Invest vs. Pay Off Debt: What Should You Do with Extra Cash?

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:
All right, welcome back to the White Coat Investor podcast. My name is Tyler Scott, I’ll be your host this week. Just me, this time. I’ve really enjoyed having the episodes with me and Jim and thank you for your kind feedback to those who’ve said you’ve enjoyed them. Well, we’re going to keep doing those. But once in a while, Jim has to work, he’s at the hospital right now, working a shift. So I’m here with you this week to take some of your questions and see if we can help keep our financial journeys moving in the right direction.

Thank you all for what you’re doing out there for our White Coat community, for the communities you live in, the different jobs and roles you play in our lives and our society. We see you, we know the struggles you have, we are grateful for you. Whether you’re a physician or an engineer or a lawyer some of these high income professionals that tend to come within our community, or if you’re a stay at home parent, if you’re a librarian, if you’re a teacher, we are so grateful that you’re here. We value your contributions; we love your questions; we want to be a resource and be useful to you because we are grateful for you.

So if no one has told you today, thank you for what you do. Please hear that from me. I really mean it. My mom’s an elementary school teacher; my dad hangs drywall. Not everything is the kind of financial questions that we take on here most often. And with the principles we talked about, we hope are relevant for anyone at any stage in any role. And we see you, we’re grateful for you. Thanks for being here. Thanks for what you do.

This podcast is sponsored by Bob Bhayani of Protuity. He is an independent provider of disability insurance and planning solutions to the medical community in every state and a long-time White Coat Investor sponsor. He specializes in working with residents and fellows early in their careers to set up sound financial and insurance strategies.

If you need to review your disability insurance coverage or just get this critical insurance in place, contact Bob at whitecoatinvestor.com/protuity or [email protected] or by calling (973) 771-9100.

Just a reminder to everyone out there about the recommended list that exists on the White Coat Investor website. One of Jim and Katie’s missions in starting white coat investor was to help connect you to the good guys in the industry. So if you go to whitecoatinvestor.com/recommended, you’ll see a list there of the good guys on Wall Street, student loan refinancing, contract review, real estate partners, loan servicers, insurance agents, financial advisors, and more.

So keep in mind when you’re looking for help in one of these areas and you want to find someone that’s been vetted by the White Coat Industry that’s treated our community well, you can go to whitecoatinvestor.com/recommended.

All right, Megan’s got three great questions from the Speak Pipe queued up for us today. So let’s start by getting to your questions and see what we can learn from each other.

PAY OFF STUDENT LOANS OR INVEST IN A PRACTICE?

Mark:
Hey, Dr. Dahle, big fan of you. This is Mark from Ohio. I have a question for you. Me and my wife are dentists. We are about three years out of school. She has student loans. I was fortunate not to have student loans. She owes about $270,000 of student loans between the two of us. We do have about $600,000 in savings. We just started maxing out 401(k) and Roth IRA this year. So we don’t really have a lot of retirement behind us just one year.

And we were wondering: is it worth it to aggressively just pay off the loan in a lump sum and then start focusing on other things, such as a practice and a house? Or is it more beneficial to maybe get the practice first then tackle the student loans?

My only thing is that the student loans, the rate is not too high. It’s about 5.6%. Could get it down to 4.6% if she does the auto pay. And also what other loan out there will allow you to do income-based repayment or forbearance. Even with the IBR rule, it’s still somewhat generous versus a practice loan or a mortgage. But yeah, just want to get your opinion on that. And maybe with that $600,000, there is value to just maybe investing $300,000 in the market and then with the other $300,000 by practice and then pay off the loans at a later date. I just want to see how you tackle this.

Tyler Scott:
Wonderful. Thanks, Mark. I’m always glad to take a question from a fellow dentist. So this is wonderful. Let me just start with a short aside that I’ll take a chance to say because Jim’s not here and he would never say this on his own because he genuinely doesn’t care. His last name is Dahle. It is a less common last name and there are many various pronunciations of it. So neither he nor anyone at WCI takes offense when other pronunciations are used.

In fact, there’s a guy on YouTube who demonstrates the 11 different pronunciation options for Dahle in the English language. I think we get a lot of people saying Dr. Dahl because we all grew up reading the many wonderful works of Roald Dahl. James the Giant Peach, Charlie and the Chocolate Factory, the BFG, the Witches, the Twits. So our elementary school librarians maybe left us all wanting to say Dr. Dahl instead of Dr. Dahle. But just a shout out that that’s how he and Katie, it’s Dahle here in Salt Lake with them.

With that linguistic and youth literature tangent aside, let’s get to this very good question. First, Mark, you are killing it, man. A two dentist household three years out of school with only $270,000 of student loans is amazing. The national average for dental graduate debt right now is close to $300,000 per person. The dental school I taught at here in the suburbs of Salt Lake is like $460,000 per person. So, for the two of you to be out of dental school with only $270,000 of loans deserves recognition and a high five.

The next celebration is that you have $600,000 of savings and you’re starting to max out your retirement accounts this year. That’s fantastic. It makes me wonder a little bit how or why part of that $600,000 isn’t already in retirement accounts, but I’m not going to miss the forest through the trees here. $600,000 of savings three years out of dental school is fantastic no matter where it’s sitting. That is way more than Megan and I had three years after I finished dental school. So, great work there.

If I were to summarize this question, it would be, “What do I do with surplus cash?” We get some version of this question every single day at White Coat Planning, and it’s a really fun one to answer. It’s more fun than the more common version of this question, which is “How do I make up for a big cash shortfall?”

Many clients come to us already realizing, or we help them realize, that they have way too little cash on hand. They don’t have an adequate emergency fund. They need a down payment for a house. They have new car or home repair or out-of-pocket medical expenses coming up with no cash to cover those large episodic expenses. So, most of the time we are setting up cash flow plans to solve for a cash shortfall. But it also happens that clients like Mark show up with big stockpiles of cash and want help thinking through the most efficient way to deploy it. So great question, Mark, and a common one.

Let’s talk about what to do with the wonderful problem of having too much cash on hand. There are basically five options when you have excess cash. You can pay down debt, keep some of the cash around, invest it, spend it, or give it away. Paying down debt, keeping thoughtful amounts of cash on hand, and investing are the three options that build or preserve wealth. Spending it or giving it away are arguably the more fun options. What combination of those things any given person chooses depends on their goals and values, which should inform their written investment plan or written financial plan.

If you ask me what I would do with excess cash, I would refer you to page 13 of my written financial plan, which says, in the event of a windfall or other review of our cash holdings, our priorities are as follows.

Number one, establish a cash cushion in our checking account equal to no less than one month of expenses. Number two, establish an emergency fund of no less than five months of expenses in a high-yield savings account. Number three, establish sinking funds of sufficient size to cover any known or plausible expenses in their given category. For example, car replacement, home repairs and upgrades, out-of-pocket medical expenses, travel plans, future backdoor Roth contributions, and most recently, we added to that future 530A account contributions for the kids.

Number four, target any debt with an after-tax rate of four percent or higher. Number five, if our annual savings rate of 30% is not on pace to be achieved, invest whatever dollar amount is needed to ensure the 30 percent threshold is met by the end of the year.

Number six, spend no more than 10% of the surplus on a bonus family fun activity or experience. Number seven, target any debt with an after-tax rate below 4%. And number eight, spend or donate the rest.

So that’s my plan. That doesn’t have to be your plan to any listener or to Mark specifically. Notice this isn’t a rigid mathematic formula. It’s a set of priorities based on our goals, risk tolerance, and values.

The point is that having a written plan in place is nice because you don’t have to solve these problems over and over again in your life. You decide once, then reference that founding constitutional document when these questions come up down the road.

And if you don’t have one of these founding constitutional documents yet in your life, please make one. You can take the Fire Your Financial Advisor course at WCI or you can go to the list of recommended financial planners on the blog and have one of them help you.

So, with that in mind, what might this thoughtful process look like specifically through Mark’s situation? First, I would have a lot of questions for Mark about his goals, his values, his comfort or disdain for debt, his comfort with market volatility and risk, and a handful of other things. Since I don’t know those answers, I’ll give one possible way to approach his desirable and legitimate problem of excess cash. I’m not saying it’s the right way or the only way. It’s just one of many reasonable ways.

Personally, Mark, I would organize this around timing because with a practice purchase and a home purchase both on the horizon, the order matters as much as the amounts. If you told me you had $600,000 in cash, $270,000 of student loans at 4.6% and no major purchases planned and asked me what to do with the cash, we’d have a very different conversation than what I’m about to say. The fact that you’re about to buy both a dental practice and a house has a major impact on your answer.

I wrote down nine steps for you to consider. Some of this is parallel to the plan I just laid out. Some of the steps are different based on your circumstances. Number one, establish a cash cushion in your checking account equal to at least one month of expenses.

I like this in my life for two reasons. First, it gives me the confidence to automate my entire financial life. All my bills are on auto pay, all the credit cards get paid automatically on their due date, all transfers to my sinking funds are automated, my monthly transfer to my taxable brokerage account happens on schedule. I don’t have to worry about forgetting any payments or any savings plans. I don’t have to overcome behavioral bias to invest. I don’t look at the market and wonder if it’s a good or bad time to buy. It just happens consistently as it should without me becoming my own worst enemy. So first reason for the cash cushion is it allows for a lot of automation, which I really enjoy.

The second reason I like a sizable cash cushion in my checking account is that it tricks me into feeling rich, regardless of my net worth or any other metric. Probably the most frequent way Megan and I have felt broke in our lives is having to look at the checking account balance before making a credit card payment or Venmoing someone for our share of an expense.

Psychologically, we found tremendous value in never having to check the balance before sending our friend $3,000 for our share of Utah Mammoth Season tickets, which we did yesterday, or pulling $1,000 cash out of the ATM.

Okay, number two, Mark, establish a reasonable emergency fund. I like to have five months of expenses. Some clients need more peace of mind than that, so they do six, nine, or 12 months. That’s all totally reasonable. Some people are comfortable with only three months, or they have so many other uses for their cash that they just need to start with a lower amount, like three months, and then build a bigger emergency fund later.

For physicians and dentists, I really don’t like to see people go lower than four months, and that’s because personal long-term disability policies typically have a 90-day waiting period, and they pay 30 days in arrears. So, in practice, the soonest you can get a disability benefit check is about four months from the date of disability.

Now, keep in mind, it can take a lot longer than that. In my case, it took six months for my claim to be decided. I got a true-up payment for the two-month delay, but I still didn’t receive anything for over six months.

And there’s one more consideration for you and your wife specifically. If you both end up working in this new practice that you buy, your household income is no longer diversified. Right now, if one of your jobs goes sideways, the other income keeps coming. But if you both end up in the same practice and a rough stretch for that practice hits both incomes at once, well, that’s an argument for landing towards the higher end of the emergency fund range rather than the lower end.

Number three, set aside money for known short-term cash needs in appropriate sinking funds. That includes car replacements, healthcare needs, planned trips that aren’t paid for yet. I’ve talked and written at length about sinking funds before, so I’ll spare everyone that speech again. The short version is that it makes sense for most clients to build up cash for large episodic expenses so their otherwise automated and smooth cash flow life is not disrupted when those inevitable expenses show up.

And also, if either of you is currently paid as an independent contractor, make sure part of that $600,000 isn’t actually money you owe in taxes. And if either of you remain an independent contractor getting paid on a 1099, I recommend setting up a sinking fund for your quarterly estimated tax payments and putting about 25 to 30% of each paycheck into that sinking fund.

Number four, keep a separate sinking fund for the home down payment and think really carefully about the order of your purchases that are coming up. Often clients tell us, “Oh yeah, I think I’ll get a house in the next two to four years.” And then a year later, they find a place that they just can’t pass on and they are really glad that they started the down payment sinking fund earlier than maybe they would have thought at the beginning of their planning process.

And I want to point out here that the order you things matters a lot. Once you own a practice, you’re self-employed and many mortgage lenders will want to see two years of tax returns before they’ll count that income. Buying the practice first can make getting a mortgage harder for a while. Meanwhile, practice lenders look at your personal debts, including a new mortgage. So talk to both lenders before you commit to which order you buy these big things.

Number five, get quotes on the practice loan from dental-specific lenders and take note of the different interest rates. Most dental practice loans come from banks with dedicated dental lending divisions and it’s worth getting quotes from several of them. This is an important thing to go shopping for.

Keep in mind that interest on the practice loan is typically tax-deductible, so you want to determine the after-tax interest rate on all your loans to make an apples-to-apples comparison when it comes to paying down debt. At your income marks, the student loan interest almost certainly is not deductible, so that’s not a factor. Mortgage interest is deductible but only if you itemize your taxes and it only helps to the extent your total itemized deductions exceed the now much larger standard deduction.

Business loan interest is typically fully deductible to the business and if your business is a pass-through entity like an S-Corp, like most dental practices end up being, that functionally means that the interest is deductible at your personal marginal tax rate. That’s what a pass-through entity means. The S-Corp doesn’t pay any taxes, the income passes through the entity and lands on your personal return.

So for example, let’s say your personal marginal tax rate is 40% between federal, state, and local taxes and let’s say the practice loan is at 10%, then the after-tax interest rate on the business loan would be 6%, so that’s how to think about that on an after-tax basis.

Okay, Mark, step number six. Decide how much, if anything, you want to put down on the practice. This is where buying a practice is pretty different from buying a house. Dental practices are among the safest loans a bank can make, so many dental lenders will finance 100% of the purchase price and some will even roll working capital into the loan.

What lenders usually care about more than a down payment is that you still have solid cash reserves after closing. Sometimes the seller of the dental practice, the previous dentist, also carries part of the price as a note, often a slice of the deal that they will hold alongside the bank. So that reduces what you borrow from the bank and keeps the seller invested in a smooth transition. If you end up with a seller note, include their interest rate in your debt comparison also.

The question for you isn’t how much are you required to put down, it’s how much do you want to put down. Jim and I both think it’s very, very important for dentists to own their jobs, so I love that you’re thinking about buying a practice, and it’s equally important that the practice has enough cash to survive the transition.

In most practice cells, the seller keeps the accounts receivable and it takes a while for insurance to actually pay you for any work you’ve done on patients since you took over, so just know that collections may take a while to ramp up after you start working as the new owner.

So, think of a down payment as a pre-payment on the practice loan that you have to make on day one before you know how the transition will go. Money you put into the practice is hard to get back out. Once that money goes into the practice, you’ve converted liquid personal capital into illiquid business equity, and you may be better off financially for doing that, or you may have simply reduced your liquidity.

When deciding how much to put down on the practice, ask yourself, “What is that money accomplishing?” Is it reducing the interest rate? Is it reducing the payment? Is it helping you qualify? Is it simply reducing the balance? Those aren’t all necessarily worth the same thing.

In your situation, given the sizable amount of cash you have on hand, it sounds like you’ve got plenty of cash to put some money down without compromising your liquidity. Then down the road when the practice is stable, the loan can usually be prepaid if you want to get rid of that debt. Just check the loan terms for prepayment penalties.

Okay, step number seven. Estimate your practice expenses and set aside a cash cushion in the business checking account and a reasonable business emergency fund. This is the exact same logic we just discussed earlier for our personal cash cushion and emergency fund. If your loan includes working capital, that can cover part of this. Just remember that’s borrowed money you’re paying interest on.

Step number eight. Hold off on any lump sum student loan payments until the purchases have closed. And there’s two reasons for this. First, lenders look at how much cash you have left after closing and a big loan payment beforehand weakens that picture.

Second, a partial prepayment doesn’t lower the required monthly payment on the student loan. It does nothing to help your debt income ratio. It just reduces your cash. And the cost of waiting is pretty small. Cash in a high yield savings account right now is earning like 3 to 4%, which might be closer to 2.5% after tax at your income. So parking $150,000 in a high yield savings account instead of putting it towards a 4% loan costs maybe three thousand dollars. That’s a pretty cheap price for flexibility during what may be the most financially fragile step of your careers as you guys get going here.

And number nine. Once the practice is stable, then direct any surplus cash to debt starting with the highest after tax rate first. So, using the example above, a practice loan costing 6% after tax would come before a student loan at 4.6%. Also, as you alluded to in your question, federal student loans have some safety net features like income driven repayment, deferment, forbearance that a practice loan doesn’t have. So that’s the reason some people choose to keep them around a little longer even at a similar tax rate.

Then after the practice loan is done, assuming its after tax rate is in fact higher, then you can attack the student loans. Also keep in mind, Mark, that owning a practice lets you set up practice retirement plans with a lot more tax advantage space. And that opportunity will start to compete with extra debt payments. So, make sure you revisit the tax efficiency of your next dollar once your profit sharing 401(k) plan and or your cash balance plan at the practice are in place.

So, to make this concrete with some made up numbers, let’s say your household spends $15,000 a month and you buy a $900,000 practice. One month in personal checking is $15,000. Six months of personal emergency fund, given the income concentration issue, I might aim for six months, so that would be $90,000. Maybe the various sinking funds add up to $30,000.

Your lender may not require a down payment on the practice, but let’s say you decide to put 10% down to lower the payment. So that’d be another $90,000. We want to set some business working capital aside for $75,000. And maybe the house down payment and closing costs are $150,000.

Add all that up, that’s about $450,000, leaving you $150,000 to put towards the practice loan or the student loans once the dust settles and things are stable at the practice. Or perhaps you’re comfortable at that point with your aggregate practice home and student debt, and maybe you choose to invest that $150,000. That would be fine too. It all depends on your goals and your values.

Your actual numbers will of course be different than my example, but the point I’m trying to make is how quickly $600,000 gets spoken for when you’re just getting started in your doctor life financial journey.

I’ll just close by saying that you said you feel the student loan interest rate of 4.6% is not too bad, and generally I agree with that. But mathematically, paying down a debt at that rate is actually a pretty good investment. Too often people compare their interest rate on the debt with what they think they can get in the market. And they’ll say something to me like, “Why would I pay down a 4% loan when I can get 8% to 10% in the market?” And I get where that’s coming from, but that is not an apples to apples comparison because it does not adjust for risk.

Paying down debt is a guaranteed after-tax, after-fee return on your money. Investments in the market could go down 5%, 10%, 25%, or even 50%. So the fair comparison to a guaranteed return like debt paydown is another guaranteed return investment like a high yield savings account or treasury bills.

And right now, after tax, those guaranteed things are paying around maybe 2.5%. So by that measure, paying off a 4.6% loan wins pretty easily. Compared to stocks, it’s a real trade-off between a guaranteed return and a possibly higher but unexpected return. And reasonable people can land in different places on that decision.

One risk of debt paydown is the liquidity issue we talked about. Once money goes to the lender, you can’t get it back. And that’s exactly why the timing we’ve talked about today matters.

Also though, keep in mind the many positive ripple effects of eliminating debt. We’ve talked a lot here about keeping one month of expenses in checking and three to six months of expenses in an emergency fund. Well, guess what happens to your monthly expenses when you pay off debt? They go down. The needed size of your cash cushion and emergency fund goes down with it.

Lower debt payments or no debt payments also reduce your ongoing fixed expenses, which can affect how much income replacement you will ultimately need from disability insurance. So, overall, your cash drag gets lower when debt’s gone, your insurance needs may be lower, and your fixed monthly obligations are lower when that debt is no longer with you.

In other words, there are many unseen mathematical benefits of eliminating debt, not to mention the behavioral and psychological ones. As Jim often says, “If you miss your student loans or your mortgage, you can always go out and get new ones.” To this point, I’ve never heard of anyone taking him up on that offer, which says something pretty powerful about how people feel about having these debts behind them.

So to recap, I’d reserve the cash needed for emergency savings, sinking funds, the house, the practice, including working capital for the business. I’d talk to the practice and mortgage lender about deciding which purchase comes first and how much to put down. And then once both transactions are completed and the practice is stabilized, I’d look at the remaining cash and compare the after-tax cost of each debt against the value of increasing tax-advantaged retirement savings and investing for the long term.

At that point, a 4.6% student loan no longer is competing with a house down payment or practice working capital. It’s competing with your other long-term uses of capital, and that’s a much easier decision to make. Overall, Mark, great job so far, great question, and best of luck with all the exciting changes coming up for you and your wife.

QUOTE OF THE DAY

Tyler Scott:
Okay, let’s get today’s quote of the day in. This quote is from Ralph Waldo Emerson. It’s one of my favorites. He said, “That which we persist in doing becomes easier to do. Not that the nature of the thing has changed, but that our power to do it has increased.”

I have loved this quote since I was in middle school, where I first learned about it from one of my history teachers, and I have found it so true in my life that it’s just our willingness to continue to do the thing that makes the thing easier. It’s not that the thing itself got less hard to accomplish, but simply our capacity and our power to do it have gotten better, and that certainly applies in our financial life with our saving or our spending, depending on which thing is hard for you to do.

Jim’s talked about the first big problem in personal finance is getting people to spend enough, so that’s one thing that a lot of us need to persist in doing that we’ll find easier to do. If we just automate our savings and keep practicing building our savings muscle, that’ll feel easier to do.

The second biggest problem in personal finance is getting people to spend their money once they realize they have enough. Same thing there. If that’s not a strong suit for us, continue to persist in doing it. Find ways to spend and to give, and you’ll find it easier to do. Not that the inherent nature of the thing has changed, but our capacity and power to do it has increased. So, great quote there from one of the great American minds, Ralph Waldo Emerson.

SHOULD YOU PRIORITIZE GROWTH IN YOUR ROTH IRA?

Fletcher:
Hi Jim, this is Fletcher from the Southeast. I have a question about optimizing asset allocation. I’m 39 years old, hoping to retire in 12 to 15 years in a lower tax bracket than my current one. I work in a procedural subspecialty with annual earnings well within the highest federal tax bracket. I just recently moved 5 to 10% of my net worth from equity index funds into bond index funds for the first time, given the historical buying opportunity for bonds right now, knowing that I will eventually need them prior to retirement.

Because these funds are tax inefficient with low growth relative to equities, I put them in my 401(k). Doing so got me thinking about the Vanguard REIT sitting in my Roth IRA. I understand why a Roth IRA would be a good place for a tax inefficient investment like a REIT, since it will never be taxed again going forward.

However, since this is the only account where I can put Roth money and my contributions are so low each year, it seems like a unique opportunity for long-term growth, such that if I take up a lot of that Roth space with limited growth investments like REITs, I’m losing out on potentially much more tax-free growth than if I put the REIT on my 401(k) with the bond ETF and filled the Roth IRA space with things like VTI, VXUS, the small cap value ETF, etc. Obviously, none of us can predict future returns, but historically broad equity funds have returned much more than REITs. Curious as to your thoughts. Thanks.

Tyler Scott:
Thanks for the question, Fletcher. It’s a great one and it touches on a topic and kind of a mistake that I see a lot of smart investors make all the time. Not saying you’re making a mistake, but it’s just a great topic. And this issue happens to be one of Jim’s documented pet peeves. And so, I happen to know how he feels about this. And I’ll try to weave that into my answer here.

So, this sounds like an asset allocation question, but it’s really an asset location question. But then at the end, it kind of secretly turns into an allocation question again. So, let’s see if we can go on this journey together.

First, a quick vocab check, because these two terms get mixed up a lot. Asset allocation is what you own and in what percentages, like 70% stocks, 30% bonds, 5% REITs, that kind of thing. Asset location is where you own it. Which investments go in your 401(k)? Which ones go in your Roth IRA? Which ones go in your taxable brokerage account?

So, Fletcher, you described this as an asset allocation question, but you aren’t asking about what you should own or how much. You’re really thinking about where to put things. So, on the surface, this is an asset location question in my mind. But by the end, I hope to show you that the decision you’re weighing actually changes your asset allocation, which is why it’s easy to get tangled up in all this.

So, let’s talk about a premise here, basically the case for high growth assets in Roth accounts. And let’s look at the reasoning, because it’s the reasoning I see a lot of people use, and it is completely logical. It sounds something like this.

“Hey, money in my Roth IRA will never be taxed again, so I want my highest growth investments in there, because the more it grows, the more tax-free money I’ll have when I withdraw it.” And Fletcher, you’re like, I have limited Roth space, so filling it with a slower-growing asset, like a REIT, feels like you’re wasting a precious opportunity.

Here’s the thing with that. That strategy will probably leave you with more money in the end, but maybe not for the reason you think. It’s not like some kind of tax trick. It’s not a free lunch. And to see why, let’s use a device that Jim uses in blog posts when he talks about this. And let’s look at our 401(k) as really two separate accounts.

And so, Jim, in the blog posts, if you go read, he’ll say like, hey, a tax-deferred account, like a 401(k), is really two accounts. One of them belongs to you, and it works exactly like a Roth IRA would. It’s your share grows tax-free and comes out tax-free. The other account belongs to the government. You’re just investing it on their behalf for a few decades, and they collect it when you finally withdraw the money.

So, let’s put some numbers on this to see if it makes sense. Let’s say you have $100,000 in a Roth IRA and $100,000 in a tax-deferred 401(k), and you expect to pay about 24% on your 401(k) withdrawals in retirement.

On paper, you have $200,000. But for planning purposes, I like to think of $24,000 of that as money that isn’t really yours yet. It’s an estimate of the future tax liability that you’ll owe the government. So, what’s actually yours? $100,000 in the Roth, definitely yours, and $76,000 in the 401(k) is yours for $176,000 total.

Now let’s say that your target is 50% stocks and 50% bonds, and you put all the stocks in the Roth and all the bonds in the 401(k). Your statements say that you have a 50-50 asset allocation, but the money that’s actually yours, $100,000 is in stocks and $76,000 is in bonds. That’s really a 57% stock allocation. Or if you want to flip it around, put all the bonds in Roth and all the stocks in the 401(k), now you really have a 43% stock allocation.

Same statements, same 50-50 allocation on paper, but one investor is meaningfully more aggressive than the other. So when you put your high-growth investments in Roth, you do end up with more tax-free money, but the reason is that you’re holding more stocks than maybe you think you really are.

The higher expected return is simply payment for taking more risk. And if we got into another massive recession or Great Depression, you would have wished you had done it the other way around.

So, is Fletcher wrong, WCI community? No, for sure not. And this is important. What he’s doing here is perfectly reasonable. In fact, it’s what Jim does in his portfolio. It’s what Megan and I do in our portfolio. Jim and I, by he, are generally putting our higher expected return assets in our Roth accounts and our bonds and our tax-deferred accounts.

Jim’s objection to this is that people think it’s a free lunch, and it’s not. If you wanted to be a real purist about it, you could tax adjust your entire asset allocation, estimate your tax rate on every account, and build your portfolio around the after-tax numbers. Almost nobody does this, including me, and I don’t blame them. It requires guessing too many things. You’d have to know future tax rates, your future income, how long you’d live, what happens to the money when you die.

There’s even a behavioral argument for doing it the way Fletcher is doing it. If putting stocks in the Roth IRA tricks you into taking a little more risk than you otherwise would be comfortable with, and you actually stick with it through a bad market, maybe you’ve done yourself a favor.

The honest version of this would be saying, “Hey, putting high growth assets in my Roth accounts is a reasonable choice that increases my risk a little bit, but it’s not a way of beating the IRS.” And here’s some good news that should save you some time. Between your equity funds like VTI, VXUS, Small Cap, or REITs, whether those sit in a Roth account or a pre-tax account doesn’t really matter that much, and Jim has said that over and over.

Once you’re choosing among stock funds between two tax-protected accounts, you’re really splitting hairs. Where it’s worth putting some thought is where do the bonds go, which brings me to the part of your question that I want to push back on in a nice way a little bit. And that’s this description you have that REITs are a limited growth investment. And I’m not sure I fully agree with that, and it’s worth talking about because it’s driving a lot of your reasoning in the question.

REITs are real estate companies, and their expected long-term returns are much more equity-like than they are bond-like. What makes them different though is how that return shows up and how it’s taxed. REITs are required to pay out at least 90% of their taxable income as dividends, so a big chunk of their return comes as dividends.

Most of those dividends are taxed at ordinary income rather than lower qualified or long-term capital gains rates. Now that said, they do get a little bit of help from the 20% QBI deduction, but even with that they’re still pretty tax inefficient. That combination of high expected return and poor tax efficiency is exactly what you would want in a tax-protected account. And it doesn’t much matter whether that’s a Roth or a pre-tax account, but either way REIT funds really belong in retirement accounts.

Now you said that historically broad stock funds have returned much higher returns than REITs, and over the last decade or two that’s definitely true. At the start of this year, REITs had returned about 6.4% over 10 years versus 15.6% for the S&P 500. But that’s a pretty recent window for those of us who are long-term investors, and over longer periods REITs have been far more competitive.

And you acknowledged in the question, Fletcher, which I appreciate that none of us has a functional crystal ball that we can’t predict future returns, but then the reasoning that followed, you were kind of assuming a pretty clear crystal ball. If we had a crystal ball, wouldn’t we have all just put Nvidia and Bitcoin in our Roth IRAs 10 years ago? But we don’t, so we didn’t. And so you’ve got to own the fact that you just don’t know what is going to be the higher performing thing.

So here’s a question worth asking yourself also on this point about REITs. VTI already holds a lot of real estate, because they’re part of this total stock market. So a separate REIT fund is really just a decision to tilt towards real estate. And if you believe in that tilt, that’s great. Keep it and just keep those funds in a retirement account. If you hold it out of some kind of FOMO or someone told you to, then it’s fair to ask whether you even need the REIT funds at all.

Okay, so now let’s talk about your bonds. You said you moved 5% to 10% of your net worth into bond funds recently, and you put them in your 401(k). So let’s look at those two decisions separately. Putting the bond funds in the 401(k) makes sense. With bond yields near 5% right now, bonds are a lot less tax-efficient than they were a few years ago when the yields were close to zero.

At these interest rates, bonds in tax-deferred accounts is a solid default choice. Even if it turns out to be the wrong call in some future scenario, it’s just not going to matter very much.

The reason you gave for buying them is where I want to push back a little. You said that it’s a historical buying opportunity for bonds. Yields are certainly more attractive right now than they were over the last 15 years or so. But that’s market timing. If it walks like market timing and talks like market timing, it’s market timing. And that’s on our kind of naughty list around here. And to solidify that point, if yields keep rising, these bonds lose value in the short term.

The better reason to add bonds at age 39, 12 to 15 years from retirement, is that your written investment plan calls for gradually reducing risk as you approach retirement. And if that’s what your plan says, great, then you’ve got the right answer. Just make sure that your written financial plan made the decision, not headlines about bond yields. And I think you’re with me on that. I just want to make that point. The reason we make the decision matters as much as the decision often.

Okay, so how to actually do asset location? If we’re not putting the least tax-efficient assets in the retirement accounts and the highest growth in the Roth accounts and calling it a day, how should you think about asset location?

The first principle is that you want as much of your money in tax-protected accounts as you reasonably can. Maxing out retirement accounts will always matter more than which fund they happen to go in or what fund goes where, I should say.

The second principle is that when you decide what goes in tax-protected accounts, you have to two things, not one. How tax-efficient the investment is and how much you expect it to return. A lot of people only look at tax efficiency, and that’s a mistake Jim has written about for years now. Something with a high expected return and poor tax efficiency, like a REIT, is a great fit for a retirement account. Something with a low expected return and great tax efficiency, like a municipal bond fund, that’s a great choice for your taxable brokerage account. Maybe all the investments you want fit into your retirement accounts just fine and you’re done. Well, that’s nice, right?

But many high earners, especially procedural subspecialists like Fletcher, run out of retirement account space pretty quickly. Your taxable account becomes a big part of the portfolio, and you still have investments that are tax inefficient to varying degrees and nowhere left to put them. That’s why Jim always answers these questions with, “The question you have to ask yourself is what goes into taxable next.”

For most investors, the best candidates for a taxable account are total U.S. stock market funds, total international stock market funds, and municipal bond funds. Total stock market funds are very tax efficient. Most of their dividends are qualified and you control when you realize the capital gains.

International stock funds have a higher dividend yield than U.S., but you can claim the foreign tax credit on those, and that makes them a little more tax efficient. And that efficiency only exists in a taxable account.

When pressed, I kind of asked Jim about this. I’m like, what do you think is better? The optimizers want to know. And he was like, they basically wash out. And so he didn’t have a lot of energy for whether it should be U.S. or international. It nets out to about the same.

And if you want bonds in your taxable account, municipal bond funds are usually the answer for people like you, Fletcher, in a high tax bracket. Their interest rate is free of federal income tax and they’re not subject to the 3.8% net investment income tax.

Taxable accounts also come with some cool tools that you don’t get in retirement accounts. You get to tax loss harvest. You can donate appreciated shares to charity. Your heirs get a step up in basis at death. And the more of those tools you use, the better stocks look in taxable accounts relative to bonds.

Now, that can beg the question, “Is asset location even worth it? This is a lot of thought and hassle here, Tyler. You got me thinking about all these different things.” And let me say, if you just want to have the same asset allocation in all your accounts, I completely endorse that. And if you’re a DIY investor, I think that should be the default. Just keep it simple.

But if you are an optimizer and you want to do everything you can to make a difference, how much does asset location really matter? And Jim has written about that asset location can add as much as 75 basis points per year to your return. I think that’s on the high end. My default assumption when we do this for White Coat Planning clients is maybe 50 basis points. But that varies depending on your circumstance.

For most people, it’s a few dozen basis points. But that’s a real value add. It’s much less important than your savings rate, much less important than your asset allocation, and much less important than keeping your costs low. But if you’re doing those things and you want to milk out another few dozen basis points of growth, asset location might be for you.

But there’s also some real cost to getting fancy with it. It adds complexity, which means someone has to keep managing it now and potentially decades from now. If you pass away first, can your spouse run this asset location strategy without you? It also makes rebalancing across accounts a lot harder. It creates an odd behavioral problem.

When all your bonds are in one account, that account return is going to look terrible relative to your other accounts where you own your equities. And then I’ve seen people start making bad decisions, staring at a lagging account, forgetting that they should be looking at their portfolio holistically.

So that’s why using the same asset allocation in every account is perfectly reasonable for DIY investors, especially if one type of account makes up most of your portfolio. If 90% of your money is in retirement accounts or 90% of it is in a taxable account, asset location barely moves the needle. It matters most when your taxable and retirement account balances are more equal. And a simple middle ground is just to keep the same allocation everywhere. Except don’t hold taxable bonds in your taxable account. Use municipal bonds instead, if your federal tax bracket starts in the 30s, you probably want to have municipal bond funds in your taxable account.

One more thing, Fletcher, if you’re like, “Hey, my Roth space is really limited.” And I believe you, you sound like a really sophisticated listener. But to just broaden this out for the rest of the audience, your question rests on the idea that the Roth IRA is the only place you can put Roth money and that it’s really small.

But before anyone else were to accept that broadly, we would want to check a few things. First, do you have access to a mega backdoor Roth? Many 401(k) plans or 403(b) plans allow you to make after tax non-Roth contributions and then convert them to Roth.

The total 401(k) contribution for this year is $72,000, which includes your money and your employer’s contribution. And if your plan allows it, you may have tens of thousands of dollars within that $72,000 space for additional Roth contributions if you’re able to do the mega backdoor Roth.

Don’t forget your spouse’s backdoor Roth. I know it’s not a huge amount, but if married, even if that spouse has no income, they can do a backdoor Roth as well for another $7,500 or $8,600 this year if you’re over 50 years old.

Don’t forget about your HSAs. Those, if you’re eligible, that’s arguably the best account out there. It’s triple tax protected. Tax break going in, tax-free growth, tax-free withdrawals if used for qualified healthcare expense. So, Fletcher, you’ve got some tax-free money in your HSA as well.

And then everyone has a kind of infinite Roth window available to them in the form of Roth conversions in early retirement. If you retire in your early 50s, you have a lot of years ahead of you before Social Security and RMDs start, and those can be great years for converting tax-deferred money to Roth at low tax rates.

You’ll notice I did not list there a Roth 401(k) option. It’s of course an option, but as we’ve said around here for a long time, someone in their peak earnings years should almost certainly be making traditional pre-tax 401(k) contributions.

So, hey, bottom line, Fletcher, you’re doing a lot of things right. You’re thinking about taxes, you’re maxing out your accounts, you’re building a bond allocation as you get older. Putting your stock funds in your Roth and your bonds and REITs in your 401(k) is a perfectly reasonable setup.

Just know that the extra tax-free money comes from extra risk, not from outsmarting the IRS. And I would just say, don’t sweat which stock funds goes where between your Roth IRA and your 401(k). It just doesn’t matter that much. Spending that energy instead on maxing out every other tax-protected account available to you, including checking for mega backdoor Roth and those things, is likely going to be more impactful.

And ultimately, the question you need to ask yourself is, “What goes into taxable next? If you guys want to take a deeper dive on this, Jim has two articles I’d recommend on the blog. They’re called My 2 Asset Location Pet Peeves, and the other one is called What Is Asset Location?

And if you need help laying out an asset location for your whole portfolio, again, go to the recommended page, find a vetted, trusted financial planner. Certainly, our team at White Coat Planning would be happy to help you. But overall, Fletcher, you’re doing great, and congratulations on the progress you’re making.

All right, everyone, thanks for joining us for another episode of the White Coat Investor podcast. Just two questions from the Speak Pipe today. And that’s a little on purpose. I just want to say that and own that, that we’ve gotten feedback from the community that you guys like it when we slow down and break these questions apart and lay them out in a more comprehensive sort of teaching way. So, this was a purposeful thing to just take two questions with a deeper dive.

As always, if you want to give feedback, you can send that to [email protected]. We read all of those emails, we take your feedback seriously. And so please let us know what we can do better to help serve you as faithful podcast listeners. We’re so grateful for you.

SPONSOR

Tyler Scott:
This podcast was sponsored by Bob Bhayani at Protuity. One listener sent us this review. “Bob has been absolutely terrific to work with. Bob has always quickly and clearly communicated with me by both email and or telephone with responses to my inquiries usually coming the same day. I have somewhat of a unique situation and Bob has been able to help explain the implications and the underwriting process in a clear and professional manner.”

Contact Bob at www.whitecoatinvestor.com/protuity today or by email at [email protected], or by calling (973) 771-9100 to get disability insurance in place today.

Thank you all for those who take the time to go leave a review on the various podcasting streaming services about the podcast. It really makes a meaningful difference in being able to spread the message of what we’re trying to do here. The algorithms of how podcasts are recommended really hinge on the number of the reviews and the magnitude, the star rating.

So, if this is meaningful to you, I know you have plenty to do in your life. And I know that everyone is constantly asking you for a review every time you go to the car wash or every restaurant. It is a tyranny of review requests out there. So, I know that. I feel that in my own life. And if you are willing to take the time, we’d be really grateful for you to go leave a review. It’s the five-star ones that make the biggest impact.

If you have critiques, if there’s things you don’t like, please send those to us and we’ll take those seriously and respond individually to you. If you have something nice to say, it really helps when you put it out there as a review.

And here’s one that came in recently and it’s a five-star review that says, “I’m so grateful for this podcast and all that it has taught me. I’ve been listening since I was in residency about five years ago and the impact WCI and Dr. Dahle have made on my personal and financial life has been profound. Thank you for all you have done for my family and I.”

We appreciate you sending those in. It really keeps us motivated to continue to provide this kind of content and stay engaged. It’s fun to hear from you all. So, thank you for those reviews.

Until next time, you’ve got this. We love you. We trust you. We believe in you. We’re grateful for you. Go out there, have written financial plans, enjoy your life, live fully and abundantly, and we’ll see you next time.

DISCLAIMER

The White Coat Investor podcast is for your entertainment and information only and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.

INTRODUCTION

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

Dr. Jim Dahle:
Welcome to the Milestones to Millionaire podcast. On this podcast, we get feedback from you guys all the time. Some of you complain that all of the guests make a lot of money and have really high net worth and are working on kind of later milestones. And then we get feedback from other people going, “Oh, we want more detail from those decamillionaires. We want to know exactly how they did it because we want to do it and not understand exactly how they got that wealthy based on that income.” And they want like an hour and a half interview with them trying to glean more detail from it.

And so it’s all up and down the line what people want. And we’ll celebrate any milestone with you. I don’t care how trivial it is or how massive it is. We’ll celebrate it with you because it just demonstrates that we’re all working on our own goals. We have our own values and we’re all in a different place in life. It’s not a competition. We’re not investing is a single player game. It’s you against your goals. It’s not you against the milestone guest of the week. And I hope that doesn’t make you feel better when you have more money than the latest guest or less money to feel bad when you have less money than the latest guest.

But today we’ve got another person who has quite a bit of wealth, quite a high income and quite a bit of wealth. And I think there’s some important lessons to be learned there by anybody, no matter what your wealth level and no matter what your income. And like some other recent guests we’ve had that have been pretty wealthy, this one’s willing to be pretty open with the situation. And so, I think we can learn a lot and I hope you find it as interesting as I did.

This podcast is sponsored by Bob Bhayani of Protuity. He is an independent provider of disability insurance and planning solutions to the medical community in every state and a long-time White Coat Investor sponsor. He specializes in working with residents and fellows early in their careers to set up sound financial and insurance strategies.

If you need to review your disability insurance coverage or get this critical insurance in place, contact Bob at whitecoatinvestor.com/protuity today by emailing [email protected] or by calling (973) 771-9100.

INTERVIEW

Dr. Jim Dahle:
Our guest today on the Milestones to Millionaire podcast is Justin. Justin, welcome to the podcast. Thank you, happy to be here. Introduce yourself a little bit. Tell us what part of the country you’re in, what you do for a living, how far you’re at a training.

Justin:
Sure, my name is Justin Sherfey, originally from outside of Seattle, Washington. Currently, I’m in Southern California and an area called the Antelope Valley. It’s kind of northeast LA for those people aren’t familiar. I’ve been in the Southern California area for about 11 years now. I’m about 25 years out of training.

Dr. Jim Dahle:
When you applied to come on the podcast, you noted a net worth milestone. You noted you were a millionaire, but you’re actually quite a bit more than a millionaire. Tell us what we’re celebrating with you today. What net worth have you reached?

Justin:
I’ve reached over $8 million at this point, probably a little closer to my original goal of $10 million, so getting closer there every day. It’s kind of funny, when I started, I wanted to be a millionaire someday. I woke up and looked and I was like, “Wow, I’m making this every year, so we can move on.” I set this goal of $10 million. As some people say, once you hit your first $10 million, it’s the hardest, but getting to the $20 million is easier. Hopefully, that’s true, so we’ll see.

Dr. Jim Dahle:
Very, very interesting. Okay, let’s talk a little bit about it. Let’s divide up your wealth at this point. What is that $8 million composed of? How much is it in retirement accounts versus other investment versus your practice versus your side businesses, etc.? How is it divided up?

Justin:
It’s divided up amongst them all, everything you listed. I have some in traditional investments, such as retirement accounts, being a business owner for some things. I have individual SEP accounts that are maxed out, so I do the traditional things in retirement.

As I made other income, I found some other avenues to put it in, so I have some real estate investments that hold some of the value as well. Then the majority of it is in the actual other businesses that I run, not only my medical practice, but the associated businesses I run around the medical practice that help me not only grow passive income, but also value and equity in those as well.

Dr. Jim Dahle:
Now, when you applied to come on the show, one of the things you wanted to emphasize was that doctors don’t just have to practice medicine. Tell us a little bit about your career path over the last 25 years, particularly with regards to those decisions you made so that you were doing more than just being an orthopedist.

Justin:
Yeah, absolutely. First and foremost, like most physicians when I come out, I was relatively not intelligent with my financial decisions. Intelligent, obviously, in the medical side, everything else. But when I left my training, I was almost $500,000 in debt, had two kids, I paid for that all myself.

So, when I got my first paycheck after 15 years of orthopedic and residency training fellowship the first thing I had to do is make my wife happy and buy a house, get her a place to put the kids. And then that spirals into all the other spending we typically do, getting a car taking care of kids, all of a sudden, we have money to buy something nice or travel.

And so I looked up after about eight years in practice, and I realized I was living paycheck to paycheck, like most of the physicians who get in that situation. So, I didn’t do this intelligently from the start, I had to kind of think about this.

At that point in my career, I was making between about $600,000, $700,000 a year as a busy orthopedic surgeon. And I said, okay, I started listening to podcasts like this, I started listening to other things, reading books, and everything I saw made me think I have to do another career, meaning I got to get into real estate, I got to own 1000 doors to make this work, I got to have some other investment or invent an app or do something else. Because as a doctor, I’m going to have some money. But all everybody I was talking to had something else that was making them the big money.

Dr. Jim Dahle:
Now, let’s pause for just a second and acknowledge that there’s a few people out there listening to this podcast going, he was making $600,000 or $ $700,000 and he felt like he had to do something else. Was that just the crowd you were running with? Was it the fact that you were in California? Or why did you feel like I can’t build wealth on $600,000 or $700,000 to the point I want to at that point?

Justin:
Yeah, I think a lot of it is just what us as physicians make. And when we come out a little bit foolish, like I said, not everybody comes out wise and is living frugal right away. We hear that all the time I was paying student loan debt, I was raising two kids. And you just start to spend your money and lifestyle creep happens. And next thing you know that $600,000 wasn’t all going in the bank at all being saved, it was being spent pretty rapidly.

So, that’s what I mean. No one’s going to feel sorry for me for making that much and telling you I’m not saving a lot. But that’s the truth of the matter. That’s kind of what was happening. So, I had to look at that and say, “What can I do?” And you started to get frustrated because you think, “Man, why did I go into this if I got to get into all these other things to really make money?”

And so, I instead said, okay, listen, I spent a lot of years, I’ve got a lot of knowledge, a lot of training, a lot of experience. I moved to Southern California about 11 years ago. I made a transition in practice. And so I really had to focus on building some wealth, kind of starting over, so to speak, because I came and joined another practice.

And so luckily, my first practice had excellent mentors on the business side of it, they really trained me how to run a practice how to run a business. I came down to my new practice and help them kind of restructure revamp. And I started to realize that there is value in just doing what I was doing better, and letting my medical practice optimize what I could make, which gave me more room to save, invest, put into other things.

And then I continued to grow that I said, okay, I’ve made a medical practice that gives me some significant income, I found ways to diversify that. So I’m not just relying on me seeing a patient. I built in some administrative businesses that kind of augment that. And I started to say, hey, these are making me a little more passive income, I’m doing some work, but they’re still generating income without me seeing a patient.

And then I branched that out and offer that to other practices as we help them with management, help them with billing. And that kind of spiraled into it again, another revenue source, another stream of income that wasn’t relying totally on me seeing patients, but I could do some administrative do some oversight and still get paid. And so, I started to balance that out between clinical practice and these entrepreneurial aspects.

And eventually led to doing more such as speaking, writing a book, consulting and other things that just augmented my income without the daily grind of patients so much. And so, I got to a point where right now my income is split basically 50/50 between things on the non-clinical side and things on the clinical side. And that allowed me to have flexibility to just put that money and have some extra revenue to start to put in some traditional things and to build these other businesses to have a lot of value in them.

Dr. Jim Dahle:
Can you talk to us a little bit about your income the last two or three years? You’re making $600,000 or $700,000 before practice in medicine, you help to optimize your practice, but I presume not quite doing full time orthopedics and full time this other thing as well. What’s that added up to the last couple of years? What does your income look like?

Justin:
Yeah, I was fortunate when we optimized our practice, we really went above the curve on what orthopedic surgeons make. So, our orthopedic surgeons in our practice, just on the clinical side, we average about anywhere from $1.2 million to about $2.1 million a year, which is really beyond the curve. It’s just a very efficient, very high volume, very well-functioning orthopedic practice. Again, because I split my time I make up right now about $1.2 million from the clinical side. On the admin side, like I said, a lot of it is built in equity, but from the administration work, the consulting work, the other avenues, I make about another $1.2 million to $1.4 million right now.

Dr. Jim Dahle:
Now, one of the downsides of having a seven figure income like that, especially for somebody that lives in Southern California, is it tends to come with a rather large bill to the IRS, as well as, I can’t remember what they call it in California, the franchise board, or I don’t remember what they call it. The California Taxing Association. Did that shock you how much you ended up paying in taxes on that sort of an income?

Justin:
Absolutely. Listen, it shocks me every time I look at that. And every time I see my taxes go out each month, each quarter, etc. Yeah. Listen, California is not the best place to do business. If I could pick this up and move it somewhere else, I probably would. And a lot of what I do, we do function out of other states and other things as well. So we kind of diversify that.

But you’re right. The cost of business in California is high. Fortunately, we’ve been able to still be successful, even in a very difficult environment, and hopefully offset any way we can those high tax burdens.

Dr. Jim Dahle:
Now, you mentioned that you have done some real estate investing as well. But when you chose to pursue your entrepreneurial spirit, you chose to make it more medicine related than more real estate related. And I’ve definitely seen docs go down both pathways. Some just love the real estate side. They then qualify for real estate professional status and get to use some of their depreciation against their clinical income and that sort of stuff.

What made you decide to kind of double down on your medical knowledge and use that to expand? It was just a passion for spreading the practice efficiencies that you developed in yours? Or what was it that caused you to go down that pathway?

Justin:
Well, it’s a little of everything. So number one, not all of us instantly understand everything in the real estate market or any other investment or revenue avenue. And so as I tried to educate myself, kind of get down in those pathways I just started to think, why did I spend all this time in school and training? And now 20 plus years in practice. And so I felt like, “Do I want to just abandon all that and move another direction?” For some people, it’s great. Yeah, they want a whole another career choice. They want to go down another path that excites them. I just felt like I was wasting experience.

And so I wanted to say, hey, I can use what I’ve learned. I can use the knowledge I have. I can use this experience, it has to be valued at something. And so I tried to look for avenues of where I can share, use, monetize, grow that experience. And so, that’s what we’ve done. And fortunately, it’s I think a great avenue and it’s worked well. And I think a lot of doctors, we don’t look at that.

We look all of a sudden at these other courses and think we have to head in one of these directions to really be successful. And I’ll tell you, in a couple of the businesses we’ve grown around the healthcare space and what I do daily we’ve walked away in the last two years from offers that would probably double my net worth overnight. And we’re still exploring that. Those are still things we keep looking at. But that’s the kind of value that we’ve been able to grow by just using the experience, the expertise, all those years invested and keeping and making those worth something.

Dr. Jim Dahle:
Now, when you calculate your net worth, do you include some figure for those businesses?

Justin:
No, no, I don’t, believe it or not.

Dr. Jim Dahle:
You’re totally ignoring the value of these side businesses.

Justin:
Yeah. Those side businesses haven’t innate value. But again, because they’re kind of unrealized gain at this point, I haven’t calculated.

Dr. Jim Dahle:
Little pie in the sky and hard to value and so on and so forth.

Justin:
Yeah.

Dr. Jim Dahle:
Okay, but when you put all that together, especially with you still working pretty hard right now, you’re likely to end up with an estate tax problem.

Justin:
Correct.

Dr. Jim Dahle:
You got to start doing some of that sort of planning, at least down the road, if not sooner rather than later. What are your thoughts with regard to that? A lot of people start thinking, “Oh, I’d like to start a charitable foundation, or I want to pass generational wealth to my children.” Have you given any thought to sort of what you want to do down the road with those sorts of levels of wealth that cause people to have to do planning to minimize the state taxes?

Justin:
Yeah, absolutely. On all of the above. One thing I’ve learned is it’s great to be successful. I don’t I love it. I’m not complaining. I wish it for everybody. But with it comes incredible headaches. I have accountants, I have estate planners, I have tax advisors, I have financial planners, because I have to manage I think it’s up to like 11 companies at this point, that we’re rolling through everything and doing all this.

So yeah, I engage all those services. I look at everything. I have a nonprofit, I have a estate planning trust that’s being formed for the family trust, we are exploring all the avenues you can to plan this. And there’s a lot of times I’m ready to say, let’s shut it down to one, get simple, when enough is enough. And you start to think about that at my age, you really start to go from their growth phase to your simplification phase.

And I’m in that right now where I’m trying to take that wealth, trying to say what I’m going to do with it, how it’s going to pass to my children or what I’m going to spend and not leave to them. And how is this all going to balance out? I’m definitely in that simplification phase at this point.

Dr. Jim Dahle:
Yeah, very cool. Okay. Well, there’s somebody out there that wants to be like you. Maybe they are early career and they feel like they’ve got the nose to the grindstone. And they’re like, “Yeah, I do know a lot. And maybe I should be doing private practice, maybe I should be doing a little bit of entrepreneurship.” What advice do you have for that doc that’s maybe a little afraid to make the leap out of clinical medicine?

Justin:
Sure. Well, shameless plug, I’ll tell them to read my book because that’s exactly what it’s about. But beside that, first, just look at your daily clinical practice. That’s your lifeblood right now. That’s where the money’s coming from. See what you can maximize there to get your return and also see what you can do that doesn’t require you to actually see a patient. So start maximizing your ancillary services, see what other things you can grow with it. For example, I’m an orthopedic practice. We also have our DME department that does braces, devices, things like that. We have imaging, we have therapy. We have things that I don’t have to do, but I still receive a revenue from. So just look at what you do every day. Maximize that.

From there, you may see another avenue that say, “Hey, I really like this. I want to kind of grow into this.” And that’s where you start to dabble and explore. You keep it simple at first and you kind of grow from there. One of the things we branched into initially was regenerative medicine. It’s the big buzzword out there now. You hear everybody doing it.

Me and a couple of partners branched out, kind of opened a regenerative part of the practice, started doing a little that on the side, dabbling that and growing that. When that worked well, we kind of let that continue to grow. So, we just look at what you do every day, see the simple opportunities to maximize it and then kind of grow from there. That’s how I would get started.

Dr. Jim Dahle:
Awesome. Well, Justin, you’ve been very successful. Congratulations to you on your success. You should be proud of what you’ve done. And we thank you not only for what you’re doing in medicine, but what you’re doing for other doctors and your side gigs, and especially for coming on the podcast and sharing it with others to inspire them to reach their goals.

Justin:
I appreciate it. Thank you so much for having me. I love it.

Dr. Jim Dahle:
Okay. I hope that was helpful to you. Entrepreneurship. I’ve talked before on this podcast, I’ll talk again on this podcast, kind of three pathways to wealth. The boring old pathway where you go to work, you carve out 20% of your income, you invest in a boring old index funds, you give it two or three decades, and yes, you retire as a financially independent multimillionaire. It’s not guaranteed, but it’s pretty darn close to being guaranteed.

The second pathway, build your own real estate empire, very reproducible compared to other types of entrepreneurship, but it does require more work, does require some more expertise, but can be faster than the first pathway. But again, no reason you can’t do the first pathway and the second pathway.

And of course, a third pathway is entrepreneurship. And what I love about this doc is he wasn’t afraid to play in all three pathways. He kept the main gig going, in fact, tried to optimize that and did optimize that, optimize his income from his practice. He also had some real estate investments. And he also pursued entrepreneurial pursuits, which so far sound like they’re working out pretty well as well.

And there’s no requirement that you have to only use one pathway. It doesn’t mean you can’t just use one pathway if you want to, but there’s no requirement that you can’t do more than one thing. And I love that he demonstrated that so well.

One of the easiest side gigs out there is to do paid surveys. If you go to whitecoatinvestor.com/survey, you will find the links we have, the partners we have that do these surveys. They want your knowledge. Sometimes it’s a pharma company or a device company or something like that. And yes, some specialties are better for this than others. Emergency medicine, maybe not quite as good as people that prescribe much more expensive stuff like neurologists and oncologists and endocrinologists, et cetera.

But for every specialty, there are opportunities to take these surveys, share your opinion and get paid for it. And you could actually start a business doing this and you do enough of this, you can probably justify opening up a solo 401(k) and putting some additional money into there and speed your way toward retirement. Yes, they have to actually want you to take the survey. And so, there’s sometimes a few questions to screen out for it. But a lot of White Coat Investors have found a lot of success doing this. One of our columnists made as much as $30,000 in a year just doing surveys.

And it’s fun because you can do it on your commute. If you’re in big city and you’re on the subway or you’re on a train or whatever, you can do it while you’re sitting there on the train, not using your time for anything else productive or while you’re bedging out, watching a little TV at night, you can knock out a survey and actually get paid to sit there and watch TV, whatever it might be. But check that out, whitecoatinvestor.com/survey.

FINANCIAL BOOT CAMP: WHOLE LIFE INSURANCE

Dr. Jim Dahle:
Whole life insurance is a type of permanent or lifelong life insurance, meaning it’s going to pay a benefit no matter when you die. So, if you die at 35, it pays out the death benefit. If you die at 95, it pays out the death benefit.

The other main type of life insurance is called term life insurance. There’s permanent life insurance and there’s term life insurance. For term life insurance to pay out, you actually have to die during the term. So if you buy a policy that basically matures or expires or whatever at age 60 and you die after 60 and you haven’t renewed it or gotten another policy, it’s not going to pay you. But if you die at 55, it’s going to pay your state, your heirs, whatever you’ve listed as the beneficiary. So, that’s the difference between permanent life insurance and term life insurance.

Because the permanent life insurance has to pay out to everybody that keeps it, it costs a lot more. A typical price difference and it varies by age and health status and that sort of thing. But typically it might cost you 10 times as much to buy a permanent life insurance policy as opposed to a term life insurance policy because it has to cover all those people that are going to die in their 60s and 80s and 90s.

But the issue is that’s an expected event for you to die at 90. That is not like a financial catastrophe, I hope. So, most people don’t actually need a lifelong or permanent life insurance policy. They need something that’s going to pay their heirs if they die before they become financially independent before they retire. And term life insurance works very well for that.

And so, that leaves this product out there, whole life insurance, with not a very big market. Because almost everybody needs term life insurance. They’ve got a kid or they’ve got a spouse or somebody they’re trying to take care of their needs if something happens to them at a young age. But not very many people have any sort of a need for a lifelong death benefit.

That leaves all these agents who get paid commissions for selling permanent life insurance trying to come up with another use for permanent life insurance, another way to convince you to buy it even though you don’t need a lifelong death benefit. They’re trying to talk you into paying 8 or 10 or 12 times as much for life insurance as you need to because then the commissions are 8 or 10 or 12 times as large. And it can be a real tragedy if you end up being underinsured because of it.

If you buy a $100,000 whole life policy instead of the million-dollar policy, term life policy that you should buy, you’re maybe spending about the same amount of money, but your heirs get a whole lot less money if you die in the next few years when you really have a huge need for life insurance. So that can be kind of tragic.

But the bigger problem, if they talk you into buying this policy for some other reason other than the death benefit, is you probably have a better use for your money. I’ve run into people who are putting 40 or 50% of their savings into whole life insurance. And that’s just way too much for something like this. The truth is 98, 99% of doctors probably don’t need whole life insurance. It’s a very niche product. It should only be bought by people in a specific niche where it makes sense to buy it.

So, some of the ways that people try to talk you into buying this policy is they tell you, “Oh, well, this is another way you can save for retirement” because a whole life policy actually acquires cash value.

Now, there’s not two pots of money. It’s one pot of money. The death benefit and the cash value that you can borrow out of the account or that you get if you surrender the policy is the same pot of money. There’s not two pots of money. There’s not a million dollar face value death benefit. And there’s not this $100,000 in cash value that you’ve accumulated inside the policy. It’s not $1.1 million. It’s just a million. And whatever you borrow against the policy has to come out of the death benefit for the remaining death benefit is paid to your heirs.

But because it’s acquiring this cash value, that does give you some other things you can do with this policy, like pay for retirement. So what can you do if you get to retirement and you have bought this whole life policy for some reason, and you actually want to use that money to spend in retirement, or you need to spend that money in retirement, how do you access that money?

Well, the first thing you can do is to just do a partial surrender of the policy. And this is really the only unique tax benefit of whole life insurance. You basically can do a partial surrender up to your basis, meaning the total amount you paid in premiums over the years. You can take that money out tax free, and you can take it out first, which is really cool. You can’t do that with a typical investment. You can’t do that with an annuity, but with a life insurance policy, you take the basis out first.

So, if you’ve got a policy that’s now worth $1.5 million, maybe you’ve paid $400,000 in premiums over the years, I don’t know what you paid. Use that first $400,000 that comes out, comes out tax free, which is pretty cool. It’s tax free and it’s interest free.

But if you want more than that money out of the policy, you got to do one of two things. You’ve got to either surrender it, in which case you now pay taxes and all the gains at ordinary income tax rates, not capital gains tax rates, or you borrow against it, just like you’d borrow against your house to spend money, or you’d borrow against your investment portfolio to spend money. And that money comes out tax free, like all loans, but not interest free.

Now there are some types of policies that can be designed so that it continues to pay dividends as though you hadn’t borrowed that money out. That’s called a non-direct recognition policy. And if you’re planning to borrow against the policy, that’s a good feature to have in your whole life insurance policy. But the bottom line is after surrendering partial surrenders of your basis, there’s some complications with getting the money out of there to spend.

The bigger problem with whole life insurance is that cash value just doesn’t grow very fast. It has a really low rate of return. And in fact, if you look at the entire premium you’re paying as making an investment, you are not paying for insurance, which obviously some of it is, but if you look at the whole thing as paying for an investment, it has a negative return for quite a while.

The very best design policies where you’re doing all kinds of paid up additions and it’s designed for you to do this. You’re still not going to break even for five or six years. Many policies don’t break even for 15 or 20 years. That’s a terrible investment. You’re better off in CDs or bonds or even just a money market fund than something that’s going to take 20 years to break even. In your money market fund, your money’s probably doubling in 20 years.

And so, it’s not a great investment from that perspective. And that’s why there’s usually a better use for your money. If you are putting money into whole life insurance policy and not even maxing out retirement accounts like Roth IRAs and 401(k)s and a second 401(k) for your side gig and a 403(b) and a 457, everything that’s available to you, you’re probably making a mistake.

And you can even make a case as long as you’re investing the money aggressively into a stock index fund or into rental property or something like that, that you can invest outside of retirement accounts and still be better off even adjusting for risk than you are putting money into a whole life insurance policy.

The only time it even comes close to starting to compare is in the long term when you’re buying very safe investments like CDs or bonds, then it’s more of a comparable return, but not for 10 or 15 or 20 years because that time period, the money has a negative return. Plus it’s hard to rebalance from a whole life insurance policy to your portfolio, et cetera, et cetera. It’s just not a great strategy.

So, what are the things where it makes sense to have a whole life insurance policy? Well, there are a few of them and perhaps one of the most significant ones is when you have a business purpose or an estate planning purpose for the long-term death benefit. You’re still interested in the death benefit, but you’ve actually got a business purpose.

For example, let’s say there’s two partners that are already 65 years old and they want to buy-sell agreement for the business. They want to have enough money that if one of them dies, the other one will own the entire business and that person that dies heirs will get cash from the life insurance policy, but now term life insurance has become really expensive so they decided we’re going to buy a whole life insurance policy that way even if we die at 83 it’s going to pay out. Okay, very reasonable use.

Another reasonable use would be like a family where all their wealth is tied up in a farm and maybe there’s four heirs, right, and they don’t want to have to split up the farm. They want one say one son to work the farm after they die, but they want everybody to get an equal amount. So, maybe they borrow against the farm and use the money to buy whole life insurance policies for the other three kids, and now everybody gets an equal amount of money. Estate planning purposes like that.

Some people really hate using banks for some reason and prefer to bank on themselves or do what’s called infinite banking, and this is basically a way in the long term that you can make a little more on your cash in exchange for dealing with the hassles of a whole life insurance policy. So, they’re essentially borrowing frequently from the policy to buy things and then paying the policy back, and that can work out okay. It’s not nearly as magical as its proponents would have you believe, but it’s possible in the long term you can make a little bit more money on your cash.

So these are some of the reasonable uses of whole life insurance policies, but as you can see they’re pretty niche. Most people do not need these things, and whole life insurance agents need to send their kids to college. They need to make some money, and so they try to really push these things you can do with whole life insurances. Great tax efficient way to invest and all these wonderful things you can do with it and try to get you to buy these policies.

But the truth is about 80% of White Coat Investors who have bought a policy regret it. About 80% of policies purchased or surrendered prior to death, so you can tell that most people buying these end up regretting it.

Treat it like a marriage. It is a lifelong commitment when you buy a lifelong insurance policy, and if you want to get out of it early just like a marriage, it’s going to cost you some hassle, and it’s probably going to cost you some money.

I hope that’s helpful in making your decisions about what to do with whole life insurance. Keep in mind if you own a policy and you’ve already owned it for 5 or 10 or 15 years, maybe you’re past a lot of the poor return years on that cash value because they tend to be heavily front-loaded. It might make sense to keep a policy you never should have bought in the first place. There’s some other things you can do with cash value you already have like exchanging it into another type of insurance like a long-term care policy or exchanging it into an annuity and using that for some retirement income. There’s some other things you can do with it.

So, a more complicated question once you already own it, but before you buy it, make sure you really want it, you really understand how it’s going to work, and that you don’t have a better use for your money. You might be paying down your mortgage, it might be investing in real estate, it might be buying index funds in your taxable account, it might be saving for your kids with a 529 or UTMA or something like that, but if you truly don’t have a better use for your money or you have one of these niche uses for a lifelong death benefit, go ahead and buy whole life insurance. I hope that’s helpful to you in understanding how whole life insurance works.

SPONSOR

Dr. Jim Dahle:
This podcast was sponsored by Bob Bhayani at Protuity. One listener sent us this review. “Bob has been absolutely terrific to work with and has always quickly and clearly communicated with me by both email and or telephone with responses to my inquiries usually coming the same day. I have somewhat of a unique situation and Bob has been able to help explain the implications and the underwriting process in a clear and professional manner.”

Contact Bob at whitecoatinvestor.com/protuity today. You can email [email protected] or you can call (973) 771-9100 to get your disability insurance in place today.

All right, keep your head up and your shoulders back. You’ve got this. We’re here to help. We’ll see you next time on the Milestones to Millionaire podcast.

DISCLAIMER

The White Coat Investor podcast is for your entertainment and information only. It should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.

INTRODUCTION

This is the White Coat Investor Podcast: Financial Bootcamp, your fast track to financial success.

Dr. Tyler Scott:
Hello, everyone. My name is Tyler Scott with White Coat Planning, and I’m here today to talk about the backdoor Roth IRA. This episode will be a little bit longer than others in the Bootcamp series, as we’re going to cover not just the steps of a backdoor Roth IRA process, but also three of the most common questions and mistakes that come up when people do it.

The steps for a backdoor Roth IRA are really quite simple, but they generate a lot of questions, and I think that’s totally reasonable because the whole backdoor Roth IRA concept is not at all intuitive. It would 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 make direct contributions to your Roth IRA. Well, how much is too much? In 2026, if you’re single and your modified adjusted gross income, or MAGI, is $168,000 or more, you can’t make any direct contributions to a Roth IRA. If you’re married filing a joint return and have a MAGI of $252,000 or greater, you cannot make direct Roth IRA contributions.

These numbers go up a little each year with inflation, but either way, it’s 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 that 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 what 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 number one: Make a non-tax-deductible contribution to a traditional IRA. Leave the money in cash. Do not 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 step 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.

Before doing step number one, there’s one thing you need to check. It’s the thing that trips up more backdoor Roths than anything else. It’s called the pro rata rule.

Here’s the problem: When you do a Roth conversion, the IRS doesn’t let you pick which IRA dollars you are converting. It takes all of your traditional IRAs, rollover IRAs, SEP IRAs, and SIMPLE IRAs and treats them as one big pre-tax pot, and they use that collective balance as listed on December 31 each year to determine the size of this pot. Any conversion you do comes out of that pot proportionally, or pro rata, as a mix of after-tax dollars and pre-tax dollars.

My favorite way to explain this is the cream-in-the-coffee analogy. Your pre-tax IRA money is the coffee. Your after-tax non-deductible contribution is the cream. Once you pour cream into the coffee, you cannot take a sip of just cream any longer. Every sip you take is a mix of both. The same is true for your IRAs. Once after-tax money is mixed in with pre-tax money, every dollar you convert is part taxable and part tax-free.

Let’s put some numbers on this. Let’s say you have $92,500 in a rollover IRA from an old job, all pre-tax. You contribute $7,500 non-deductible dollars to a traditional IRA and convert it to your Roth IRA, thinking the conversion is tax-free. But the IRS looks at the whole pot. That’s $100,000 total in the pot, and only 7.5% of it is after-tax. So only 7.5% of your conversion, or $560, is tax-free. The other $6,940 is taxable.

Timing matters also because the IRS uses your December 31 balance. You can do a perfectly clean backdoor Roth in February, roll over an old 401(k) into an IRA in November, and still get caught by the pro rata rule for that year.

So what counts as coffee and what doesn’t? The following count: traditional IRAs, rollover IRAs, SEP IRAs, and SIMPLE IRAs. The following do not count: 401(k)s, 403(b)s, 457s, Roth IRAs, and any inherited IRAs, even if that inherited IRA was one of the kinds of coffee I just mentioned that were “bad,” the traditional, rollover, SEP, and SIMPLEs. Your spouse’s IRAs don’t count either because the pro rata rule applies to each person separately.

If you do have pre-tax money in an IRA, you have two main ways to fix this problem. The most common is to roll that money into your current employer’s 401(k) or 403(b), if the plan accepts roll-ins. Many plans do, but you just need to check first. If you’re self-employed, a solo 401(k) can do this same job.

The other option is just to convert all of the pre-tax dollars to Roth and pay whatever taxes are due, which can make sense to choose this option if you’re in a low-income year or if you just have a low balance in a pre-tax IRA.

No matter how you get there, the goal is the same. You need to have a zero-dollar pre-tax IRA balance on December 31 every year across all pre-tax IRAs except the inherited ones. So unlike real coffee, you actually can get the cream back out. You just have to move the coffee somewhere else first.

Okay, so that’s the pro rata rule, and now I have you reaching for some cold brew. Let’s look at some common backdoor Roth mistakes, which generate most of the questions I get at White Coat Planning and Jim gets at the White Coat Investor on the podcast.

Common mistake number one: converting more than the contribution limit.

Let’s say you make the maximum allowable contribution to the traditional IRA for 2026, which is $7,500, or $8,600 if you’re 50 or over, and you leave that in cash in the traditional IRA, just like I told you to do earlier. Then a day or two later, you convert the entire balance of the traditional IRA to the Roth IRA, and the balance is $7,500.33. So far, you’re doing great, but now you’re worried about this 33 cents taking you above the annual limit.

First, where did the 33 cents come from? It’s interest. Remember how we said to leave the money in the traditional IRA in cash? Well, at most brokerages like Vanguard, Fidelity, and Schwab, that cash earns interest, and even a day or two of interest on $7,500 can add up to some cents or a few dollars.

Well, now what? The 2026 limit is $7,500, and people worry they’ve broken some kind of rule by exceeding that limit. It just begs the question: What limit? This is where people get caught up. The limit is for the contribution, not for the conversion. There is no limit on how much you can convert from your traditional IRA to your Roth IRA in a given year.

And 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 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 they’re in a lowish tax bracket for some other reason, like taking a sabbatical or going back to school or being in training, 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, into 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, people ask us how much should I convert, or when should I consider a Roth conversion.

All of this is to say 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 there, no one’s going to stop you. You just need to understand how much in taxes you’re going to owe on that conversion.

This all brings us back to our 33 cents. Given that step one of this process was to contribute $7,500 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 do not. Did we break any rules by converting more than the $7,500 limit? No, we did not. But if we have any earnings on our $7,500 between the time of the contribution and the time of the conversion, do we owe taxes on those earnings? Yes, yes we do.

Is there a limit on how much we can convert to our Roth IRA? No, that’s what we just talked about. So can we convert $7,500.33 to our Roth IRA without breaking any rules? Yes, absolutely. The only question is how much will we owe in taxes for doing so.

The $7,500 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, and hence no tax due.

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 $7,505, you owe $5 times 40%, which equals $2 of taxes. No big deal, right? You didn’t break any rules. The backdoor Roth police are not coming to your door. You just have to pay taxes on the extra amount you converted due to growth.

Alternatively, you could leave the 87 cents or the five bucks in the traditional IRA, but that will complicate your or your CPA’s task of filling out Form 8606. Remember the cream and the coffee. Those leftover dollars are pre-tax coffee sitting in your traditional IRA on December 31, and they’ll make next year’s conversion partly taxable.

Jim has a whole post about all this called “Pennies and the Backdoor Roth IRA” that will walk you through all of it if you want to read more. For now, suffice it to say that it is much easier and cleaner to just get all your pre-tax IRAs down to $0 before December 31 each year.

And that leads me to my final point here about problem number one. Sometimes you can see the extra interest before you do the conversion, which is actually kind of nice. At least you know it’s there. The more annoying version of this problem I see all the time with clients is they put $7,500 in the traditional IRA early in January. They convert the entire balance later that month, and that balance shows $7,500 at that time, so they think they’re good to go. They think they’re all clean and done.

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. Your Form 8606 will be a little wacky, and the pro rata rules can apply down the road.”

And they say, “Wait, what the heck? I converted the entire balance when I was done. There was no money left in the traditional IRA. Where did this dollar and 68 cents magically come from?”

The answer is that it was an interest payment made in arrears. Often, these brokerages don’t make daily interest payments. They do it weekly or monthly. So, you know, if you put the money in on January 2 and converted it on January 4, well, on January 9 they look back and say, “Hey, how much did Joe have in his account on January 2? Oh, it looks like he had $7,500 in there. We owe him $1.68,” and then they put the interest payment in long after you think you’ve emptied the account.

So look out for that. I personally always log into my traditional IRA around December 1 or Thanksgiving each year just to make sure it’s at zero.

In short, don’t worry if you convert a little over the contribution limit in a given year. You’ll owe a little tax on that. Just make sure you 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.

Common mistake number two: making a direct Roth contribution when you weren’t eligible.

This one is a little more complicated to clean up. It’s making a direct Roth IRA contribution and realizing later that your income for the year was too high. This is usually a mistake made out of benevolent exuberance. People who have been in a good habit of funding their Roth IRA early in the calendar year back when their income was below the limits keep doing it without thinking about the totality of their income for that year.

Then they realize after the fact that their income for the year exceeds the limits for direct Roth IRA contributions, and they need to fix what is now an ineligible or excess contribution. This happens so often that I wrote a blog post about it called “Backdoor Roth When Your Life Is In Flux.” Jim has one too called “IRA Recharacterizations: I Should Have Backdoor Roth.” So go read those for more information on this topic.

In my post, I point out a few common scenarios where you’ll find yourself wishing you would use the backdoor loophole. The most common situation is for someone in their final year of training, like a resident or fellow. They are so accustomed to being low income that they don’t pause to realize that even with a partial year of full attending income, by the end of the year their income will exceed the limits, even though they were a poor resident at the time of the contribution back in January or February. When you take the entire year into account, they made too much money for that direct contribution.

Another situation is getting married to another earner during the year. Let’s say you’re a first-year resident making $60,000, and you make your direct Roth IRA contribution in January, and then you marry an attending in July. Guess what? Your tax filing for that year is going to be married filing jointly, and your combined income is going to be way above the income limits.

Now your Roth IRA contribution you made back in January needed to happen via the backdoor loophole, even though you made the direct contribution as a well-meaning, low-income single person at the start of the year.

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

Our married earner has become accustomed to making direct Roth IRA contributions for themselves and their stay-at-home spouse each January, but by the end of the year, the couple is divorced, and both spouses are filing taxes as either 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 contribution, suddenly finds themselves with a MAGI that exceeds the limit for a single or head of household filer.

Another situation where this comes up a lot is with clients pursuing Public Service Loan Forgiveness. For complex reasons that go well beyond 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 loan forgiveness.

The MAGI limit for direct Roth IRA contributions begins to phase out at $0 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 limit, and they make their maximum Roth IRA contributions each January. Then let’s say March of the following year, about 15 months later, they meet with one of our student loan experts at White Coat Planning for a consultation on their student loans and learn that, in fact, they need to be filing their taxes separately, both for the previous tax year that they haven’t filed yet and for the years to come.

They have unexpectedly found themselves with ineligible contributions from both the Roth IRA contribution they made a couple months ago in January of this year and for the Roth IRA contributions they made 15 months ago. Now they’ve got two years of ineligible contributions in their Roth IRA if they decide to file separately.

This accidental direct Roth IRA contribution can also happen to people who just end up making more money in a year than they expected. And this actually happened to me when I switched from dentistry to financial planning. I had every reason to believe that my first year in the new job would be a low-income year as I got my feet underneath me, so I made a direct Roth IRA contribution for both me and Megan, my wife, in January of 2022.

To my great surprise and delight, it didn’t take me nearly as long as I thought to hit my stride in this new world, and I ended up surpassing the MAGI limit for direct Roth IRA contributions by the end of 2022. That was a happy oops, but still an oops.

The point is, there are a lot of ways that this mistake happens. It’s not just for those finishing training, though that’s probably the most common group who makes this mistake.

Well, how do you fix it? First, don’t stress too much. It’s not that big of a deal to fix. 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 dollars.”

There’s just a couple things to be aware of if you do this. First, it’s going to require calling the custodian of your Roth IRA, being on hold, filling out paperwork, and navigating a bureaucratic process that’ll eat up some of your time and probably raise your blood pressure a little bit.

If you don’t already have a traditional IRA, you’re going to need to open one first. And before you do the backdoor step, remember the pro rata rule. If you rolled your residency 403(b) into a rollover IRA, or you have a SEP IRA from moonlighting, you’ve got to deal with that first.

Next, keep in mind that any growth on the original ineligible Roth IRA contribution from the date of the contribution until the date of the recharacterization, those earnings move over to the traditional IRA as well. When you convert it all back to the Roth IRA, that growth will be taxable to you as ordinary income at your marginal tax rate. This can result in a few hundred dollars of tax.

And finally, just know that the deadline to complete a recharacterization is October 15 of the year following the tax year the contribution was originally for. If you made an ineligible contribution for the 2026 tax year, you have until October 15, 2027, to get it recharacterized.

But remember, you have until April 15 to make your Roth contribution from the previous year. So if you made an ineligible contribution early in 2026 for the 2025 tax year, your deadline to fix it via recharacterization is October 15, 2026, because 2026 is the year after 2025, and you messed up your 2025 contribution, even though you made that contribution early in 2026.

If you miss the deadline, recharacterization is off the table. You’ll need to withdraw the excess contribution, and you’ll owe a 6% penalty on that excess amount for every year it stayed in the Roth IRA. So don’t let it get to that point. Get your recharacterization done on time. Get those dollars into a traditional IRA and start the backdoor process from there.

That takes us to common mistake number three: not filling out Form 8606 or filling it out wrong.

This may not be the most common question we get, but it is the most common mistake I see when reviewing clients’ tax returns. Here’s why the form matters so much. After you do your conversion, your brokerage sends you a Form 1099-R the following January. It shows your $7,500 leaving the traditional IRA, and it often lists the amount as fully taxable with a little box checked that says “Taxable amount not determined.”

The brokerage has no idea whether your contribution was deductible. You never told them, and there’s no way to tell them. Form 8606 is the only place you can tell the IRS, “Hey, I already paid tax on this money.”

If that form isn’t filed or it’s filled out wrong, the IRS sees a $7,500 distribution from your IRA and treats it as taxable income. You already paid tax on that money when you earned it, and now you pay tax on it again. You can get taxed twice on the same dollars, which is terrible. That’s the exact opposite of the whole point of this exercise.

And I see this happen in two main ways. First, people do their backdoor Roth and never tell their CPA, so their CPA gets Form 1099-R and has no idea there was a non-deductible contribution made and reports the conversion as taxable.

Second, the CPA knows about the backdoor Roth maneuver but fills out the form wrong anyway. This happens a lot when you make last year’s contribution between January and April and then convert it this year, and you end up splitting the paperwork across two tax years.

So two things. First, tell your CPA about your backdoor Roth every single year in writing. Don’t assume they’ll figure it out. Second, actually look at Form 8606 yourself before it’s filed. You don’t need to understand every line. Just look at line 18, the taxable amount for your conversion. For a clean backdoor Roth, it should say $0 or a few dollars because of the interest, like we talked about earlier. If it says $7,500, something is definitely wrong.

And I’ll tell you a little personal story here. I do my own taxes every year with TurboTax, and getting TurboTax to fill out Form 8606 correctly is actually the hardest step in my whole backdoor Roth process every year. The contribution and conversion take me 10 minutes, maybe. TurboTax is the hard part.

What makes it so confusing is that the conversion goes in the income section where you enter Form 1099-R, and the contribution goes in the deductions and credits section where you tell it the contribution was non-deductible. Since you’re usually doing the income section first, you end up entering the second step before the first step. It’s kind of a mess.

Jim has a post with screenshots that walks you through it. It’s called “How to Report a Backdoor Roth on TurboTax.” I pull it up every year when I do my tax return. Again, when you’re done, look at Form 8606 that TurboTax generates and do the same check on line 18.

If you’re listening to this and realizing you got it wrong in a past year, don’t panic. It’s usually fixable. You can file an amended return with a correct Form 8606. You generally have three years to claim that refund. If you never filed a Form 8606 for a year and you made non-deductible contributions, you can usually file it late to establish your basis.

The real disaster is when nobody catches it and that after-tax basis gets lost forever. Jim has a post on this as well called “How to Fix Backdoor Roth IRA Screwups” that goes through all these fixes.

The moral of the story is: When in doubt, just use the backdoor loophole. There’s no penalty for using it if you don’t have to. Make sure to check for cream in your coffee before you start. Get your traditional IRA to zero by December 31, and make sure Form 8606 gets filled out correctly every year.

Thanks for listening, and happy backdoor Rothing.

DISCLAIMER

The White Coat Investor Podcast is for your entertainment and information only and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.