[Editor's Note: The following post from Physician on FIRE is a quick primer to help the beginning investor understand and prioritize the various investing accounts. We're trying to get more basic information on the site to help those who need it most.]
New visitors to Physician on FIRE may be excited at the prospects of financial independence and the possibility of reasonably early retirement, but overwhelmed when presented with a lot of technical talk about specific investment accounts and strategies.
This is totally understandable; we’re not taught the difference between a 401(k) and 457(b) in medical school or residency. If you’re self-employed like I once was, you may have opened a SEP-IRA (as I once did) when an individual 401(k) may have been a better idea.
Even the White Coat Investor wasn’t born with knowledge of expense ratios, the difference between short-term and long-term capital gains, or ordinary versus qualified dividends. Or was he?
No, Dr. Dahle has actually admitted to making more money mistakes than I did, and to be honest, I had only a rudimentary understanding of most of this stuff until about five years ago when I decided to really focus on my finances. For the first five to seven years of my career, I just shoveled money into accounts and made investments that were acceptable, but certainly not optimal.
Investing Basics for Physicians With Little Time or Experience
I’ve been asked who I’m writing for, and my answer is that I’m writing with someone a lot like me, or a younger version of me, in mind. This is the article for the version of me from a decade or so ago. The newly minted attending and newlywed, starting a family, serving on an ill-fated Board, and working way more than necessary.
That me didn’t have the time or energy to focus on personal finance. He knew enough to steer clear of whole life insurance salesman and to invest mostly in mutual funds. He had term life and disability insurance. He had the bases covered, but if he knew then what he knows now, he would have done some things differently.
If you’re like me back then, you’re not going to read hundreds of blog posts to tease out the information you’re looking for. The only books you have time to read are Little Golden Books. You want to be told what to do or have someone do it for you. It’s no wonder financial advisors are so popular.
I strongly recommend you read a grown-up book or two on personal finance, and if you are dedicated to becoming a do-it-yourself investor, I’ve got a great 20-step guide to doing just that. But if you’re ready to learn the basics, I can get you started down that path.
Employer-Based Retirement Plans
Nearly all employed attending physicians and some residents will have access to a workplace retirement plan or plans. For the employed physician, the most common names for those are 401(k) and 403(b). There could also be a 401(a) in there, as well, which is often used for matching or profit-sharing.
The 401(k) and 403(b) are similar in many ways; the latter is used by governmental institutions such as a University-affiliated academic medical center. These have the same contribution limits ($19,500 in 2020 or $26,000 if you’re 50 or over) and you will often have limited investment options.
Another account with the same investment limits that many physicians will have available is a 457(b). These come in two flavors: governmental and non-governmental. Perhaps surprisingly, governmental is actually the better tasting.
Why? A governmental 457(b) can be rolled over into an IRA, whereas a non-governmental 457(b) cannot. Also, a governmental 457(b) is backed by governmental solvency, whereas a non-governmental 457(b) is subject to the solvency of the employer.
These are technically deferred compensation plans, and the money’s not truly yours until you take withdrawals from the accounts. These 457(b) plans often have limited withdrawal options. I have always maxed mine out, but be sure to understand the limitations of your particular plan before choosing to do the same.
Finally, some physicians may have access to a non-qualified deferred compensation (NQDC) plan. These act in some ways like a traditional 457(b). The tax is deferred until the time you withdraw the money. There is some danger in that the money still belongs to the employer until it’s withdrawn by you.
A major difference is that there is no limit to how much money can be placed in the NQDC plan, allowing the employee to dial in the tax bracket of choice. A plan like this could be a real boon for an aspiring early retiree. I would not place millions into a plan like this if retirement were 20 years away, though. I don’t have that much faith in any single employer.
How do you choose the investment(s) to place in these accounts? Don’t fear the stock market. Understand that investing in a stock-based mutual fund means that you’re buying ownership in a bunch of actual companies that produce some form of product and earn real revenue. Many investors have become wealthy by investing in the stock market and those who sit on the sidelines for too long inevitably regret it.
Also, understand that the stock market’s value can drop a lot in a hurry, but as long as you don’t sell before it bounces back (which typically takes no more than a few years), the drop isn’t going to ruin you, despite how it affects your balance on paper.
With that in mind, assuming you’re young enough to be invested for decades, a stock-heavy portfolio is most likely to give you the best long-term returns. I’d recommend an overall proportion of at least 70% stocks, and 100% stock is not unreasonable if you’ve got nerves of steel. My investor policy statement, which is just a written plan for investing, calls for 10% bonds, with the rest in stock-based mutual funds and real estate funds.
Should you make traditional or Roth contributions to these plans? I could write an entire blog post on the factors that go into this decision (and I did). Most often, for the high-income professional, I recommend tax-deferred traditional contributions.
Self-employed and Partnership Retirement Plans
If you’re self-employed, you may have the option of contributing to either an individual 401(k) or a SEP IRA, each of which can accept up to $57,000 in contributions (or $63,500 in an individual 401(k) for those 50 and over).
I prefer opening an individual 401(k) (also commonly referred to as a “solo 401(k)”) rather than a SEP-IRA to keep open the possibility to fund a personal Roth account via the “Backdoor.” A Simple IRA is not a great choice as the amount you can invest is much lower ($57,000 versus $13,500) and again you’ll be subject to the pro-rata rule when attempting the backdoor Roth, just as you would with the SEP-IRA.
With the individual 401(k) or SEP IRA, You’ll be able to invest up to $57,000 or $63,500 in tax-deferred dollars, lowering your tax burden by about $15,000 to $25,000 or more depending on your overall household income and state in which you live.
The amount you can invest in an individual 401(k) is limited by your income. Employee contributions are limited to $19,500 and employer contributions are limited to 25% of your W-2 wages (when taxed as an S-corp). See the IRS documents for the precise details on this number. It can get complicated quickly.
If you make really big bucks and want to defer a lot more income, it may be worth exploring a defined benefit plan. These carry higher fees and must be invested in a less aggressive manner (100% stocks would not fly), but can potentially be an option if it makes sense for you or your group.
Additional Retirement Plans
If your health insurance plan is considered an HDHP (high deductible health plan), you will be able to invest in an HSA. This allows you to defer another $7,100 of income per family or $3,550 as an individual in 2020 as you max out an HSA.
The beauty of these accounts is that they are tax-deductible in the year of contribution, but also grow tax-free and are treated like Roth money when withdrawn to be used to cover eligible health care expenses. The only way you pay tax on these contributions is if you withdraw the money for non-healthcare purposes, which you’re allowed to do when you turn 65, but most of us will have health care expenses that meet or exceed the balance of the HSA eventually.
The vast majority of physician households will earn too much money to qualify for either a tax-deductible IRA contribution or a direct Roth IRA contribution. That leaves us with the “backdoor Roth” contribution of $6,000. If you’re married, your spouse can also contribute $6,000 to a spousal IRA regardless of whether he or she has earned income (as long as one spouse has earned income to justify the contributions).
The backdoor Roth steps are pretty simple, but if you’re new to the concept, please read both my step by step guide with Vanguard screenshots and the White Coat Investor’s 17 ways to mess it up. One of the big ones, which I alluded to above, is having money in any form of IRA in your name. You will pay tax on the second step of the backdoor Roth two-step if you do, and it’s best to rollover any IRA money into a 401(k) if that’s an option.
Other Investment Accounts
If you have filled every tax-advantaged bucket available to you and still have money left to invest, you’re clearly doing something right. This is one point where I see many readers wondering what to do next.
The good news is you have options. If you are debt-averse and have medium-to-high interest debt, this would be a good time to start chipping away at your debt.
Real estate is an avenue that many consider at this point, and there’s a myriad of ways in which to do so. I have only dabbled in crowdfunded real estate and own a Vanguard REIT mutual fund. There are entire sites devoted to real estate, a topic that is beyond the scope of this investment basics series, but I will touch on it in Part II. Look to Passive Income MD for more information on the topic.
This is also a good time to consider investing in stocks and bonds in ways that are not tax-advantaged, or at least not tax-free.
The most common way to do this is to buy more mutual funds or exchange-traded funds (ETFs). The two are similar; I have a slight preference for mutual funds, but I have nothing against ETFs.
With mutual funds, you can easily own partial shares (some brokerages do this with ETFs but many do not).
Mutual funds can also easily be exchanged for another fund without you missing a day or two in the market (a benefit when tax-loss harvesting). You don’t have to bother with a settlement fund when buying and selling mutual funds.
Mutual funds are purchased at the price of the next market closing time. ETFs, on the other hand, have prices that fluctuate throughout the day, and you’ll pay a small premium to the current asking price (the bid / ask spread) when you purchase them.
ETFs can offer lower expense ratios (Vanguard admiral funds with higher investment minimums have the same expense ratios as the ETFs) and are more portable between brokerages (can be transferred “in-kind” without being sold).
Another advantage of many non-Vanguard ETFs is that they’re slightly more tax-efficient when held in a “taxable account.” Vanguard’s mutual funds are structured in a way that makes them similarly tax-efficient.
You don’t have to choose one or the other. Many investors will have both, and it’s not worth losing any sleep over deciding which is best. Both accomplish the same thing — giving you ownership of a basket of stocks and/or bonds.
The Taxable Account
When I say “taxable account,” what is that, exactly? It’s just the account in which you buy assets with your post-tax money. These are also referred to as “non-qualified accounts” or “brokerage accounts.”
Don’t be confused by the various terms; they all mean the same thing. It’s just an account that holds mutual funds, ETFs, stocks, or what have you. It doesn’t have the specific tax advantages of some of the retirement accounts, so extra attention needs to be paid to the tax implications of taxable account investing.
However, the taxation on these accounts isn’t nearly as bad as one might assume based on the name. In fact, there are ways in which it can be as good as a Roth IRA or awfully close to it.
How can a taxable account act like a Roth IRA? You could own assets that pay no dividend (Warren Buffett’s Berkshire Hathaway stock being a prime example), let it grow tax-free during your working years, and make your withdrawals tax-free in retirement as long as you have taxable income of $80,000 or less based on 2020 tax code if married filing jointly (half that for singles).
If you’re more comfortable with index funds rather than individual stocks (the only individual stock I own is Berkshire Hathaway, by the way), expect to see a tax drag due to dividends in the range of 0.3% to 0.6% per year depending on how much you earn and where you live.
To put this in perspective, it’s common for many financial advisors to charge 1% or more per year for their services and many actively managed funds also have expense ratios that exceed 0.6%. The tax drag on these funds will be much higher though, as buying and selling by the fund manager creates additional taxable events. If you’re going to consider actively managed mutual funds (as opposed to passive index funds), please do so in a tax-advantaged account.
In terms of dollars, for every $100,000 you have in a taxable account invested in passive index funds, expect to pay $300 to $600 per year in taxes on the dividends (this is assuming 2% qualified dividends, which is about what you’ll currently get from a total stock market or S&P 500 fund). If someone is managing your investments for you with a 1% Assets Under Management (AUM) fee, you will be paying him or her $1,000 per year per $100,000 invested.
The taxation on the withdrawal of funds in a taxable account depends on several factors. If you pay any tax on the withdrawals, tax is only due on the capital gains. Capital gains are the difference between what you paid (the cost basis) and the price at which you sell. Capital gains on assets held less then a year are considered short term gains and are taxed at your marginal income tax rate.
Capital gains on assets held longer than a year, called long-term capital gains, are taxed favorably, and are based on taxable income. Typically in the 2020 tax year, you’ll owe state income tax plus:
- 0% with taxable income of $40,000 or less (filing single) or $80,000 (married filing jointly)
- 15% with taxable income of $80,001 to $200,000 (filing single) or $250,000 (married filing jointly)
- 18.8% with taxable income from $200,001 to $441,500 (filing single) or $250,001 to $496,600 (married filing jointly)
- 23.8% with taxable income of $441,501 or more (filing single) or $496,601 or more (married filing jointly)
I’ve highlighted ways to avoid capital gains taxes here. If you can’t avoid them, you can minimize them. Avoid actively managed funds in a taxable account (high turnover) and avoid high-dividend or high-yield (non-municipal bond funds) in a taxable account.
Some investors are enamored with dividends, but in my math-based opinion, the higher your dividend yield, the lower your after-tax returns. I’d rather create my own dividend by selling shares when I need the money, an argument I’ve made with further clarity in a previous post.
Which Accounts to Prioritize?
Ideally, a physician should be able to maximize every account available, but that isn’t always the case. Residents are often living paycheck to paycheck, and attendings are often focused on paying off debt and saving up for big purchases like a down payment on a home or buying into a practice.
First, be sure to invest enough in a 401(k) or 403(b) to get any matching contribution offered by an employer. Never say “no” to free money.
If you can afford to fully fund the 401(k), go ahead and fill it up to the $19,500 max or $26,000 if 50 or older. This is also a good time to max out the “triple-tax-free” HSA.
Next, I’d do the backdoor Roth. A couple can sneak $12,000 into an account that will grow tax-free and not be subject to tax upon withdrawal, regardless of the filer’s marginal tax bracket at the time of withdrawal.
Then, you’re left with a taxable account and perhaps a 457(b) or defined benefit plan. There are many variables to consider as the latter plans may have lousy investment options or high fees. There is also a benefit to having money readily available (in a taxable account) as opposed to tucked away in an account where the money’s less accessible.
In Part I, I’ve highlighted the various accounts in which an investor can place his or her hard-earned money. This post is continued in Part II in which I discuss choosing investments for those accounts, focusing on asset allocation, asset location (yes, those are two very different things), investment fees, and a little more information on real estate.
I also created a spreadsheet for you to help you keep track of all these accounts and investments. You know how I love spreadsheets.
Which of these accounts do you have available? Which do you fully fund to the max? Have you started a taxable account?
Minor correction: 26,000 is the annual 401K contribution over 50.
There is also a 401k Roth available for many employer plans.
Good catch. Didn’t update that when we republished it.
Thanks!
I try to update these annually, but sometimes an old number sneaks by me. I did get the update right in the closing section, at least!
Best,
-PoF
Another minor correction. The IRA limits are now $7000 (2019 and 2020), so back door limit is $14000 for a couple. There are a couple of places where these numbers are incorrect.
My bad, that’s the over-50 limits. I guess I’m giving away my age.
Six short years, and I’ll be making bigger contributions, too!
I have a question about TLH that I think I know the answer to, but am not quite sure. I am trying to learn, but completely novice. These posts always say you can’t hold the same fund anywhere else, and that you have to have it in a taxable account in order for you to partake in the glories of TLH. In the end, I ended up having quite a few more questions than I realized that have stewed around while digesting these posts.
Questions:
1. If you have only Roth IRA (and spousal), 401a, 403b, and 457b, you are ineligible for TLH, correct?
2. Assuming that you read the “1 billion portfolios better than yours” post and believed it, and are holding basically VTSAX, VFIAX only in each account (I think I may be holding a bit of each in all the “4” plans, and only VFIAX in the Roths…yes I will download and use the spreadsheet) — if you buy these funds in a taxable account in the future, do these holdings exclude you from TLH?
3. In order to get around that without changing up what I’m holding in my other accounts, I believe I’d have to buy something like VTIAX in the taxable account. This correct as well? It’s not a bad idea anyway I think, since I currently don’t hold any international stocks.
4. These posts seem to indicate you should NOT put your accounts on to automatically roll your dividends back into your accounts to help avoid wash sales. Am I understanding that right? So in essence, you have to periodically go back in and tell them where to go? How often should you do that, and do you just put them back into the fund that you’re holding anyway typically?
Thanks for your help!
Oh, and one last curiosity here. In your 2011 post you said you had a taxable account that was dwindling due to contributions to charities. Is there some particular benefit to having your charitable contributions coming out of a taxable account like that, or was it just something you liked to do?
You can hold it, you just can’t buy it elsewhere within 30 days of selling in taxable. To be fair, the law only specifies IRAs. So 401(k)s are in a bit of a gray area. But the truth is no one is looking and this sort of stuff probably happens all the time to people who don’t pay much attention to this.
1. The only account that you’ll get a benefit from tax loss harvesting is a taxable brokerage account. I’ve written detailed guides with screenshots for both Vanguard and Fidelity:
https://www.physicianonfire.com/tax-loss-harvesting-vanguard/
https://www.physicianonfire.com/tax-loss-harvesting-fidelity/
The rest of your questions are answered in the posts above, but briefly…
2. I don’t hold anything in tax-advantaged accounts that I have in taxable. The taxable account gets large cap / total US stock & international stock funds. The rest get REITs, bonds, mid cap and small cap funds.
3. Not a bad idea, and you’ll benefit from a foreign tax credit by holding VTIAX in taxable. I do!
4. Correct. With most funds (and all that I own with Vanguard), it’s 4 times per year. Late March, June, September, and November, I manually reinvest the dividends.
5. If you’re asking me (the author of this post), I’ve written extensively about the benefit of using donor advised funds. WCI and I had a pro / con piece on them that you can find on this site. I don’t want to put another link in the comment or I may land in the Spam comment box. But it should be easy to find.
Cheers!
-PoF
Dr Dahle what are your thoughts on EQRP. I dont think I saw anything in the WCI on this ( but it is a huge forum so sorry if I missed it).
Not quite sure I understand it all the way yet but it is a self directed 401k seems like and was just wondering if you have used any particular company for this type of self directed investing.
Why or Why not
Thank you
Here is my list of recommended self-directed 401(k) providers:
https://www.whitecoatinvestor.com/retirementaccounts/
eQRP sponsored the WCI conference and I think they would do a fine job with it too.
Love the book, and fantastic content! Getting my feet wet with managing my finances as a freshly minted attending. Having just completed fellowship (where I was a part-time employee at a VA), I had access to a TSP-account. I contributed to it as Roth-contributions at the time since I heard “it’s supposed to be better” but now realize I probably should have put it in as tax-deferred; whatever’s done is done. They also matched it but I see on my TSP-account that any matching is considered tax-deferred, not Roth.
With my new employer (large PE-owned group), I now have a 401k (no matching). Would my contributions to both TSP and my 401k for 2020 max out to $19,500 (assuming it would be just the tax-deferred portion of my TSP and my current 401k)? I definitely didn’t maximize my TSP contributions, but now that I’m earning significantly more, can I cap my 401k for this year so that I can hit the 19.5k for 2020 (even though the majority of it would come from my new job)? I’m guessing most 401k plans allow you to change the amount you contribute? Sorry in advance if this seems completely elementary — I looked through some of the other 401k posts and couldn’t find the answer to this — if I happen to over-contribute to my 401k (say if I didn’t taken into account what I contributed to the TSP) does that go back to my salary or is it lost in some way? Also, is a TSP an account in which I can temporarily place money in for a back-door Roth down the line?
Once maxing out on these I plan on hitting the loans hard the next year or two; great thing about covid is that the interest on federal loans isn’t being charged through 12/2020. I have a chance to reduce the total loan-amount these next few months and will refinance starting January 2021 to avoid capitalizing the interest to the new principal. Fortunately each refi company from whom I got quotes said in the quoting-process “FYI the government isn’t charging you interest at this time” which is why I’ll hold of on refinancing until they start charging interest again.
Thanks again for all the great content!
https://www.whitecoatinvestor.com/multiple-401k-rules/
$19.5K total employee contributions between the two. You probably can’t contribute to your new one this year anyway, so pay off those loans.
Backdoor Roths are done in an IRA, not an employer retirement plan like the TSP or a 401(k).
Don’t overcontribute. It’s a pain to fix the issue. But eventually yes, it “goes back to your salary” as taxable income.