Warning: We're getting into the weeds today. This is definitely NOT a back to basics post.
As discussed in a previous post, the Section 199A pass-thru business tax deduction has forced us to revamp a large part of our financial lives. This deduction, designed to keep pass-thru business owners (sole proprietorships, partnerships, and S Corps) competitive with C Corps after the Tax Cuts and Jobs Act of 2017 (TCJA), is our new largest deduction (it used to be retirement account contributions and charitable deductions). Rearranging our financial lives in order to maximize it is well worth our time and effort.
Roth vs Tax-Deferred 401(k) Contributions
For a long time, I have generally recommended that doctors in their peak earnings years preferentially use tax-deferred retirement accounts. This allows them to get a tax deduction now, enjoy tax-protected and asset-protected growth, and most importantly, score some extra money from the arbitrage available between their high marginal tax rate now and their usually lower tax rates later. However, I have also been careful to point out that there are exceptions to this rule, one of which is being a super-saver.
Now there is no dictionary definition of super-saver, but the idea behind it is if you are going to be well into the top tax bracket in retirement, you may want to rethink the traditional tax-deferred advice and instead make tax-free (Roth) contributions and maybe even do some Roth conversions, even at the top tax rate.
There are a number of advantages for the very wealthy to having a larger portion of their portfolio in Roth accounts:
- No required minimum distributions forcing you to move money from a tax-protected account to a taxable account
- More of your portfolio is in tax-protected accounts and thus grows faster
- A larger percentage of your heirs' inheritance can be stretched
- More ability to lower your tax bill in retirement
- A good hedge against rising tax rates
- Less likelihood of having an estate tax problem
- Better asset protection since more of the portfolio is in a retirement account instead of a taxable account
Despite those advantages, it's still the right move for most docs to do tax-deferred contributions because of that arbitrage between tax rates. However, over the last few years as The White Coat Investor has seen unexpected financial success, more and more I have found myself looking at our tax-deferred contributions and wondering if we were doing the right thing.
- We are certainly super-savers. Despite the kitchen renovation that has exploded into tearing off multiple walls of our house this Fall (more on that in future posts), generally living on 5-10% of your gross income has an interesting side effect of causing your portfolio to grow very rapidly despite large charitable contributions.
- It is now quite possible that we will have an estate tax problem I never expected, especially if the estate tax exemption is lowered at some point in the future. While I fully expect to cure our estate tax problem by simply increasing gifting and charitable contributions, having more money in Roth accounts instead of tax-deferred + taxable accounts does reduce the size of our estate and provide more options.
All of that already had me thinking about changing over to Roth 401(k) contributions for the employee portion of our 401(k)s, but when the TCJA was passed, it was the final nail in the coffin. Not only was it quite likely that we were better off with Roth contributions, but now we weren't even getting a 37% deduction on our solo 401(k) employer contributions since they are subtracted from the Ordinary Business Income on which the 199A deduction is calculated. We were only getting a 37% * 80% = 29.6% deduction. It seems really silly to take a 29.6% deduction now knowing we would be paying at least 32% at withdrawal on that money. So we have decided to stop making those contributions starting in 2019.
The Mega Backdoor Roth IRA
So are we just going to invest in taxable? No way. Tax-protected growth and asset protection is just too valuable. Instead of making “employer contributions” to our solo 401(k), we're going to make employee after-tax contributions. We get no deduction for these contributions, and, if the 401(k) allows it, we can either do an instant Roth conversion of those funds inside the 401(k) or transfer the money to an outside Roth IRA, tax-free. This process (after-tax contributions + instant Roth conversion) is known as a Mega-Backdoor Roth IRA. If you thought a Backdoor Roth IRA was awesome, wait until you get a load of just how much money you contribute to a Roth IRA each year through a Mega Backdoor Roth IRA.
- $32K tax-deferred employer (self-match) contribution into my partnership 401(k)/PSP (I no longer make enough clinically to max it out)
- $30K tax-deferred contribution into partnership Cash Balance/Defined Benefit Plan
- $19K tax-deferred employee contribution into my WCI 401(k)
- $37K tax-deferred employer contribution into my WCI 401(k)
- $19K tax-deferred employee contribution into Katie's WCI 401(k)
- $37K tax-deferred employer contribution into Katie's WCI 401(k)
- $7K HSA contribution
- $6K into my Backdoor Roth IRA
- $6K into Katie's Backdoor Roth IRA
- Total tax-deferred contributions: $144K
- Total HSA contributions: $7K
- Total tax-free contributions: $12K
- Total tax-protected contributions: $163K
- Total tax-protected contributions adjusted for taxes (45.2% marginal rate): $98K
What we are doing now:
- $19K tax-deferred employee contribution into my partnership 401(k)/PSP (New plan this year allows employee contributions)
- $32K tax-deferred employer contribution into my partnership 401(k)/PSP
- $17.5K tax-deferred employee contribution into my partnership Cash Balance/Defined Benefit Plan (New plan this year affects my contribution)
- $56K after-tax contribution into my WCI 401(k)/Mega Backdoor Roth IRA
- $19K tax-deferred contribution into Katie's WCI 401(k)
- $37K after-tax contribution into Katie's WCI 401(k)/Mega Backdoor Roth IRA
- $6K into my Backdoor Roth IRA
- $6K into Katie's Backdoor Roth IRA
- Total tax-deferred contributions: $87.5K
- Total HSA contributions: $7K
- Total tax-free contributions: $105K
- Total tax-protected contributions: $199.5K
- Total tax-protected contributions adjusted for taxes (45.2% marginal rate): $160K
I'm ignoring the savings we do for our kids (Roth IRAs, UGMAs, 529s) and our taxable account contributions (actually the majority of our savings these days) here. But just looking at the tax-protected accounts, we've gone from sheltering $163K to sheltering $199.5K. If you actually adjust those tax-deferred amounts for our current marginal tax rate of 45.2%, we've gone from $98K to $160K, a 63% increase. But wait, there's more.
Katie's Pay Cut
By going to after-tax contributions for Katie, Katie no longer needs to make as much money as she used to in order to max out the 401(k). So I gave myself a raise and cut her pay dramatically. Yup, our family is voluntarily contributing to the gender pay disparity. But there is a method to our madness. Think about it. The White Coat Investor, LLC files taxes as an S Corp.
How much salary does she need to be paid in order to be able to contribute $56K to a 401(k) as employee tax-deferred and employee after-tax contributions? Well, $56K plus enough to cover her payroll taxes. How much did she need to be paid in order to contribute $56K to a 401(k) as employee tax-deferred and employer tax-deferred contributions? Well, $37K/20% = $185K + enough to cover her payroll taxes. So she can take a 75% pay cut and still max out that account.
“What? I still don't get it? Why do you want to pay her less?”
Because, my young padawan, every dollar she gets paid as salary costs us 15.2% in payroll taxes. If we pay her $185K, we pay 12.4%*132,900 = $16,479.60 in Social Security taxes and 2.9%*185,000 = $5,365 in Medicare taxes. So we want to pay her as little as possible while still being able to max out that account and justify the salary to the IRS. (Since her job description is so flexible and those types of jobs typically don't pay very much, that's pretty easy to do. How many of you are paying full-time employees less than Katie is paid part-time?)
The issue, of course, is that the 199A deduction, at least at our income level, is partially based on the salaries our company pays. So if we pay her less money, our 199A deduction shrinks proportionally. That's no good. So what's the solution? We just pay me more. So she took a big pay cut and I got a big raise. Yay me! Overall, the total salary paid by the company will be similar so the 199A deduction will be similar.
So why did I get the raise instead of her? Are we sexist? Nope. Remember I have that other job down at the hospital. Even if I were only making $56K with WCI, I would still pay the maximum Social Security tax each year. That's not the case for Katie whose only job is with WCI. The bottom line is that we're saving Social Security taxes on the difference between the 2019 Social Security wage base ($132,900) and the salary we pay Katie (about $64,000). ($132,900-$64,00) * 12.4% = $8,544. There is no Medicare tax savings of course, since we're getting the same total salary as a couple and it's all subject to Medicare. And half of that SS tax we would have paid for Katie is deductible, so it's really only $6,613 we're saving but hey, $6,613 more than covers a luxurious six-day heli-skiing vacation. It's real money.
Other Retirement Account Changes
#1 Cash Balance Plan Contributions
The careful reader will notice a few other changes in our retirement account line-up for 2019. My cash balance plan contribution went down. I'm pretty annoyed with it, but we changed plans this year. The new one admittedly has a better design, but its structure has a nasty side effect for young super-savers. Whereas the old plan let everyone contribute up to $30K, in the new plan the contribution limits are determined by age.
- <35 $5K
- 36-40 $7.5K
- 41-45 $17.5K
- 46-50 $40K
- 51-55 $80K
- 56+ $120K
I turn 44 in 2019, so it'll still be a couple of years before this change works out better for me.
#2 Partnership 401(k) over WCI 401(k)
You will notice I am now using my $19K employee contribution at the partnership 401(k) instead of the WCI 401(k). It made a lot of sense to use it in the WCI 401(k) when I was making more money practicing medicine than running WCI. Now the situation is reversed. I don't actually make enough clinically to max out the partnership 401(k) even if I use the employee contribution there, but I can contribute more overall if I use the employee contribution there instead of our individual 401(k). Our partnership's new 401(k)/PSP actually allows employee contributions now, so I will just do that.
#3 Tax-Deferred Partnership 401(k) Contributions
You will also notice that I am doing tax-deferred contributions to my partnership 401(k). Remember that income is not eligible for the 199A deduction because medicine is a specified service business and our taxable income is well over the $315-415K limit. So that deduction is still worth 37% (federal) to us rather than 29.6% like it would be in the WCI 401(k). Maybe we'll be in the 37% bracket in retirement, maybe we won't, but we'll certainly be in a bracket higher than 29.6%. At least for 2019, we'll continue to do tax-deferred contributions if they are available to us. We're only talking about $19K here anyway, the rest (both the profit-sharing portion and the cash balance contribution) have to be tax-deferred.
You will notice Katie's employee contribution is also tax-deferred. That income is deferred from her salary, and so doesn't count toward Ordinary Business Income for the 199A deduction, so it still provides us a 37% (federal) deduction. We'll continue to use that for 2019 for the same reasoning outlined above.
Additional Complexity Using a Mega Backdoor Roth IRA
It's pretty obvious to see the advantages of these changes for us. We're able to protect a ton more money after-tax, really maximize the value of our retirement accounts, and even lower our payroll taxes (pretty much a free lunch in our case). The big downside, unfortunately, is additional complexity. As if our financial lives weren't complex enough already.
For years we've had the WCI 401(k) at Vanguard. Vanguard's individual 401(k) has its issues. The customer service isn't awesome, they don't allow IRA rollovers, and until recently, they didn't let you buy the lower cost admiral shares funds. But it was good enough for our purposes for a long time. The big problem now, however, was that the Vanguard individual 401(k), at least the off-the-shelf version, doesn't allow after-tax employee contributions or in-service conversions/rollovers, the two features necessary to do a Mega Backdoor Roth IRA. As I looked around at the other off-the-shelf individual 401(k)s, (Fidelity, Schwab, eTrade, TD Ameritrade) I found that none of them really allowed this. I would need to go to a customized plan and I was going to need professional help to do so. And professional help is rarely free and often quite expensive.
A Customized Mega Backdoor Roth IRA Plan with Mysolo401k.net
After shopping around a bit, I settled on mysolo401k.net. The fees were low and their website actually discussed the Mega Backdoor Roth IRA in detail. I thought that was a good sign. Within minutes I had the head of the company, Mark Nolan JD, on the phone answering my questions. It was such a good experience I thought they would make a great new affiliate partner for The White Coat Investor. It's always easier to plug companies that I actually use. At first, they agreed to not only pay me an affiliate fee for new business I brought them, but also discount their fees from $795 up-front plus $125/year to $700 up-front plus $125/year. Win-win-win. Shortly after I did a podcast mentioning them, they backed out of the agreement and decided to just lower their fees to $500 up-front and $125/year. Lame for me, but it's still a win for you and for them. Maybe I can talk them into sponsoring a podcast or something down the road.
Another option for you could be Rocket Dollar ($100 off with code WHITECOATINVESTOR) or My 401K ($50 bonus for going through my link) who I do have affiliate deals with. They administer self-directed Solo 401(k)s and IRAs. Because it's self-directed, you can buy real estate properties on your own or leverage RE crowdfunding platforms like Equity Multiple, RealtyMogul, Fundrise, Roofstock, CrowdStreet, etc.
Choosing a Fund Custodian
There was an incredible amount of paperwork involved. Pages and pages and pages and pages and pages. You see, mysolo401k.net isn't going to function as the custodian of the funds. They had to go to either Schwab or Fidelity. I already had accounts at both (partnership 401(k) at Schwab and HSA/Credit Cards at Fidelity), but decided to go Fidelity because I thought I might just use the 0% ER index funds there. Of course, when there are two companies involved and 4 new accounts (a tax-deferred and an after-tax for both of us and we didn't bother with the Roth accounts since we figured we'd just do rollovers to our Vanguard Roth IRAs) a few minor things were screwed up and had to be redone. But I was impressed with how much better the service was from both companies than what I've come to expect from Vanguard.
Once I got our 401(k) money over to Fidelity, I was disappointed to discover that I couldn't buy the 0% ER Index Funds after all. No biggie, I just paid a $4.95 commission and bought Vanguard ETFs. This isn't my first rodeo, but I was surprised that Fidelity didn't want my business in that respect.
Another great feature of having a 401(k) plan actually designed by someone who knows what the heck they are doing is that this is a self-directed “checkbook” 401(k). That means I can invest it in anything I want (except Fidelity 0% ER index funds apparently). I suspect I will eventually take advantage of this feature to move some of my very tax-inefficient debt real estate/hard money loan funds out of taxable and into tax-protected.
This post is long enough, let's wrap it up. Here are the take-home points:
- If you qualify for the 199A deduction, you might want to consider Roth and Mega Backdoor Roth 401(k) contributions.
- If you want to do a Mega Backdoor Roth IRA in your i401(k), you're going to need a customized plan.
- After-tax 401(k) contributions allow you to max out your 401(k) on much less income.
- Maximizing your use of retirement accounts helps you reach your financial goals faster and protect assets from creditors, but often introduces a lot of complexity to your financial life.
What do you think? Have you done a Mega Backdoor Roth IRA before? Did you make any changes to your retirement plans in response to the new 199A deduction? Comment below!