to happen in Roth land.

Business owners like Jim with enough money, like we talked about earlier, can do it all at once. There's just $70,000 deposited into the after-tax account and immediately transferred to the Roth account. This isn't always possible, however. I have a client that's a physician at the University of Pittsburgh, and her 401(k), which does allow the mega backdoor Roth, it only allows two transfers a year from her after-tax account to the Roth sub-account.

This means she's contributing after-tax dollars each pay period. Those dollars are experiencing some growth. Then she moves it all to the Roth account every six months and has to declare that growth as ordinary income. It's a bummer. It's a mild bummer for her because overall, the access to the mega backdoor Roth far outweighs the small annoyance, but it's still not as good as it could be. The point is, don't leave the money in the after-tax bucket longer than you have to and make the transfers automatic and or immediate if at all possible.

Okay. Let's tackle one more question for today's episode from Nick on this mega backdoor Roth topic. Nick, sorry, this question is from a long time ago. I know that you're giving some 2024 contribution limits, but something happened to the Speak Pipe questions and we resurrected some old ones. Thanks for being patient with the response.

MEGA BACKDOOR ROTH CONTRIBUTION

Nick:
Hi, Dr. Dahle. This is Nick, an emergency physician. I have a question about a mega backdoor Roth. I'm 46, married, and because of a heavy clinical load and some side gigs, I make about $600,000 a year. I'm of the opinion right now, as a high earner, I should be doing traditional or pre-tax contributions.

Of the $600,000, about $90,000 is W-2 income, and that employer offers a 2.5% match, so I contribute $2,250 to a Schwab 401(k) to get the match there, and they don't have the ability to take after-tax contributions, so can't do a mega backdoor Roth in that account.

For the rest of my income, I'm paid as an independent contractor and contribute to a cookie cutter solo 401(k) from Fidelity. I max that out with $20,750 as an employee contribution and $46,000 as an employer contribution. As a higher earner, I also put six figures into a taxable brokerage account, and that account has grown to be bigger than our tax advantaged savings.

I understand the advantage of the mega backdoor Roth, but not sure I can do so, as I think I have filled up already my 401(k) tax advantage space. If there's a way to do a mega backdoor Roth, I would, and I appreciate your opinion on the matter. Thanks for all you do.

Tyler Scott:
Okay, friends, from what you've learned so far today, what would you say to Nick about his need or ability to do a mega backdoor Roth contribution? Think along with me here, and let's see if we can solidify some of what we've learned, and also try to give Nick some good advice.

Nick is 46. He makes $600,000. $90,000 of that is as a W-2 employee at the hospital, and the other $510,000 is as a 1099 independent contractor. His W-2 employer offers a 2.5% match in this Schwab 401(k), and he's contributing a little over $2,200, so his employer will put in $2,200 as well. He's making a smart choice here, so he doesn't leave $2,200 of free money on the table at the hospital. That's great.

We also know that the Schwab 401(k) through the hospital does not allow for mega backdoor Roth. Then he's making another smart decision by having a solo 401(k) for his 1099 income.

Let's pause here to test ourselves a little bit. What piece of information do you wish we had right now? When you hear, “Hey, I'm a self-employed person, and I'm about to ask a question that includes employer contributions to a solo 401(k)”, what are you desperate to know next? You want to know what kind of business entity he has set up. We wish we knew if Nick were operating as an LLC or an S-corp.

Why? Because our employer contribution limit is very different for those entities. For an LLC, how much are the employer contributions? Very good. 20% of our net business profits. And if he were an S-corp, how much can his employer contributions be? 25% of his W-2 salary. Very good.

In this case, it doesn't matter because he told us he's maxing out the rest of his employee contribution in his Fidelity Solo 401(k) and making the full $46,000 employer contribution as well.

He's doing this all pre-tax, which is almost certainly the right thing to do given he is in his peak earnings years. We've been recommending that here for a long time on the podcast, that it's almost always the right thing to do pre-tax when you're in your peak earnings years. If you want to go down the rabbit hole on that, go listen to the other pre-tax versus Roth podcast. Jim and Chris Davin talked about that at length.

Whether he is an LLC with sufficient profits or his S-corp salary is high enough, we believe Nick when he says he's maxing out his Fidelity Solo 401(k). I also realized I just said there a minute ago that he's maxing out the rest of his employee contribution on the solo 401(k) side. Let's make sure we're all on the same page about that statement.

Nick is not just asking a mega backdoor Roth question here. He's taking us into the world of multiple 401(k)s. This is one of the areas most prone to mistaken advice in the personal finance field. This $70,000 415(c) limit we've been talking about this whole time is not per person. The limit is per unrelated employer. If you work for two different employers, you get two 415(c) limits, even if one of those two employers is yourself, as is the case with Nick.

That being said, the $23,500 employee elective deferral limit is per person. If you have five jobs, you don't get to put in $23,500 at each job. You need to divide up that $23,500 in such a way to maximize the match your employer offers at each of those five jobs.

Notice Nick alluded to this in his question. He said he's putting in a little over $2,200 in his Schwab 401(k) at the hospital, and then he's putting in the rest of his employee elective deferral limit, nearly $21,000, at his other employer, which is himself, in his Fidelity Solo 401(k).

Is that the right decision? I don't think so. I think Nick should consider making his entire $23,500 employee elective deferral limit at the hospital, assuming it's not a crappy plan with terrible fees and terrible investments.

Why do I think that? Because he could then use the entire and separate $70,000 415(c) limit in his solo 401(k). He said he's making $510,000 in 1099 money, so even with some business expenses, let's say his net business profits are $450,000. Well, if he's an LLC, he can put in the lesser of $70,000 or 20% of those profits in the solo 401(k) all as employer contributions.

Well, what's 20% of 450,000? It's $90,000. That's more than enough to load up his solo 401(k) at Fidelity with the full $70,000 employer contribution to max out this separate 415(c) limit, and he's going to put another $23,500 in as an employee at the hospital 401(k) with Schwab, plus he's going to get the hospital's 2.5% match. That feels pretty cool. Go read Jim's post on multiple 401(k) rules for a better understanding of all of this.

Well, that's not the question Nick asked. He asked about whether a mega backdoor Roth makes sense for him in a solo 401(k). Well, friends at home, what do you think? Does the mega backdoor Roth have a role to play here? No. No, it does not. Not in the solo 401(k) anyway. He makes enough in net business profits or has a high enough W-2 salary from his S-corp that he can get $70,000 in the solo 401(k) all as pre-tax contributions, and that's awesome. No mega backdoor Roth needed.

Where we wish we had a mega backdoor Roth is in the Schwab 401(k) at the hospital. If that plan had a mega backdoor Roth, we could max out that 415(c) limit as well, and Nick would be packing away $140,000 into his two 401(k)s this year. He'd be doing about $98,000 pre-tax and about $42,000 Roth. That would be pretty sweet. But alas, Nick has to live with the opportunity to only put away $98,000 pre-tax, and the rest of his investments need to go to his HSA, backdoor Roth, and his taxable account.

Now, Nick, if your 1099 income ever drops to where you can't max out your 415(c) limit or you hit age 50 and that 415(c) limit gets a little higher due to catch-up contributions, perhaps you will find the mega backdoor Roth useful to you in your solo 401(k) at that point.

But you probably can't do it with that cookie-cutter solo 401(k) you've got at Fidelity. You're going to want to go to our recommended list on the webpage, scroll down, click on Retirement Accounts and HSAs, scroll down from there to where you get to Customized Solo 401(k) Providers, and for a few hundred bucks, you can get a 401(k) that will let you do all the mega backdoor Rothing you ever dreamed of.

Okay, remember, friends, don't just listen to talking heads like me and venture out there to do this on your own. Make sure to get your tax professional involved in all the minutiae and details and mechanics of all this. It actually can be pretty complicated.

Okay, that's all the questions for today. Thanks for spending an hour with us and for your ongoing support. I really love you guys. I love this community. It is so fun to be a part of this. I'm so grateful to all of you who make it such a rewarding place for all of us to learn and grow together. So, thanks for your questions. Thanks for listening. Thanks for being a part of this just beautiful group of people that we've created.

If you like what you're hearing from any of us, probably more so from Jim, but if you like anything you're listening to, please be open to leaving a five-star review on Apple or wherever you listen.

Today's five-star review comes from Adam Henry. He described himself as a young doc improving his financial wellness. Five stars. “Incredibly important information for maintaining a healthy financial lifestyle. Highly recommended.” Even if you don't leave a review, we appreciate you sharing the podcast with friends, families, members, and anyone who you think may benefit.

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DISCLAIMER

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INTRODUCTION

This is the White Coat Investor podcast Milestones to Millionaire – Celebrating stories of success along the journey to financial freedom.

Dr. Jim Dahle:
This is Milestones to Millionaire podcast number 233 – Dual dock couple pays off half a million dollars in loans while one of them stays at home.

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Mortar leverages over two decades of experience in architecture, development, and asset management in their projects to build value and minimize risk for investors. Invest in tax-efficient, high-return, risk-adjusted strategies with Mortar Group at whitecoatinvestor.com/mortar.

All right, don't forget all of you out there in White Coat Investor land. If you're looking for a little bit of extra money for not much more work or commitment, you might be able to be paid pretty darn well for giving your opinion on surveys. People want your opinion, it's valuable, and they will pay you for it.

If you go to whitecoatinvestor.com/surveys, you will see a whole bunch of companies that you can sign up with that will send you surveys from time to time. Now, they usually have a few screen out questions and only some of them pay you if you get screened out of the survey, but assuming you're who they're actually looking for, they will pay you substantially to share your opinion. One of our columnists has even made $30,000 in a year. That's another month or two of income for most doctors taking these surveys. So, check that out.

All right, this is the Milestones to Millionaire podcast. We celebrate your stories and use them to inspire others to do the same. You can sign up to come on the podcast, whitecoatinvestor.com/milestones.

All right, we've got a great interview today. Like we had a month ago, this is another repeat offender. Someone who's been on the podcast before. And I like doing these because I love illustrating the progression that you guys are making out there in White Coat Investor land as you go through your financial careers in parallel with your medical or other careers. Stick around after this interview. We're going to talk for a little bit about the concept of geographic arbitrage or geo-arbitrage.

INTERVIEW

We have another repeat offender on our Milestones to Millionaire podcast. Shane, welcome back to the podcast.

Shane:
Jim, it's great to be with you. I appreciate you having me back on. Glad there's not another repeat offender.

Dr. Jim Dahle:
Yeah. Well, we occasionally do have people who come on for another milestone and we love to do that because we love to see the progress all the White Coat Investors are making out there in their financial lives.

For those keeping score at home, the last podcast Shane was on was number 89. And the milestone we celebrated was him paying off his student loans. Here we are now, what, 144 episodes later, that's almost three years’ worth of episodes later, celebrating your next milestone. Tell us what you've accomplished.

Shane:
Well, I had so much fun paying off the first student loan, which was mine, I decided to do it all over again and paid off my wife's student loan. And I think I mentioned it back then that she's also a doctor, but it was very important that she stay home with our children and be a stay-at-home mom. And so, we transitioned to that and she still had a student loan and was not eligible for a PSLF anymore. So I said, “Well, let's just pay that one off too.” And that one was $254,335 and a penny.

Dr. Jim Dahle:
And a penny. The penny is the important part for sure.

Shane:
Very important.

Dr. Jim Dahle:
But that's not all, you guys have also hit a net worth milestone recently. Tell us about that.

Shane:
We did, we definitely crossed the million dollar net worth mark, which is still pretty surreal to say. I never envisioned that we would be millionaires this early in our career, but I guess paying off a half million dollars of student loans is a pretty decent return on investment and definitely help you get there.

Dr. Jim Dahle:
Yeah, pretty cool. Okay, well, give us the scoop. How far are you each out of training? What part of the country and what kind of income we've been looking at since you got out of training?

Shane:
Yeah, certainly. We finished training, I did in 2018 and my wife did in 2019 and she ended up going to fellowship down here in Phoenix, which is where we still live. Very hot this time of year, but beautiful otherwise. And so, she transitioned into that role in the end of 2020. And I kept working, I'm a pediatric hospitalist. And so, my income is kind of in the mid-range for pediatricians in the mid-$200,000s per year.

I think last time I had mentioned that I had the worst timing in the history of refinancing anything, because I refinanced my student loan back when we were both working three days before the CARES Act, and then they all went to zero. I was kind of stuck with that. We ended up working out and I got mine paid off when we talked about it last time. And then my wife was ineligible for any of the other programs. And so, we said, we're just going to pay off hers too to ensure that we had that financial freedom and those things moving forward. And so, that's when we started, just kept on the march, so to speak. It was pretty easy to transition.

Dr. Jim Dahle:
Let's talk about the decision for one of you to be a stay at home parent. Tell us when that came, what you weighed was you made that decision, the financial ramifications, let's talk about that.

Shane:
Absolutely. It's not a decision we made lightly. And I think that a lot of our training was, as I'm sure you appreciate, you're kind of on the hamster wheel and you're always thinking about the next thing. You're always trying to finish. You go to undergrad and then you go to med school and then you go to residency. It's always like trying to climb the mountain and move on to the next thing. And then once you get past that, you start sitting down and you're older and you think about what's important to you in life. And it's remembering your “why” and remembering why you want to do things like this, like pay off a student loan.

For us, our oldest daughter has some special needs. She has Williams syndrome. And so, she's very special to our heart. My wife was really tired of missing things that was happening in her life as far as some of her medical problems and some of her schooling needs. And so, she said, that's the most important thing to me is to be a mom, to take care of her and her other kids. And now we have three with number four on the way next month. And she has not looked back at all. It's been very fulfilling to her.

And fortunately, we're in a profession where my income supports the whole family. You don't need two people to work. And I know that's not the reality for a lot of people, but we were very blessed and fortunate to be able to make that decision. And it's been the best one for our family.

Dr. Jim Dahle:
Yeah. How far after she completed her training did you guys make that decision?

Shane:
She was in the, she had just finished the first year of her fellowship in maternal fetal medicine when that decision came down. And so, that was about five years after graduation from medical school.

Dr. Jim Dahle:
And her career plans, does she plan to go back and practice at some point, use the degree in some function or is she content to be a stay-at-home parent at this point?

Shane:
She's very content and she is amazing at it. She's obviously the best wife and the best stay-at-home mom I could have ever asked for. And so, I definitely support her in that. And I think that that is her primary vocation. I can imagine sometime in the future when the kids are grown, she'll end up probably going back and practicing a little bit because she still does enjoy medicine, but definitely in a reduced capacity. She's glad to be in her primary vocation now.

Dr. Jim Dahle:
And you never know, right? When Katie started her next career and now she's a politician. She was elected to the school board. So you never know what the next chapter in your life is going to look like.

Shane:
Congratulations.

Dr. Jim Dahle:
Yeah, exactly. I hear the job description. I'm like, that sounds like the worst job ever, Katie, but she loves it and she's making a difference and she's very good at it.

Shane:
Yeah, good for her, good for you guys.

Dr. Jim Dahle:
At any rate, let's talk about the financial journey here. You guys have not been out of training that long to be millionaires. You've only been out seven years. It took us seven years to become millionaires and we did not start anywhere near the student loan debt that you guys have. So, tell us how you did it. I calculate if I just look at your income here mid $200,000s-ish, the amount of money you've made over the last seven years is less than $2 million and you've got a million of it left. This is remarkable. So, tell us how you did this.

Shane:
One bite at a time, one step at a time. The med school adage about drinking from the fire hose was definitely applicable, like we were talking about. You definitely take it one step at a time. And so, I decided, last time we visited, I ended up working a lot of extra jobs, locum-wise, to supplement the income. We've always had a savings rate of about probably 25 to 30%.

And so, we always maxed out our deferred retirement accounts while she had one and then for me, and we ended up maxing 457 and then the Roth IRAs and the HSA and then everything on top of that kind of went to the student loan. And I ended up having to work some extra jobs to make sure those payments were still being made on the timeline that we had established. And so, it did require some extra work and that was kind of part of the journey.

And as I sat back and I reflected on the day that we made the last payment, I remember exactly where I was sitting as far as when the journey started. I had just graduated residency. We were still in Illinois. And when you work for the university up there, they pay you monthly. And so, it's that first attending paycheck. It's five figures, it hits your bank account. And I was sitting in a Panera Bread in Peoria, Illinois, thinking, “Man, what am I going to do with this? I really wanted to buy a car. I really wanted to do some other things that we had postponed.” You live like a resident for three years and a really difficult residency program, especially for my wife and OB.

I remember sitting there and I wrestled with that decision. And eventually I decided to pay off in bulk my last undergrad loan for $5,000 and some change. And so, I made that payment after much fussing and discussing amongst myself at that Panera. And I really never looked back. And I think that was the watershed moment for me. And so, well, this is important to us to be out of debt and you got to take the first step somewhere. So that was our first step.

And then, like you mentioned so much on your blog and in your book, it's a lot of motivation and you have a lot of fortitude. But once you see that sum start going down by four or five figures every month, it becomes really motivating. And it's a little bit easier to kind of delay that gratification.

Dr. Jim Dahle:
Yeah. Now, there was a move at some point. It sounds like from the Chicago area, not that cheap of a place to live. Maybe docs don't necessarily get paid all that much there. And the tax rate's relatively high and the cost of living is relatively high to Phoenix, which has a state income tax, but it's lower. It's not the cheapest place in the nation to live, but it's much cheaper than Chicago. Tell us about the decision to go someplace that was a little bit cheaper cost of living.

Shane:
Yeah, certainly the decision was actually pretty easy because that's where my wife ended up accepted into fellowship. That's what drove us to move down here to Phoenix and a very family-friendly program and a little bit cheaper than Illinois as far as taxes go. The cost of living is still pretty high out here, especially post COVID.

But that was where the decision started. And then I landed in a very good job working for a very good health system that's taking great care of us. And so, that offset a lot of those somewhat increased living expenses, although the tax rates were certainly lower down here as far as state income tax and some of the other taxes that you did getting out of Illinois. I love Peoria and I love downstate Illinois, but getting out of Illinois and the tax burden definitely feels like the last chopper out of Vietnam type situation right before 2020.

Dr. Jim Dahle:
Yeah, it's amazing how much faster it is to build wealth in places where you're paying much less in income tax. This is a substantial expense for many physicians across the country.

Okay, let's give some advice to people out there that are maybe in your shoes. Maybe they're two young attendings and one of them, they've got a kid or two and one of them is thinking about going part time or thinking about stopping for a few years or stopping permanently. What advice do you have for them as far as their finances?

Shane:
I think that you always have to remember your “why: and you always have to remember what's important to you and what do you want to get out of life. And for my wife and I, it was certainly her wellbeing and the wellbeing of our children. And they've been homeschooled for five years now and it's been the most fruitful endeavor that we've undertaken and that was very important to us.

I think that it's really easy to get caught up in the rat race, get caught up in the keep up with the Joneses and all those things that you talk about on your blog. And so behaviorally, it's easy to put that as the primary focus, but it's always necessary to take a step back and evaluate what's important to you. Money's a great servant, but it's a terrible master. And I think it's easy to get caught chasing the money and chasing the security, whereas it should be at the service of something greater. And for us, that was our family and having that security and the ability for my wife to stay home and care for our children.

Dr. Jim Dahle:
You'd encourage other people to figure out their “why” and prioritize what's most important to them.

Shane:
I would, and I think that's probably the most important. Like you make a written investing plan, you make a written financial plan and you try to stick to it, you definitely should have a personal statement for your family. You should have a statement of goals or a mission statement for your family and what's important to you. And then you should put your resources at the service of that. And that'd be the advice I would have for anybody young attending starting out.

If a pediatric hospitalist can pay off a half million dollars in loans, then you can do it too, no matter what specialty you're in. If that's what's important to you, then you should go for it. And if you want to put your money at the service of something else, just make sure it's what's important to you and make sure that you've had that talk with your spouse, your significant other and always have that at the forefront of your decision-making.

Dr. Jim Dahle:
Now you guys have freed up a substantial percentage of your income that was going to lenders. What are you doing with it?

Shane:
That's a great question. I haven't quite figured it out yet. I think that I would like to lubricate the lifestyle just a little bit. I've been driving a 2012 Nissan Versa for the past 13 years. I may upgrade that a little bit and we may take a couple of trips now that it's paid off. But then I think we're going to get back to really trying to reach that financial independence because definitely, I love practicing medicine. It's what I envisioned doing for a long time, but I would like to practice it on my terms into the future and not have that commitment long-term. We feel like you have to do certain things, the pressure to pass student loans or to maintain a certain lifestyle.

I think keeping investing and maybe dabble a little bit in real estate. And I think that's kind of the next steps for us. But like you said, you never know what comes next. I don't think I'll be in politics though.

Dr. Jim Dahle:
Very cool. Well, I'll tell you what, I do enjoy part-time medicine. It's everything I like about medicine and a whole lot less of the stuff I don't like. I definitely encourage that sort of thing.

But okay, let's celebrate this with you. You have accomplished something that is really profound. We're always getting asked by people, get more pediatricians on. We want more lower income docs on. And here we go. Lower income doc paid off a gob ton of student loans, and became a millionaire just as quickly as I did as an emergency doc who didn't have student loans. So, congratulations to both of you and thank you for being so willing to come on the podcast and share your story with the community.

Shane:
You bet. It's a pleasure to be with you. I appreciate you let me tell our story.

Dr. Jim Dahle:
All right, I hope you enjoyed that interview as much as I did. I love having repeat clients, customers, visitors, guests, offenders, whatever you want to call them on the podcast because it's fun. Because I often do ask, “Hey, what's your next financial goal?” And then actually getting to hear about them accomplishing it a year and a half, two years, three years later is pretty awesome.

Congratulations to all of you out there, whether you've been on the podcast or not that are accomplishing financial goals and working toward them. It's a one player game. It's you against your goals. You're not competing with the person on the podcast. You're not competing with your partners at work. You're not competing with anybody else. It's just you and your goals, single player game. But it's nice to celebrate it with some other people in the community from time to time.

FINANCE 101: GEOGRAPHIC ARBITRAGE

Okay, I promised you at the top of the podcast, we're going to talk about this concept that we alluded to in the interview, geographic arbitrage. I think this is really powerful. I have seen this work very, very well in the lives of many White Coat Investors. It just costs a lot of money to live someplace like the San Francisco Bay Area, to live someplace like Manhattan, to live someplace like Washington, DC.

And as the price of housing in particular goes up all over the country, more and more and more areas are becoming high cost of living areas and very high cost of living areas. Well, that isn't everywhere in the country. There are places in this country where housing is not that expensive. And you go there and look at a big fat multi-thousand square foot doctor home on multiple acres, and you're amazed how cheap it is.

You come from California to Nevada or wherever, and you're like, “Wow, it's only $600,000. I'll take two.” Because that house was $2.5 million or $4 million in the Bay Area. So you realize that with housing, your money goes a lot further.

Well, that's not all, right? There are other expenses as well, because everybody else living in the Bay Area has also got high expenses. They have to charge a lot for their services. You find when you go to the Midwest or Texas or the South or whatever, you find out that everything is cheaper. Your childcare is cheaper. Your groceries are cheaper. People that can work on your house are cheaper and it's amazing.

But you know what's amazing about those places? Medicine pays the same or better. Sometimes it pays better. You go to a small town or medium-sized town and they are thrilled to have you. They're spending $50,000 or $80,000 just to recruit you to come to that town. So they might give you a big fat signing bonus in addition to this lower cost of living.

Plus you got to realize the tax burden is not the same in every state in this country. You're going to pay more in income tax in some places than others. Now I live in a relatively medium, moderate kind of income tax state. I think we're at 4.65 or 4.75% or something, but it's a relatively flat tax. It's not progressive system in Utah. It's kind of in the middle.

There are seven states that don't charge income taxes at all. You want to go to Texas or Florida or Alaska or Nevada or Wyoming, I know I'm forgetting a few and that's okay. You guys know what they are if you live there. They don't charge income tax at all. And there's lots of places that charge much less than New York or California or some of these for lack of a better term, typically blue states that have relatively high tax burdens.

Now, sometimes you get more for those taxes and sometimes you don't. Sometimes it's just a sunshine tax you get because the weather there is nice. Well, the weather is not that bad in other places and sometimes just as nice. So, you really got to weigh the benefits of being in those high cost of living areas and make sure they're really worth it to you. And it might be because you have family there. I get it. I like living near family as well. Although when we moved here, we didn't have any family living here. They subsequently moved to where we were amazingly and that could happen, I suppose, in your family as well.

You also might be there because it has something unique about the job. Maybe it's a particularly unique academic job or something really cool about it that you can't do somewhere else. I get it. It might be worth it to you, but at least calculate the cost. It might be you get to live around people that are like you are. Maybe it's a more diverse kind of place. That's often the case on the coasts where the cost of living tends to be higher.

But again, you've got to ask yourself, “Is this worth it to me?” And actually calculate out the cost. What does it mean if you live in Portland instead of Indianapolis? What does it mean for your finances if you move to Texas or Florida or Nevada? And if you take that income tax savings and you put it toward retirement, how many years sooner do you retire? How much more can you spend during retirement? Maybe it's five, six, seven years sooner that you retire.

You've got to ask yourself, “Is practicing and living in California worth having five to seven fewer years of those go-go years of retirement?” Maybe it is, maybe it isn't. But I want you to make that decision consciously and deliberately and with all the information you need to have. And I think there's a lot of docs out there that don't care that much where they live because their hobbies or whatever, where their family is, it's no different whether they're living somewhere else.

And I'll tell you what. The people in those areas definitely need medical care and they will be thrilled to have you come to their communities, practice there and live there, establish a life there. You'll be pretty amazed how awesome of a life you can have in some of these areas with a much lower cost of living.

That's geographic arbitrage. Consider it. It's not right for everybody, clearly. And I know the people in expensive, high cost of living areas are thrilled to have doctors there to take care of them as well. So, maybe everybody shouldn't leave those areas. I want them to have medical care as well.

But particularly, if you are in a difficult financial position for whatever reason, particularly low income or particularly high student loans or whatever, give geographic arbitrage some consideration. You might be surprised just how much of a difference it can make in the quality of your overall life.

SPONSOR

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All right, thanks for being with us. Hope you're having a wonderful summer. I know we are. In between the time I record this and when you listen to it, I've got a couple of awesome trips planned that I'm looking forward to. And I hope you have had some good stuff happening as well.

Congratulations to all of you accomplishing your milestones out there. We'd like to hear from a few of you. Sign up at whitecoatinvestor.com/milestones, and we will celebrate this with you and use it to inspire others to do the same.

Keep your head up and shoulders back. We'll see you next time.

DISCLAIMER

The hosts of the White Coat Investor are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.