Bonds in a Rising Interest Rate Environment – Podcast #84

Podcast #84 Show Notes: Bonds in a Rising Interest Rate Environment

I was asked for some good strategies for investing in bonds in a rising interest rate environment, like short term bonds, money market funds, inflation adjusted bonds, and stable value funds. Don’t extrapolate the past into the future. Interest rates may go up, down, or stay flat.  Like you, I have no idea what the answer is. Neither does anybody else. Make sure you have an investing plan that is highly likely to reach your goals no matter what happens with interest rates in the short run and in the long run. I prefer a fixed asset allocation strategy. If you had a working crystal ball, stay in cash until rates are done going up, then switch to long term bonds until rates are done going down then switch again. You can hedge your bets by staying short, but there is a very real cost to doing that and we discuss that in this episode.

Podcast #84 Sponsor

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Splash Financial is proud to partner with WCI to help you save thousands when refinancing your medical school loans. Splash Financial partners with banks and credit unions to negotiate market leading rates on your behalf. Refinancing with Splash Financial will simplify your loans and could lower your monthly payments, helping you achieve your financial goals. Our fast and easy online application allows you to check your rate in under 3 minutes and apply with no application, origination or prepayment fees. Our US-based concierge customer service team is available every step of the way via call or text. WCI readers receive a $2,000 bonus when they successfully refinance loans over $200k, a $1,000 bonus for loans over $100k, or a $500 bonus for loans over $50k. Go to Splash Financial to learn more!

Quote of the Day

Our quote of the day today comes from Indra Nooyi. She said,

“there is nothing like a concrete life plan to weigh you down. Because if you always have one eye on some future goal you stop paying attention to the job at hand, miss opportunities that might arise, and stay fixedly on one path even when a better, newer course might have opened up.”

Financial Education Books

Be sure to check out my recommended books list. Books are really the best in a lot of ways because all the information that has to be updated continually is not that important when it comes to drawing up your own financial plan. Sometimes a book that is 10 or 20 years old has the information that you need in it to put together a plan that will last for the future.  I like the fact that reading a few good books can really provide you a solid initial financial education. Books have a format to them that allows you to go step by step in putting together your initial financial plan. Whereas you are never going to get that out of a podcast or a blog that you’re following and certainly not out of a forum, where it’s just haphazardly bouncing around from one topic to another. So I encourage you to spend at least a little bit of time reading good investing books and you can find a list of those here.

Investing in Bonds

A listener asked me for some good strategies for investing in bonds in a rising interest rate environment. She asked about short term bonds and money market funds and inflation adjusted bonds and stable value funds. I think she is making a classic mistake about extrapolating the past into the future. For example, this whole phrase a rising interest rate environment assumes you know what is going to happen in the future. It is saying that you know interest rates are going up and I would propose that you don’t know that, at least not any further than the next few months, if the Fed maybe telegraphed what they are going to do at their next meeting. But for the most part those prices have already been incorporated or those interest rate changes have already been incorporated into the prices of bonds. So I think assuming that you know which way bond rates are going to go is a big mistake.

Interest rates may go up. They may go down. They may stay flat. I remember when interest rates dropped dramatically after the 2008 crisis, people talked about how interest rates have nowhere to go but up. Guess what? They kept going down. They went down, down, down, down, down. Even when everyone was saying they have to go up. Interest rates don’t have to go up. They could stay right where they are today for years, for decades.  I think making the assumption that rates are going up is probably a mistake. I think you need a plan that will allow you to be successful no matter what interest rates do in the future.

If you had a working crystal ball what you would do is you would stay in cash until rates are done going up and then you would switch to long term bonds until rates are done going down and then you’d switch again. But none of us have a working crystal ball. Now you can hedge your bets by keeping your term risk low, by keeping the term of your bonds short. That lowers your interest rate risk. But the problem is there’s a very real cost to doing that and you can see what that cost is by looking at the current yields on various types of bonds.

If you just go to the Vanguard page where they list all their mutual funds, you can look at the yields on the various types of fixed income funds there. Right now as I’m recording this podcast that says that cash via the prime money market fund is paying two point two five percent per year. The short term bond index fund is paying three point one percent. The intermediate term bond index fund is paying three point six one percent. And the long term bond index fund is paying four point one nine percent. So that’s the price you pay. If you want to stay short in cash at 2.25 percent instead of long term bonds at four point one nine percent. You’re giving up 2 percent a year. That is not insignificant especially if rates go down from here or even if they just stay where they’re at. You know you basically made a guess, you made a bet on where interest rates are going when you decide to stay short. And I think that can be a dangerous thing to do.

In reality when you are a long term investor in bonds, you want rates to go up as long as inflation stays stable, as long as inflation isn’t going up with them. You want interest rates to be higher because once you’ve invested in those higher interest rate bonds for at least the duration of the bonds you own, then you’re coming out ahead. For example if you have a bunch of bonds at 4 percent and interest rates go up 1 percent so now you can buy bonds at 5 percent and the duration of your bonds was five years. Well starting at five years you’re coming out ahead with that interest rate being higher at 5 percent instead of 4 percent. You got to realize that that is a good thing for bond investors. Now it’s not a good thing if inflation goes to 15 percent because inflation is particularly bad for bond investors. But as long as inflation is stable that’s good.

Even people who own Treasury Inflation Protected Securities, to protect them from unexpected inflation, don’t want unexpected inflation. The reason why is because they own other assets most of the time.

Let’s talk about stable value funds which are sometimes offered through an insurance company. Probably the most famous one is the thrift savings plan that VA workers and military docs have access to. The G fund there is essentially a stable value fund. It offers you bond like yields with money market fund risk which is a pretty attractive combination. If you have one of those available in your 401k that’s not a bad choice especially if the yield is pretty high on it. It is a good choice if you’re really worried that rates are going to go up. Obviously when rates go down that’s not going to help you much. You’d normally get a little kicker on your bond returns when rates drop. At least in the short term you get that kicker, you don’t get that in the G fund. So bear in mind that is the risk.

In general with bonds I prefer a fixed asset allocation strategy. I’ve just decided I’m going to put 10 percent now of my portfolio into TIPS and I put 10 percent into the G fund or similar bond funds for nominal bonds and I literally just rebalance. I rebalance and don’t change the plan based on what I think interest rates are going to do. And I recommend you adopt a similar approach. Otherwise you’re stuck trying to decide when do you change the duration of your bonds and when do you change them back? You have to be right not once but twice when you’re trying to time the market like that. I think that is pretty difficult to do and will cause you a lot of stress trying to do it.

529 for Military Families

When I first started saving for my kids college, I was in the military. I was an Alaska resident. There was no state tax benefit whatsoever for using a 529 plan so I didn’t use a 529 plan. I actually use an education savings account at Vanguard. The big downside of an education savings account is you can only put two grand in there per kid per year. Military docs don’t make that much so maybe that’s all they can afford. If all you’re putting in there is a couple of grand per kid per year then I think education savings account is perfectly fine. The other thing you can do is what I did when I moved to Utah. I moved that money out of the education savings account into the 529 and took a state tax break in Utah for moving it. So I actually was able to preserve a state tax break by using the education savings accounts before I moved into a state where I actually owed state tax.

Now if you’re already a resident of a state that pays state tax figure out how to change your residency to Nevada or Florida or Washington or Alaska. 90 percent of the military people seem to be residents of a tax free state. That’s a pretty advantageous thing for a military doc to do. You can’t just declare it. You usually have to go live there for a period of time but most of the time at some point during your career you can figure out how to do that. Realize the 529 are portable, you can roll them over from one state to another or you can have accounts in many different states. You can have 529s all over the place so you don’t actually have to guess where you’re going to end up when you start these things. You can move them. You can have multiple accounts, it’s not that big of a deal. If my state wasn’t given me a state tax break and I wanted to save more than $2000 per kid per year, I would just look at the good 529 plans out there. We’re talking about Utah and Nevada and Ohio and New York and California. You can just choose any state, if you’re not getting a state tax benefit in your state.

IRA Recharacterizations

IRA recharacterizations are not permitted anymore in 2018. The problem is a lot of people get confused about this. Does this mean no more backdoor Roth IRA contributions? People are mistaking what a recharacterization is and what a conversion is. A backdoor Roth IRA is when you contribute money to a traditional IRA because you make too much money and you’ve got a retirement plan at work. You don’t get to take a deduction for that. So the next day you transfer it. You convert it to a Roth IRA and it’s never taxed again. That’s a backdoor Roth IRA. That is still completely allowed in 2018 and in 2019. Nothing has changed there with regards to that process. What has changed is a recharacterization of a Roth IRA or Roth conversion. So if you convert an account to a Roth IRA now you can’t recharacterize it back to a traditional IRA. That eliminates a strategy that some people were doing occasionally in which they would convert multiple Roth IRAs.  For example they would take some money from their IRA and they would convert five thousand dollars worth of a gold fund, five thousand dollars worth of an international stock fund, five thousand dollars worth of a bond fund, and five thousand dollars worth of a U.S. stock fund. Toward the end of the year they would see which one of these has done better. And the one that has done the best they would leave as the conversion they meant to do and they would recharacterize the other three. They called this the Roth IRA horse race. It is a pretty ingenious strategy but it is now no longer allowed. That is what is not permitted anymore. The backdoor Roth IRA itself is fine.

529s and Scholarship Money

A 529 plan that is owned by you or your children does count on the Free Application for Federal Student Aid toward parental and student assets. So in theory it can reduce the amount of financial aid you receive from an institution whether that be a need based grant, some sort of need based scholarship, or loans. This won’t reduce their eligibility for a merit scholarship for music or academics or athletics.

Tax Saving Strategies for Doctors in Group Practices

There are three categories that help people reduce their tax burden.

  1. The first category is really understanding the rules of the tax advantaged accounts that are available to you. I’m primarily talking about your retirement accounts. You want to cut your tax bill? Max ALL those suckers out. Retirement accounts are the best tax reduction thing out there for a typical doctor.
  2. The next category is recognizing things that are business expenses. Business expenses are the best kind of deduction there is because you don’t have to pay any sort of payroll taxes or income taxes on them. Recognize those expenses and make sure you claim them.
  3. The last category is to live your life in such a way as the IRS wants you to live it. The IRS wants you to give money to charity. If you’re itemizing deductions on schedule A you get a deduction for giving money to charity, so if you do that, that helps reduce your tax bill. Now obviously if you give ten thousand dollars to charity and it saves you four thousand two hundred dollars off your tax bill, like it does for me, you’re coming out behind just giving money to charity to try to reduce your taxes but living your life in the way that IRS wants you to, does reduce your taxes. Same thing with having kids. You may qualify you for some child tax credits. Getting married, you end up using the married bracket instead of the single brackets.  I suppose there is possibility there to have a marriage penalty but a lot of times, particularly if you’re married to a lower earner or to a stay at home parent, that dramatically lowers your tax burden. But the bottom line is spending and giving and living your life like the IRS wants you to does reduce your taxes.

Getting Rid of Insurance You Don’t Need

Another reader was suckered into buying a bunch of insurance they don’t need from a company notorious for selling doctors insurance they don’t need.  He is single with no one else depending on his income and now owns both a term and a whole life policy.

Here is what I told him:

  1. He mistook a commissioned salesman for a financial adviser. He needs to fire him now.
  2. If he anticipates having someone depending on his income anytime soon he needs to get a term life insurance policy. He can find an independent agent on our recommended agents page that can sell him one of those at probably 50 percent less or 100 percent less than than what he is paying now.
  3. He now has a disability policy that is a little bit inferior to what he can get from the big five or six companies. Now maybe it doesn’t matter,  if you’re terribly disabled both of them are probably going to pay you just fine. But if you want the best policy and the best and strongest definition you’re probably going to want to meet with an independent insurance agent who can sell you a policy from any of the big five or six companies and compare what you have to what is available and make a rational informed decision about what to do.
  4. If he still wants a financial advisor I’ve got a list of advisers that I recommend. A real adviser charges you for the advice. They don’t make commissions off what they’re selling you. All of the advisors on my page will offer good advice at a fair price.
  5. He needs to get rid of the whole life policy. Remember if you have a whole life policy that you’ve had for decades it may make sense to keep it. It’s worth getting it evaluated, looking at and focusing not so much on what’s been spent in the past but what your return ought to be going forward. But when you’ve only had one for a year you might as well just dump it.

It is unfortunate. I hate hearing these stories. I hear them very often. If you want to read more stories like them I suggest a thread on the White Coat Investor Forum called Inappropriate Whole Life Insurance Policy of the Week.  Most of them are actually this same policy that this reader has, it is frequently sold to doctors.

Converting Traditional IRA to Roth IRA

“I finished my medicine residency this year so 2018 will likely be the lowest earning year for a while. This combined with my wife’s maternity leave and changes to the tax laws will put us in the 24 percent marginal tax bracket this year with another sixty thousand dollars of possible income before moving into the next marginal tax bracket. Given that we’re moving into a higher tax rate for the next many years and federal tax rates are quite low I’m thinking about incurring taxes now so I don’t have to incur them later. I’m thinking about either converting the traditional to Roth retirement accounts with about seventy five thousand dollars in such accounts and or redeeming 26 year old EE savings bonds it will stop producing interest in 2022 regardless. That would generate about 13000 dollars in taxable interest. Seems like either would be a good move since in future years I would have to pay a higher marginal rate to make a conversion or redeem these savings bonds. Do you think this is a good move?”

Yes I do think it’s a good move. I think great years for Roth conversions are during medical school when you don’t have any other income. Next best after that are those years in which you’re a resident for the entire year. Then of course the next best after that is the year you leave residency when you have half a resident income and half of attending income which is what we’re talking about in this situation. So yes I would do that conversion. I would convert as much as I had, if I had the money to be able to pay the taxes on those conversions.

I suspect getting out of those savings bonds this year is also probably a smart move. He has only a few more years of interest that can be earned on them before they stop earning interest. And they’re not that awesome of an investment to start with so why not redeem those and get started with more appropriate investments in a taxable account.

Student Loan Management

“I’m a family practice doc in a big city. I have about 250,000 dollars in student loans at about 5 percent. I was planning on going for forgiveness in 25 total years and then paying the taxes on that. Can I refinance that to a lower interest rate and still go for forgiveness? Also can the amount I pay in taxes somehow be considered a business write off? I did need to pay that to maintain a business.”

Wow. We are talking about IBR, paye, and repaye forgiveness. In these programs you have to make payments for 20 to 25 years. That is a long time to have student loans, almost your entire career. That sounds terrible to me to have this shackle hanging over your neck especially when I see so many docs clear this debt in one to five years after coming out of residency. It makes me cry to see somebody think about dragging it out for 25 years. To make matters worse after those 25 years, you have to save up for the tax bomb which may be the same size as the initial loans, depending on your situation. The truth of the matter is for this family practice doc probably making 200 thousand dollars a year paying off 250,000 dollars in student loans should be three or four year project. That’s not a 25 year project.

The question however was can I refinance this to a lower interest rate and still go for forgiveness? And the answer is no. Once you refinance those loans they are now private loans and are no longer eligible for the IBR, paye, repaye, or the Public Service Loan Forgiveness program. The last question can the amount I pay in taxes somehow be considered a business write off? Boy wouldn’t that be awesome. No that doesn’t work. Kind of sucks. You’re paying them off with after tax dollars. That’s why you want to get them out of your life as soon as you can.

Ending

If you still feel like a little bit lost and you need a little bit more structure in developing your financial plan, consider our Fire your Financial Adviser online course. The point of this course is that you get to the end of it and you have a written financial plan that you can follow for the rest of your career. It is probably one of the best ways you can spend your money and your time early in your career to get this stuff under control.

Full Transcription

[00:00:00] 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. Here’s your host Dr. Jim Dahle.

[00:00:20] This is White coat investor podcast number 84. Where we are going to talk about bonds in a rising interest rate environment. Our sponsor Splash Financial is proud to partner with white coat investor to help you save thousands when refinancing your medical school loans. Splash Financial partners with banks and credit unions to negotiate market leading rates on your behalf. Refinancing with Splash Financial will simplify your loans and could lower your monthly payments helping you achieve your financial goals. Our fast and easy online application allows you to check your rate in under three minutes and apply with no application origination or prepayment fees. Our U.S. based concierge customer service team is available every step of the way, be it call or text. WCI readers receive a 2000 dollar bonus when they successfully refinance loans over 200,000, a one thousand dollar bonus for loans over 100,000, or 500 bonus for loans over 50,000. Go to White coat investor dot com slash splash financial to learn more.

[00:01:13] Thanks for what you do. I know you’re job is not easy. You’re likely on your way into work or maybe on your way home trying to relax a little bit, recover from the stresses of the day. And thank you. Thank you for what you do. I know you probably didn’t hear that today at work and so it’s good for somebody to tell you that.

[00:01:30] Our quote of the day today comes from Indra Nooyi. She said there is nothing like a concrete life plan to weigh you down. Because if you always have one eye on some future goal you stop paying attention to the job at hand, miss opportunities that might arise, and stay fixedly on one path even when a better newer course might have opened up.

[00:01:49] Be sure to check out the recommended books list on White Coat investor. The books are really the best in a lot of ways because all the information that has to be updated continually is not that important when it comes to drawing up your own financial plan. Sometimes a book that’s 10 or 20 years old has the information that you need in it in putting together a plan that will last for the future. So I really like the fact that reading a few good books can really provide you a solid initial financial education. I think part of it is just that books a lot of times have a format to them in a system to them that allows you to go step by step in putting together your initial financial plan. Whereas you’re never going to get that out of a podcast or a blog that you’re following and certainly not out of a forum where it’s just haphazardly bouncing around from one topic to another. So I do encourage you to spend the least a little bit of time in good investing books and you can find a list of those at Whitecoat investor dot com under the books tab. If you look under the tab for the white coat investor book there is also a link there for great books by others. And check out my list of recommended books there.

[00:02:56] All right our first question today comes from our speak pipe questions. If you’d like to leave us a question for the White Coat investor you can do that on our podcast page and record that and we’ll put it on to the podcast. So far we haven’t haven’t missed a single one every single one that’s been left. We put on the podcast so if you want to hear your voice on the right coat investor podcast here’s your chance.

[00:03:17] Yes I was calling wondering if you can do a podcast regarding bonds. You know like strategies for rising interest rates. You know I know you have stable value bonds, short term bonds, typically you know we use intermediate bonds but with the rise in interest rates I was just wondering if you could do a podcast on some good strategies for rising in bond rates such as money markets bonds or short term bonds or I’ve heard about inflation adjusted bonds but those don’t seem to be working to well right now. Alright. Thanks.

[00:03:54] Basically this question asked me to hit a podcast on some good strategies for bonds. Investing in a rising interest rate environment. So she was asking about short term bonds and money market funds and inflation adjusted bonds and stable value funds and I think she’s kind of making a classic mistake about extrapolating the past into the future. Right. For example, this whole phrase a rising interest rate environment assumes you know what’s going to happen in the future. It’s saying that you know interest rates are going up and I would propose that you don’t know that at least not any further than the next few months if the Fed maybe is telegraphed what they’re going to do at their next meeting. But for the most part those prices have already been incorporated or those interest rate changes are already been incorporated into the prices of bonds. And so I think assuming that you know which way bonds are going to go is a big mistake.

[00:04:50] Interest rates may go up. May go down they may stay flat. I remember after interest rates dropped dramatically after the 2008 crisis, six or eight years people talked about oh interest rates have nowhere to go but up nowhere to go but up they’re going to go up. Guess what? They kept going down. They went down down down down down. Even when everyone was saying they got to go up. Interest rates don’t have to go up.

[00:05:11] They could stay right where they are today for years, for decades. I mean take a look at Japan. Interest rates have been low for decades in Japan. They could also go back down to where they were a couple of years ago. Interest rates have come up over the last couple of years and they could easily go back to right where they were. So I think making that assumption that rates are going up and you know they’re going up is probably a mistake. I think you need a plan that will allow you to be successful no matter what interest rates do in the future. I mean seriously if your plan requires you’d have a working crystal ball that tells you what interest rates are going to be in two years. That’s going to be a pretty tough plan to come up with.

[00:05:47] I mean if you had a working crystal ball what you would do is you would stay in cash until rates are done going up and then you would switch to long term bonds until rates are done going down and then you’d switch again. But none of us have a working crystal ball. Now you can hedge your bets by keeping your term risk low, by keeping the term of your bonds short. That lowers your interest rate risk. But the problem is there’s a very real cost to doing that and you can see what that cost is by looking at the current yields on various types of bonds.

[00:06:16] If you just go to the Vanguard page where they list all their mutual funds, I look at it all the time. I just google Vanguard mutual funds by asset class. You can look at the yields on the various types of fixed income funds there. Right now as I’m recording this podcast that says that cash via the prime money market fund is paying two point two five percent per year. There are short term bond index fund is paying three point one percent. There are intermediate term bond index fund is paying three point six one percent. And the long term bond index fund is paying four point one nine percent. So that’s the price you pay. If you want to stay short in cash at 2.25 percent instead of long term bonds at four point one nine percent. You’re giving up 2 percent a year. That is not insignificant especially if rates go down from here or even if they just stay where they’re at. You know you basically made a guess, you made a bet on where interest rates are going when you decide to stay short. And I think that can be a dangerous thing to do.

[00:07:15] In reality anyway when you are a long term investor, when you’re a long term investor in bonds. You want rates to go up as long as inflation stays stable, as long as inflation isn’t going up with them. You want interest rates to be higher because once you’ve invested in those higher interest rate bonds for at least the duration of the bonds you own, then you’re coming out ahead. For example if you have a bunch of bonds at 4 percent and interest rates go up 1 percent so now you can buy bonds at 5 percent and the duration of your bonds was five years. Well starting at five years you’re coming out ahead with that interest rate being higher at 5 percent instead of 4 percent. You got to realize that that is a good thing for bond investors. Now it’s not a good thing if inflation goes to 15 percent because inflation is particularly bad for bond investors. But as long as inflation is stable that’s good.

[00:08:11] I mean even Tipps owners, people who own Treasury Inflation Protected Securities, to protect them from an inflated unexpected inflation. Even they don’t want unexpected inflation. The reason why is because they own other assets most of the time, it’s not going to help your job and near buying power and you know your other investments particularly your bonds and so you don’t necessarily want, you know unexpected inflation at any time. Ideally that stays low and it stays very stable.

[00:08:41] Speaking of stable let’s talk about stable value funds now stable value funds are sometimes offered through an insurance company. Probably the most famous one is the thrift savings plan that VA workers and military docs have access to. The G fund there is essentially a stable value fund. It offers you bond like yields with money market fund risk which is a pretty attractive combination. And so if you have one of those available in your 401k that’s not a bad choice especially if the yield is pretty high on it. I think that’s a good choice if you’re really worried that rates are going to go up. Obviously when rates go down that’s not going to help you much. You’d normally get a little kicker on your bond returns when rates drop. At least in the short term you get that kicker you don’t get that in the G fund. Ask me how I know, because I’ve held the G. fund for the last 15 years and most of which interest rates have gone down. And that decision has actually cost me money over the long run. But that’s OK. That was my plan and I stuck with it and I certainly made up for it in other parts of the plan. But bear in mind that that is the risk.

[00:09:49] In general with bonds I prefer a fixed asset allocation strategy. I’ve just decided I’m going 10 percent now of my portfolio into tips and I put 10 percent into the G fund or similar bond funds for nominal bonds and I literally just rebalance I rebalance or rebalance or rebalance I don’t change the plan. Based on what I think interest rates are going to do. And I recommend you adopt a similar approach. Otherwise you’re stuck trying to decide well when do I change the duration of my bonds and when do I change them back. And you have to be right not once but twice when you’re trying to time the market like that. And I think that’s pretty difficult to do and will cause you a lot of stress trying to do it.

[00:10:32] All right now we’ve got another speakpipe question here from Katie.

[00:10:36] Our first born is eight months old. And we want to start putting money away in a 529 for him. We’re a military family though and so we’ll be moving frequently for the foreseeable future until we part ways with the army. So my question is do you really have any option besides putting all contributions for him and any subsequent children that we have in one states plan that has lower costs and better investment choices. I’m just not sure how the home state benefits work for military families who are always on the move.

[00:11:10] She is asking about 529 plans for military families and this is a great question. It is one I feel qualified to answer because I’ve been in this situation. When I first started saving for my kids college, I was in the military. I was an Alaska resident. And so there was no state tax benefit whatsoever for using a 529 plan. So you know what I did? I didn’t use a 529 plan. I actually use an education savings account an ESA at Vanguard. The nice thing about that is it is where all the other investments were. And it allowed me to have a slightly lower fees because I could get just the standard Vanguard fees rather than the extra fees that most even good 529 add on to the mutual fund costs. And since there was no state tax benefit anyway for Alaskans to use a 529 it wasn’t hurting me. Now the big downside of an education savings account is you can only put two grand in there per kid per year. But you know what? Military docs don’t make that much. And maybe that’s all you can afford. If all you’re putting in there is a couple of grand per kid per year. Then I think education savings account is perfectly fine. The other thing you can do is what I did when I moved to Utah. I moved that money out of the education savings account into the 529 and took a state tax break in Utah for moving it. So I actually was able to preserve a state tax break by using the education savings accounts before I moved into a state. Where I actually owed state tax.

[00:12:35] Now if you’re already a resident of a state that pay state tax. My first question for you is what do you do it, right? Figure out how to change your residency to Nevada or Florida or Washington or Alaska. Drive around the military base and look at the license plates and you’ll see that 90 percent of the people there seem to be residents of a tax free state. And that’s a pretty advantageous thing for a military doc to do is to figure out a way to do that and you can’t just declare it, usually have to go live there for a period of time or something. But most of the time at some point during your career you can figure out how to do that. But if you are in a state that you know you’re paying state taxes on, your resident state whatever, you’re stuck that way and you’re just worried that you’re going to be moving to another state at some point in the future. Well realize the 529 are portable you can roll them over from one state to another or you can have accounts in many different states. You can have one in Utah, one in Idaho and one in Maryland and one in Florida. You can have 529s all over the place so you don’t actually have to guess where you’re going to end up when you start these things. You can move them. You can have multiple accounts it’s not that big of a deal. But what I would do if my state wasn’t given me a state tax break and I wanted to save more than 2000 per kid per year I would just look at the good 529 plans out there and it’s usually a short list it’s usually the same states on it. We’re talking about Utah and Nevada and Ohio and New York and California. You know the list changes every now and then but typically it’s almost always got Utah and Nevada on it. The Nevada ones run straight through Vanguard, the Utah one offers both Vanguard and DFA funds. They have a long history of lowering expenses there and solid management and solid investment offerings. Maybe you can save a few basis points right now in New York and California. I think those are actually very slightly cheaper than Utah’s plan. But overall those are going to be your winners if you can just choose any state, if you’re not getting a state tax benefit in your state.

[00:14:38] All right. Next question comes from someone who forwarded me a notice they got from Vanguard and if you invest at vanguard you should have gotten this notice, no matter where you invest, you probably got a notice similar to it and it basically tells you that IRA recharacterizations are not permitted anymore in 2018. And so that shouldn’t be a huge surprise to anybody that’s been paying attention. The problem is a lot of people get confused about this. All of a sudden they start asking questions like this one. So does this mean no more backdoor Roth IRA contributions? I already maxed mine out for 2018 back in January but that’s no longer an option in 2019?! Well the problem is people are mistaking what a recharacterization is and what a conversion is. A backdoor Roth IRA is when you contribute money to a traditional IRA because you make too much money and you’ve got a retirement plan at work. You don’t get to take a deduction for that. So the next day you transfer it. You convert it to a Roth IRA and it’s never taxed again. That’s a backdoor Roth IRA. That is still completely allowed in 2018 and in 2019. Nothing has changed there with regards to that to that process. What has changed is a recharacterization of a Roth IRA or Roth conversion. OK so if you convert an account to a Roth IRA now you can’t recharacterize it back to a traditional IRA. So that eliminates a strategy that some people were doing occasionally in which they would convert multiple Roth IRAs for example if they wanted to have five thousand dollar Roth IRA conversion. They would take some money from their IRA and they would convert five thousand dollars worth of a gold fund. Five thousand dollars worth of an international stock fund and five thousand dollars worth of a bond fund and five thousand dollars worth of a U.S. stock fund. And toward the end of the year they would see which one of these is done better. And that one that has done the best they would leave as the conversion they meant to do and they would recharacterize the other three. And they called this the Roth IRA horserace. It is a pretty ingenious strategy but it is now no longer allowed. That is what is not permitted anymore. The backdoor Rothery itself is fine.

[00:17:02] Okay next question. I was told by someone at Northwestern Mutual the 529 plans would reduce a child’s scholarship ability. Any advice for physician couples? Yeah first advice is stop talking to somebody at Northwestern Mutual. You know without having to run into leibel concerns for talking badly about another company, let’s just say that I would not send my friends and family to that particular institution for financial advice. I think what they’re referring to here as they’re most likely trying to sell you a whole life insurance policy, is that 529 plans that are owned by you or your children do count on the Free Application for Federal Student Aid toward parental and student assets. So in theory it can reduce the amount of financial aid you receive from an institution whether that be a need based grant, some sort of need based scholarship, or loans. Now here’s the truth of the matter for most listeners to this podcast that have a high income, your kid is not going to qualify for need based aid anyway. And this sort of thing isn’t going to reduce their eligibility for a merit scholarship for music or academics or athletics.

[00:18:20] And so I would not worry about that. However it’s true. 529 do reduce your Ability to acquire traditional financial aid. That’s not necessarily a bad thing for this audience and it certainly is not a reason I would buy a whole life insurance policy from Northwestern Mutual for.

[00:18:37] This next question would you do a podcast on tax saving strategies for doctors in group practices. Well I’m not into a whole podcast on that today but I think it’s worthwhile going over three things, three categories that help people reduce their tax burden.

[00:18:53] The first category is really understanding the rules of the tax advantaged accounts that are available to you. I’m primarily talking here about your retirement accounts. For example if you have a 401k with a profit sharing plan or you’re allowed to put fifty six thousand dollars a year into 2019. That’s a huge tax savings. You want to cut your tax bill. Max that sucker out. You probably just knocked twenty or twenty five thousand dollars off your tax bill. Maybe you have a defined benefit or cash balance plan that you can stack on top of that for another 25 or 50 or 100 thousand dollars. You know obviously that’s going to dramatically reduce your tax bill. But even the smaller accounts like health savings accounts and 529 and the Backdoor Roth IRA all this stuff reduces your tax bill.

[00:19:38] And if you’re investing in a regular non-qualified taxable or brokerage account investing tax efficiently there can also reduce your tax bill. So these are all investing related tax reduction strategies. But honestly retirement accounts are the best tax reduction thing out there for a typical doctor. The next category however is recognizing things that are business expenses. Business expenses are the best kind of deduction there is because you don’t have to pay any sort of payroll taxes on them. You don’t have to pay any sort of income taxes on them and basically it’s just like income you never got. So for example for the white coat investor I spent a lot of time on the Internet as you might imagine. And my internet service is a business expense so I basically get to pay for that was totally pre-tax dollars. And so recognize those things and make sure you claim them as business expenses. For a typical doctor we’re talking about white coat and scrubs and maybe your shoes. You know the sorts of uniform things, your cell phone plan maybe, your computer you know and as much as you use these things for business and maybe just a percentage of what it cost you. That’s all a business expense. Your CME expenses, you know aside from the traditional stuff at your clinic like you know the utility bills and the mortgage at the clinic that sort of stuff. These are all business expenses and so recognize those and make sure you claim them. And then of course the last category is to live your life in such a way as the IRS wants you to live it. And what I’m what I mean by that. Well the IRS wants you to give money to charity. You know if you’re itemizing deductions on schedule A you get a deduction for giving money to charity so if you do that that helps reduce your tax bill. Now obviously if you give ten thousand dollars to charity and it saves you four thousand two hundred dollars off your tax bill like it does for me you’re coming out behind just giving money to charity to try to reduce your taxes but living your life in the way that IRS wants you to does reduce your taxes. Same thing you know having kids may qualify you for some child tax credits, getting married, you end up with using the married bracket instead of the single brackets. And I suppose there is possibility there to have a marriage penalty but a lot of times particularly if you’re married to a lower earner or to a stay at home parent that dramatically lowers your tax burden. But the bottom line is spending and giving and living your life like the IRS wants you to does reduce your taxes. So those are the three main categories of tax saving strategies for doctors and others.

[00:22:13] All right. Next question right out of school I decided to get a financial adviser, an old friend from college and soon learned I was suckered into buying a bunch of insurance I don’t need. I now have a Northwestern Mutual 65 life policy with a fourteen thousand dollar annualized premium and thirty six thousand dollars in cash value. I also have Northwestern Mutual guaranteed renewable disability insurance and term 80 life insurance. Wow that is just the combination you know. You go see a northwestern guy and you get those three policies. It’s like clockwork. I’m single no children need advice as to the next step. This is great. This is somebody with nobody else depend on their incomes been sold not one but two life insurance policies he doesn’t need. I’m starting to learn a lot through your website and reading about doing some of this myself. I’d eventually like to fire my adviser but at this point I’m not rushing that. Well in this case you’ve actually mistaken your adviser for a commissioned, Mistaken a commissioned salesman for a financial adviser, so I probably would rush firing this particular advisor. I know you’ve addressed this topic a lot. I’ve read through most of it to the point that my eyes are crossing. Well I’m sorry to hear that. I wish I could make it simpler. I try to have a start here tab, I try to you know have it be easily searchable on the blog and you know on the podcast and that sort of thing. But I understand that you know when you’re first getting into this stuff and first becoming financially literate it can be difficult to catch up. So let’s go step by step through some of the issues here. As I mentioned this doc mistook a commissioned salesman for a financial adviser. This friend and you know I don’t mean to be too critical here because my friend got me into a Northwestern Mutual Whole life insurance policy that was completely inappropriate for me. So these are not things that I’m somehow immune to. These are mistakes I’ve simply already made. But basically this friend took advantage of the friendship to transfer about ten thousand dollars out of this doctor’s pocket into his or hers. So I encourage this doctor to ask your friend what the commission was on that whole life policy they sold you. And I would bet that you would be shocked how large it was.

[00:24:17] Mistake number two this Doc bought a whole life insurance policy that he didn’t need. You know I did the same thing, bought the same exact policy actually from the same exact company and my return after seven years was a cumulative 33 percent loss. OK. Mistake number three. Doc bought a lousy term policy. I bought the same stupid one. You know you’d be appalled how much cheaper you can get term life insurance than what they’re selling there. If you go to someplace like my blog advertisers site term for sale dot com and you don’t have to give any personal information you can see what the going rate is for term life insurance and compare this policy to the top of the list for a five year level term policy because that’s what this term 80 is, the price goes up every five years, to the price you’re paying and you’ll probably be appalled when you realize you can get it for 50 percent less or 100 percent less than than what you’re paying.

[00:25:09] About the disability policy the Northwestern definition of disability is a little bit inferior to what you can get from the big five or six companies. Now maybe it doesn’t matter, you know if you’re terribly disabled both of them are probably going to pay you just fine. But if you want the best policy and the best and strongest definition you’re probably going to want to meet with an independent insurance agent who can sell you a policy from any of the big five or six companies and compare what you have to what is available and make a rational informed decision about what to do.

[00:25:43] So in this case this doc needs to move on from this adviser fire him and either learn how to do this yourself or hire a real adviser, you know one who only charges you a fee, one who has a fiduciary duty, one who isn’t just peddling financial products to you. A real adviser charges you for the advice. It doesn’t make commissions off what they’re selling you. So I give him a link to my list of good advisers. I’ve got a list of advisers that I recommend on the white coat investor site. You just look under the recommended tab. But you know I want to ask this doc why do you keep taking advice from someone who gave you bad advice. That doesn’t make any sense. You know we all get when this happens to us and it happened to me and it’s happened to lots and lots of you. You get that terrible feeling in your gut that you’ve been ripped off and you don’t want to confront your friend about it and here’s one avoid the whole thing you know. But the truth of the matter is we’re all gonna go through that and it goes away eventually as you take steps to take better control of your financial life and learn more about this and use it to motivate yourself to be financially successful.

[00:26:45] I actually sat down a few weeks ago with one of my classmates from medical school and went through some of her financial situation and she ended up yes firing her Northwestern Mutual adviser out of it and you know what she was surprised that it really wasn’t that big of a deal even though she still sees him in social situations. It really wasn’t nearly as awkward as she worried. So I would go ahead and do that and move on and realize that we all make mistakes.

[00:27:15] Number two you got to get rid of a whole life policy. I mean this is not a situation where this whole life policy makes sense. It is not a great whole life policy. You don’t have to talk to your friend to do it. You can go directly to Northwestern Mutual. You’ve lost some money there. But you know it’s only been a year in this situation and you’ll probably get some of the money back. Remember if you have a whole life policy that you’ve had for decades it may make sense to keep it. It’s worth getting it evaluated from somebody like James Hunt that does a lot of these evaluations. And you know looking at and focusing not so much on what’s been spent in the past but what your return ought to be going forward. But when you’ve only had this thing for a year and obviously it doesn’t make sense then you might as well just dump it.

[00:27:57] In this case this doc doesn’t you need the term life insurance policy. So unless this docs anticipates very soon having someone else depending on his income might as well dump the term life insurance policy as well. If you do want one get a better one before surrendering the one you don’t want. And then of course you need to meet with an independent disability insurance agent to compare his policy. So it’s unfortunate. I hate hearing those stories. I hear them very often. If you want to read more stories like them I suggest a thread on the white coat investor forum called inappropriate whole life policy of the week and most of them are actually this same policy that this reader has, it is frequently sold to doctors.

[00:28:39] Our next question comes from Josh in San Francisco says Dr. Dahle I’m a longtime reader listener first time question asker very much appreciate all the great information you put out there. Well thank you Josh that’s very nice of you. I finished my medicine residency this year so 2018 will likely be the lowest earning year for a while. This combined with my wife’s maternity leave and changes to the tax laws will put us in the 24 percent marginal tax bracket this year with another sixty thousand dollars of possible income before moving into the next marginal tax bracket. Given that we’re moving into a higher tax rate for the next many years and federal tax rates are quite low I’m thinking about incurring taxes now so I don’t have to incur them later. I’m thinking about either converting the traditional to Roth retirement accounts with about seventy five thousand dollars in such accounts and or redeeming 26 year old EE savings bonds it will stop producing interest in 2022 regardless. That would generate about 13000 dollars in taxable interest. Seems like either would be a good move since in future years I would have to pay a higher marginal rate to make a conversion or redeem these savings bonds. Do you think this is a good move. Yes I do think it’s a good move. I think great years for Roth conversions are well the best years probably during medical school when you don’t have any other income. Next best after that are those years in which you’re a resident for the entire year. You know you’re basically out of resident income and you can convert a lot of money at a very low tax rate and then of course the next best after that is the year you leave residency when you have half a resident income and half of attending income which is what we’re talking about in this situation. So yeah I would do that conversion I would convert as much as I had, if I had the money to be able to pay the taxes on those conversions.

[00:30:17] And I suspect getting out of those savings bonds this year is also probably a smart move he’s only got a few more years of interest that can be earned on them before they stop earning interest. And they’re not that awesome of an investment to start with so why not redeem those and get started with more appropriate investments in a taxable account. Now that’s assuming there’s not a plan to use these bonds shortly to pay for something like education where you can actually get that interest, those taxes waived on that interest.

[00:30:48] OK. Next question. I’m a family practice doc in a big city. I have about 250000 dollars in student loans at about 5 percent. I was planning on going for forgiveness in 25 total years and then paying the taxes on that. Question can I refinance that to a lower interest rate and still go for forgiveness? Also can the amount I pay in taxes somehow be considered a business write off? I did need to pay that to maintain a business.

[00:31:12] Oh boy. All right. This is not a great plan. We’re talking here about IBR, paye, repaye forgiveness. OK. In these programs you have to make payments for 20 to 25 years. With IBR it is 25, with paye it is 20, with repaye its 20 for undergraduate and 25 for graduate. That’s a long time to have student loans, to drag those out for almost your entire career. That sounds terrible to me to have this shackle hanging over your neck especially when I see so many docs clear this debt in one two three maybe five years after coming out of residency it makes me cry to see somebody think about dragging it out for 25 years. To make matters worse after those 25 years even if there’s something left forgive which there probably won’t be for most doctors, particularly this doc. It’s a family practice doc with only 250,000 debt. Is it is taxable. You’ve got to save up for the tax bomb which may be the same size as the initial loans. You know depending on your situation. But the truth of the matter is for this family practice doc probably making 200 thousand dollars a year paying off 250000 dollars in student loans. I mean that’s a three or four year project. That’s not a 25 year project. So I would not go for this repaye forgiveness. Now have I seen some situations where this sort of thing might make sense. Sure, if you got a veterinarian making seventy thousand dollars a year and they owe four hundred thousand dollars in student loans maybe that 25 year plan does work. For a physician you know you owe a million dollars. Maybe it makes sense but not for someone who has two fifty thousand dollars and has an income of a couple hundred thousand dollars. That’s somebody who can live like a resident for two to five years after residency and clear that up and get the monkey off your back. The question however was Can I refinance this to a lower interest rate and still go for forgiveness. And the answer is No. Once you refinance those loans they are now private loans they are no longer eligible for the IBR, paye, repaye, or the Public Service Loan Forgiveness program and then the last question was can the amount I pay in taxes somehow be considered a business write off. Boy wouldn’t that be awesome. No that doesn’t work. In fact the only way you can write off that interest is when you’re earning a very small amount of money. You know typical resident can deduct up to 2500 dollars worth of student loan interest per year. But. You know an attending can’t. Once you start earning higher money you can’t do that. And you know what. To be honest I cannot recall right now whether that changed in the 2018 tax law changes I would have to go look that up to make sure that a resident can even still get that. But an attendee has never been able to deduct their student loans. So kind of sucks. You’re paying them off with after tax dollars. That’s why you want to get them out of your life as soon as you can.

[00:34:11] All right if you still feel like a little bit lost and you need a little bit more structure in developing your financial plan, in doing your initial financial education I want to suggest our Fire your Financial Adviser online course. Now it’s kind of provocatively titled and the truth of the matter is the whole first section explains how to work with a good financial adviser or how to find one. How to work with them how to make sure you’re paying a fair price. So it’s not like you have to do this on your own. But the point of this course is that you get to the end of it and you have a written financial plan that you’ve written that you can follow for the rest of your career. And so I think it’s probably one of the best ways you can spend your money and your time early in your career to get this stuff under control. And yes we charge about 500 bucks for it. But you know what that’s dramatically cheaper than what you’re going to pay to a financial adviser and especially if you start getting bad advice from a financial adviser. It’s a real bargain. So here’s the deal with it though. If you don’t like it if you feel like it’s not worth your 500 bucks. Shoot us an email within seven days no questions asked. We’ll give you every penny back.

[00:35:21] You know that’s how strongly I feel that this is a good course for you and let me be honest with you. Less than 2 percent of people that buy this course ask for their money back. The other 98 percent are totally satisfied with it and feel like it was a great use of their money. We get great feedback on this course. I think you’ll find it very beneficial. There’s no risk in trying it. Go check it out today. There’s links to it at Whitecoat investor dot com.

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[00:36:37] Head up, shoulders back. You’ve got this. We can help. We’ll see you next time on the White Coat investor podcast.

[00:36:43] Your host Dr. Dahle is a practicing emergency physician, blogger, author and podcaster. He’s not a licensed accountant attorney or financial advisor. So this podcast is for your entertainment and information only and should not be considered official personalize financial advice.