By Dr. James M. Dahle, WCI Founder
I get lots of questions from readers about whether they should take advantage of their Roth 401(k) (or 403(b)) option to save for retirement. They're usually looking for an easy, straightforward answer. Unfortunately, it isn't that easy.
I only have one rule of thumb, and that's that residents (and military docs) should make Roth contributions and attendings should generally make traditional, tax-advantaged contributions. But there are plenty of exceptions even to that rule. Others have touched on this question before, notably The Finance Buff, in perhaps his best ever column, who made The Case Against the Roth 401(k) and the Bogleheads in their Wiki Page on Traditional vs. Roth.
Here, I'll try to outline the considerations high-income professionals like doctors ought to consider in the Roth or Traditional 401(k) decision.
General Guidelines for Evaluating Roth or Traditional 401(k) Contributions:
- If you’re a resident or military member, maximize Roth contributions.
- If you’re in a low-income year for any reason, such as a sabbatical, use Roth contributions.
- Use a personal and spousal Backdoor Roth IRA each year. That way, even if you choose to make all tax-deferred 401(k) contributions, you’re still getting some money into Roth accounts.
- If you can pay the tax with money in a taxable account and expect to work part-time or retire in your 50s, then consider making Roth conversions during those years before receiving Social Security or a pension to “fill up the lower brackets.”
- If you save and invest more than 20% of your gross income, lean a little more toward Roth investments. If you save and invest less, use tax-deferred accounts preferentially.
Tax Diversification Is Useful
Remember that in retirement you can minimize your effective tax rate by withdrawing some of your income from tax-deferred (traditional 401(k)), some from taxable accounts at preferential long-term capital gains rates, and some from tax-free (primarily Roth, but also borrowing against cash value life insurance or other assets) accounts. No one knows exactly what percentage of a portfolio a retiree will ideally have in Roth accounts on the eve of their retirement, but most experts agree that you ideally want some of both.
Don't Forget the Backdoor Roth IRA
In 2022, a married couple can contribute $6,000 ($7,000 if over 50) each to a Roth IRA each year—usually via the back door for most high-income professionals since they make too much to contribute directly. If you are limited to a $20,500 contribution to your 401(k) in 2022, then making the 401(k) tax-deferred and also maxing out Backdoor Roth IRAs should provide you the tax diversification that you're looking for.
Marginal Tax Rate at Contribution vs. Marginal Tax Rate at Withdrawal
The most important consideration in the Roth vs Traditional 401(k) debate is your tax rate and how it will change when you retire. Most importantly, remember that your contributions are made at your MARGINAL tax rate (i.e. the rate at which the last dollar you made is taxed), but withdrawals may be taken at much lower rates. For example, if your only taxable income in retirement was from 401(k) withdrawals in 2021 and you were a married couple that took the standard deduction, the taxes on those withdrawals were 0% for the first $25,100 that was withdrawn, 10% for the next $19,900, 15% for the next $61,150, and 22% for the next $91,700.
Obviously, if you are saving taxes at 35% when you contribute money and paying taxes at 35% when you withdraw money, then it doesn't matter which account you use. But thanks to the fact you are likely to have a lower marginal rate in retirement and the fact that you contribute at your marginal rate and withdraw at your effective tax rate, most doctors in their peak earning years are going to be better off deferring taxes whenever possible.
But there may be some other considerations.
More information here:
- 2022 Tax Brackets: How They Actually Work
- Roth vs. Tax-Deferred: The Critical Concept of Filling the Tax Brackets
Political/Economic Considerations
Many people hold strong views about future political and economic possibilities that influence their choice of Roth or traditional 401(k). For example, if you believe that future tax rates are going to be much higher than current tax rates, you might be more likely to make Roth contributions and pay your tax now at what you believe will be a lower rate. If rates go up severely, your marginal rate now might even be lower than your effective tax rate later.
Many investors also worry that the government will change “the deal” with Roth accounts and tax them in some way despite promising via the current tax code not to do so. If you're worried about this, you may prefer to get your tax break as soon as possible with a tax-deferred contribution. Some people take their Social Security payments as soon as possible due to similar concerns, despite the fact that under current law it often doesn't make sense mathematically.
Other Retirement Income
If you expect a relatively high amount of taxable income in retirement besides 401(k)/IRA withdrawals, you may be more likely to want to pre-pay your taxes by making Roth contributions. The most common type of income is Social Security. For most retired professionals, 85% of their Social Security income will be taxable. Although individual circumstances vary, most will want to delay their Social Security to age 70, so this effect won't be seen in earlier retirement years. Other retirement income may include a spouse who continues to work, rental income from investment properties, income from taxable investing accounts, and pensions. The more of it you have, the higher the rate at which those 401(k) withdrawals will be taxed.
Estate Planning Considerations
There is no doubt that if you don't plan on spending the money in your retirement accounts and plan to give it to your heirs instead, Roth contributions are very useful. The main reason is that Roth IRAs (although interestingly, not Roth 401(k)s) don't have Required Minimum Distributions (RMDs) starting at age 72. If you take RMDs out of an account from age 72 until your death at age 90, the account is going to be a lot smaller than if you didn't have to take those. Even if the money is still given to the heir, it will be a smaller amount without the tax-deferred growth available in the retirement account.
Once the IRA or Roth IRA is inherited (Stretch IRA), RMDs start based on the age of the heir. But if the heir is very young, the account is likely to continue to grow if only the RMDs are withdrawn. A tax-free Stretch Roth IRA has the potential to grow to an even larger sum of completely tax-free money (since it can grow tax-free for an additional 10 years after death before withdrawals are made). Your heirs will, of course, prefer that you pay the taxes instead of them. If your heirs don't make much money, though, it's possible that they may have a lower tax rate than you. That means the overall tax rate paid by the family will be lower if the heirs pay the taxes.
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If you would prefer to give your retirement account money to charities, you're probably better off with a tax-deferred account, since neither you nor the charity will have to pay taxes on that money at all. Of course, you don't get the usual tax deduction for the contribution if you use your never-taxed IRA money to make the donation.
If you are above the estate tax exemption limits, Roth money counts exactly the same as tax-deferred money when it comes to calculating estate taxes, but it is actually more after-income-tax money.
Future Conversions
One of the best arguments against pre-paying your taxes by making Roth 401(k) contributions is that you don't know what the future holds. You can do Roth conversions in later years when your income may be lower. This might be due to cutting back on hours, getting paid less, taking unpaid maternity/paternity leave, doing a sabbatical, or early retirement years prior to taking Social Security. It's much better to do a Roth conversion at 10%-22% than to make Roth contributions paying tax at 28% or more.
Ability to Contribute More
If you are already maxing out your available retirement accounts, you may lean a little more toward making Roth contributions so you can get more money (on an after-tax basis) into retirement accounts where it will enjoy preferential tax and asset protection treatment. For example, if your marginal tax rate is 37%, putting $20,500 into a traditional 401(k) in 2022 is the equivalent of $12,915 after-tax. If you instead put it into a Roth 401(k), the amount of after-tax money in the retirement account is the full $20,500. Keep in mind that Roth contributions are limited to $20,500 even if your profit-sharing plan otherwise allows you to contribute $61,000 (so you could do $20,500 into the Roth 401(k) and $40,500 into the traditional 401(k)). There is no such thing as a Roth SEP IRA, so if you're using a SEP as your retirement account, Roth contributions aren't even an option.
State Taxes
All of the discussion above has focused on the federal tax laws. State tax laws also affect the Roth or traditional 401(k) decision. Perhaps the most common is when you plan to retire in a different state than the one you spent your working years in. If you plan to move to a state without an income tax in retirement, tax-deferred contributions now will be that much better. If you plan to return to New York or California from your job in Florida or Nevada, however, you may wish to pay those taxes up front.
Phaseouts
The tax code is complex and not always logical or fair. If your taxable income is in the range of a phaseout, choosing to make Roth contributions over traditional contributions may cost you a lot more than you think. Most of these phaseouts occur in the $25,000-$250,000 taxable income range which can catch a lot of physicians. Be sure to run the numbers both ways prior to making Roth 401(k) contributions. It might not be worth it if you lose a valuable deduction due to a phaseout. The 199A deduction can cause people to want to do all kinds of interesting things with their retirement accounts.
Going for PSLF
If you are going for PSLF, you are likely trying to keep your IDR payments low to maximize the amount forgiven. A great way to lower your taxable income is to make tax-deferred account contributions.
More information here:
Roth vs. Traditional When Going for PSLF
College Aid
The expected family contribution that is an important factor in determining what grants and loans your college student is eligible for also could have a minor effect on this decision. The calculation uses your after-tax income PLUS any retirement contributions. So, the same amount of after-tax money contributed to a Roth 401(k) instead of a traditional 401(k) lowers your expected family contribution. Also, remember that any Roth conversions done during the college years will also increase your expected family contribution. Let's be honest, though, the children of most physicians won't qualify for any financial aid anyway.
Very High-Income Professionals
If you have a very high income, which I usually define as $500,000-$2 million, you may prefer to make Roth contributions. It allows you to provide asset protection and tax-advantaged growth to more money on an after-tax basis, and if most of your income is going to be taxed at the highest tax rate in retirement, there is little advantage to withdrawing at your effective tax rate (since it is nearly the same as your marginal rate). Along the same lines, you may wish to do Roth conversions of your tax-deferred accounts.
Super Savers
Those who save a lot of money may also want to preferentially use Roth accounts. Basically, because they save so much, they'll accumulate so much wealth that they'll actually be in a higher bracket in retirement than even most of their peak earnings years. This is one reason Katie and I are doing Roth contributions in our 401(k)s these days.
More information here:
Supersavers and the Roth vs. Traditional 401(k) Dilemma
What do you think? Do you use a Roth 401(k)/403(b)? Why or why not? Any other factors that should be considered in this decision? Comment below!
A lot of this depends also on your expected income in retirement. Ie: Very high income professionals wont necessarily need more $$ in retirement. Some may plan on early retirement for instance
This seems like a shift in your thinking. Nothing wrong with that. When the facts change, we should change our minds (this was probably never said by Keynes) http://blogs.wsj.com/marketbeat/2011/02/11/keynes-he-didnt-say-half-of-what-he-said-or-did-he/
I’m not sure what the shift is. Perhaps you could clarify.
I think there is no clear cut answer for high income generators and high savors. There are advantages for each
– Many of such people think of passing money to their Heirs for which Roth is handy.
– Also while doing calculations, AMT should be kept in mind. I personally get hit by AMT hence try contributing everything pretax for now.
– The question that puzzles me the most is what to do if I have the ability to max my retirement accounts and do back door roth and then should I make more Roth contributions because effectively i m putting more dollars into retirement while doing roth and likely will not be using all the money for my retirement. For now I am doing pretax 17500 in each 403 b and 457 and doing 51000 in profit sharing ( along with employer contribution and doing backdoor roth IRA. I still have money saved in Taxable which makes me wonder if I shd do roth instead,
You’d have to run the numbers with reasonable assumptions to know for sure.
I live in a state that does’t have state tax, so that point hit home for me pretty hard. We might just retire in a state that does.
I’m aiming for about 33% Traditional / 66% Roth. I don’t have math that supports that ratio, but it feels right to me. I don’t want to be filling my lower brackets with Roth money, but maybe Social Security will take care of those brackets for me to where I won’t need Traditional money. This is where I get a bit stuck, as I don’t have a complete grasp yet on all the ins and outs of how to retire “right”.
You may find it tricky to keep the Roth that high since most retirement space is generally tax deferred. For example, I have around $81K in tax-protected space per year, and at a maximum I can only do $28.5K in Roth. Many people don’t have a Roth option in their 401K at all.
Very good point. I do have the option for Roth 401(K). I plan on maxing my 401(k) starting in 2014. I was considering doing Teaditional to ensure I have enough salary left to use, but maybe if I’m going to be maxing, I should just make the Roth max work. It almost feels like leaving money on the table if you max but not in the Roth, doesn’t it?
How are you able to contribute $28.5K to a Roth? I thought the max is $5500 (x2 if you contribute for your spouse).
I believe that amount comes from:
His Roth IRA: $5,500
Her Roth IRA: $5,500
His Roth 401(k): $17,500
Perhaps I misunderstood his post. I thought he meant to say his tax-protected space is $81K in addition to $28.5 Roth. If he contributes $17.5K to a Roth 401K, then he can’t contribute to a traditional 401K (pre-tax). Which means that his tax-protected space would shrink to $63.5K.
James- Can you break down your $81k of tax protected space per year? Having a hard time adding it all up (so far 51k retirement, roth IRA 11k, HSA 6500 – what makes up the rest?)
Defined benefit plan $15K. $52K this year for 401K/Profit-sharing plan. What’s that, $84,500?
Got it. Yep, 84.5k. Do you / are you able to do both backdoor roth IRA personal / spousal, and designate full 17.5k of 52k in 401(k) as Roth?
I could do $17.5K as Roth, but I don’t. Just the backdoor Roths, plus a small conversion a few years ago as I left the military, and the Roths built up from intern year on.
I used to think that the Roth was appropriate for all investors up to age 50 unless they planned to retire in a much lower income tax state (TX, WY, WA, NV, NH, TN, FL, et al). However, given that the federal debt obligation plus unfunded liabilities translates to about $20,000 per year for each taxpayer in America (that’s a 40% tax rate vs. median income), income tax increases are inevitable and each investor who has access to a Roth, should maximize at least until age 60 and probably until they retire. It is a vital method of combating potential tax increases!
Hi Chris! Nice to see you here. I think your data on the federal debt obligation is way too low. The most recent figure I heard was $130K per taxpayer! I agree that contributing to Roth accounts, whether via a Roth 401K or through backdoor Roths, and/or doing Roth conversions between early retirement and taking Social Security, are great ways to ensure tax diversification in retirement. That tax diversification will be worthwhile whether rates go up or not!
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Hey there,
Isn’t there an earning limit for Roth IRA?
If you make over 130K, you can’t add to your roth IRA?
thanks!
There is no income limit for Roth 401K contributions, only for Roth IRA contributions. But you can get around that using a “Backdoor Roth IRA.” Details found here:
https://www.whitecoatinvestor.com/backdoor-roth-ira-tutorial/
So if I’m about to start med school next year and have some income I’d like to put into an IRA, what should I do now?
I’d like to think after residency I’ll be making over 130K.
Is there some sort of guide for this? Not very hip to financial lingo.
Thanks
Seems like you should qualify for a Roth IRA right now. Until April 15, 2014, you can make 2013 contributions if you’d like.
Ah ok that’s what I was thinking. Keep contributing to roth IRA until I hit the 130K salary cap? And then once I’m over 130K, do a traditional IRA?
As a general rule, residents should use a Roth IRA instead of a traditional one. You’ll need to do some reading and develop an investing plan in order to figure out what investment to put into the Roth IRA. Keep reading and you’ll figure it out.
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Thank you for a great summary. I don’t understand one line, “Keep in mind that Roth contributions are limited to $17,500 even if your profit-sharing plan otherwise allows you to contribute $51,000 (so you could do $17,500 into the Roth 401K and $33,500 into the traditional 401K.)”
Can I as a resident contribute to both a traditional 401k and a roth 401k. If so, what is the maximum? Can I contribute 17.5k to both?
Thanks!
You can contribute $17.5K total to a 401(k), including both Roth and traditional in any combination. Your employer may contribute another $34,500 (up to $52K, the 2014 limit). This is all tax-deferred money. Hope that helps.
What if your stay-at-home spouse opened a 1099 contractor business earning 17.5k per year? Could she contribute 34k (employer match) each year?
She is the employer. If the business only earned $17.5K, she could only contribute $17.5K. If her business earned say, $57.5K, she could contribute the $17.5K employee portion plus almost $10K in employer portion.
Thank you for this post. Although I’m a new attorney, and not a doctor, I’ve found that almost all of what you write is applicable to me, and professionals in general.
Your article makes a pretty strong case for traditional 401Ks, with a minority of retirement assets in a Roth 401K. However, for us lawyer folks who had nothing like residency (or a period working for the military) with a comparatively low salary, should we still contribute to a Roth when we are just starting off? Our salary is lower than it will be in later years, but still high enough that it might be analogous to “attending” levels. I currently make $160K, and the lockstep salary/bonus increases in BigLaw slowly take you to around $350K in the next eight years. At that point you either make partner and enter very high income territory, or you don’t and you hope to gracefully land in-house somewhere around $200K.
I also read the other articles that you linked from this one, but I still can’t seem to figure out what to do given my financial situation. I am sort of leaning towards maxing out Roth contributions for a couple years, as these will hopefully be the lowest-earning years of my career. But $160K is still not a “low” salary, so I can’t tell if that’s a terrible idea. Also, no state tax where I live, no AMT considerations, no applicable phaseouts. Any thoughts?
It’s true. It’s aimed at docs, but it applies to most high income professionals and many low income folks as well.
It’s hard for me to say for sure. The good news is it isn’t like there’s a bad option here. Saving money in a Roth is good. Saving money in a tax-deferred account is also good. What you’re trying to avoid doing is deferring money at 28% now, and paying 33% on it when you pull the money out. Or paying tax at 28% now, when you could have pulled it out in 30 years at 15%. It’s not like you can’t do a backdoor Roth on the side and get some Roth money going now, but it’s nice to front load those Roth accounts a bit. How’s that for a non answer? When the answer isn’t obvious, it probably doesn’t matter much. It’s going to be obvious later in your career at peak earnings. It’s pretty obvious for most residents. You’re somewhere in between. Probably doesn’t matter much.
Wouldn’t contributing a majority of funds pre-tax to a traditional 401k instead of a Roth still make sense here, especially if he ends up in-house somewhere making $200k?
The logic I’m following is what you laid out in another post – specifically that he’ll be contributing marginal dollars now (at 28% to 33%, and maybe more) vs. withdrawing dollars in retirement that would be subject to his average tax rate, which is much more likely to be less than his marginal rate now.
I guess this might not hold if he ends up a partner making crazy-high income, but otherwise, one in this situation should mostly contribute to the pre-tax traditional 401k, no?
Mostly, yes. It is a good general rule that in your peak earnings years you should favor tax-deferred accounts. But it’s complicated and there are a lot of factors in play. In his case, the fact that he has minimal if any Roth space may make it worth it to him to possibly end up paying more taxes overall.
Why are the comments on this page all italicized? Extremely hard to read!
That’s a good question. I’ll look at the code and see if I can fix it.
Fixed. Stray italics code.
Ahhh. Refreshing.
About the Roth 401k though: Do you treat both spouse’s portfolio as one when filing jointly? ie: Don’t use the Roth 401k on the non-physician spouse either because taxed the same?
Exactly. Look at it all together, unless you’re planning a divorce soon.
James,
I’ll be a new attending next year with a salary of 250K base. If things work out as projected, my salary should be around 700K within 3-4 years. My uncertainty lies in where to put my money. If I understand correctly, it seems that my marginal tax rate in retirement would certainly be less than my marginal tax rate during the peak of my career (i don’t plan on replacing $400K of income annually in retirement- so unless I generate other sources of income such as real estate, my primary means of income would be retirement accounts). With this understanding, it seems that a traditional account would provide more yield than a Roth account due to a marginal tax rate which is significantly less in retirement. After maxing out a 401K, should I then max out an traditional or Roth IRA? My instinct is to contribute to the traditional account.
My other question, is how does one maintain both traditional and backdoor Roth accounts with the pro-rata rule. My understanding is that when converting to a Roth IRA, an investor can have no other IRA accounts. So does this mean that once you start building traditional accounts that you don’t wish to convert to Roth accounts, you can no longer grow you Roth accounts with additional contribution?
1) You should max out a Roth IRA. You can’t deduct a traditional IRA at your income levels if you also have a 401(k). But you can do a backdoor Roth. So you should.
2) You don’t maintain both. You have to get rid of the traditional IRA. It doesn’t sound like you have one yet, so that should be relatively easy for you to avoid getting one.
3) There are some docs who have large traditional IRAs (cost prohibitive to convert the whole thing) and no 401(k) to roll them into who do not do backdoor Roth IRAs for this reason. It doesn’t sound like this applies to you.
With respect to the income limits, may I suggest updating the “Taxation of Retirement Accounts” page to reflect the limitations for high-income folks?
I’m not sure what you would like to see updated. What do you see as different for high income folks on this page?
https://www.whitecoatinvestor.com/retirement-accounts/retirement-account-taxation/
So for instance, a higher income person may contribute to a traditional IRA but it is not deductible if you have an existing retirement plan (as you’ve mentioned to JS in your reply above). This is not true for 401K, 403B, etc. Also higher income person cannot contribute directly to a Roth IRA (only via a conversion from a non-deductible IRA), but may contribute to a Roth 401K. It would also be nice to see the contribution limits on there, but it’s your chart so keep it simple if you prefer! I like citing this chart when illustrating a point to my friends, colleagues, etc.
I added a footnote to the page that addresses your concerns.
Just found the “Numbers Unlimited” page which has the contribution limits info I was looking for. Thanks!
In the intro to your post, you mention the Bogleheads wiki post about this issue (namely that dollars contributed to a tax deferred account now are contributed at a person’s current marginal tax rate, but are withdrawn at that person’s average tax rate, making a case that it is optimal to contribute dollars to a non-Roth account while in higher tax brackets).
However, I clicked on your link to the Bogle wiki, and it looks like they’re still making the comparison of marginal rates today to marginal rates in the future, and not average tax rates in the future…am I missing something? Is that wiki wrong, in your opinion (again, assuming one is in medium to high marginal rates while contributing and not planning to have income in retirement over $150k or so)?
Technically it is marginal to marginal, but it’s marginal to marginal for every dollar. If in early retirement (prior to SS) your only taxable income from a tax deferred account, your first $20K or so will be totally tax free. Then the next chunk is at 10%. Then a big chunk at 15%. Then a big chunk at 25%. Whereas pretty much every dollar I put in tax-deferred accounts this year was saved at 33, 35, or 39.6% Federal. 39.6% to 0% is obviously huge. 33% to 25%, less so, but still a nice boost.
Hi,
I was wondering if you can give me advice on how to allocate my retirement savinngs. My current residency program does not provide matching for the 403b plan. I will be maxing out my Roth IRA for this year. I would like to know where should I invest money after the Roth IRA since there’s no match for 403b. Should I open a 403b account anyways or put money into a traditional IRA/brokerage account/etc instead? Are there other options? Thanks!
You can put it in the 403(b) and convert it the year you leave residency. Or invest in taxable. Or save up a downpayment. Or pay off med school loans. Lots of good choices.
Just became eligible for 401k with employer, spouse maxes 403b with my employer…we have this question before us, do we want a Roth401k or Traditional401k?
First, thank you very much for compiling the above and links to other pages…have spent the last week pouring over what is best for us.
We are easily going to be in the 33% Federal and 3% State tax bracket this year and was hoping maybe this one last question will help answer our conundrum:
Facts:
-401k will be matched to max out contribution $53k-Horrible investment choices (ERs all >1% with 12b-1 fees of >0.5%)
-Plan to retire/move to a state with no state income taxes
-Plan to continue Backdoor ROTH every year
My original thought was-no brainer, T401k for the federal AND state tax break, but if I am planning on rolling this 401K into a TIRA in the future and then slowly convert to ROTH when able, I may be loosing my ability to do Backdoor Conversions in the future with the pro-rata rule, correct? If so, is this loss worth still going with Traditional? Thoughts would be greatly appreciated.
Definitely moving to a tax-free state later AND maxing out backdoor Roth IRAs? I’d lean very heavily toward traditional contributions if I were you. Sorry your 401(k) sucks, but the choices on the Roth side are probably exactly the same.
As of now, I’ve been told by some people to do 100% roth 403b contributions and from others to do 100% traditional so I am doing about a 50:50 split and maxing out this account. I am a pediatrician just out of residency and making decent money. I don’t think my salary is going to go up too much over the years but it could. I would assume near retirement I will be working less hours, playing more golf, and making less money if all goes as planned. If you were in my shoes, what would you do? I haven’t set up my roth IRA yet but when I do so I was thinking about keeping that 50:50 split amongst my combined retirement accounts. So what do you think? Thanks.
If you’re in your first 6 months out of residency, I’d go 100% Roth. Then 100% traditional starting next year. That’s the general advice for docs. There may be something unique about you that you should do something different, but probably not.
Thank you very much for this post. My wife and I have been going back and forth on this issue. I am directly out of residency (30 years old) and am going to maximize my Roth 403(b) and both of our IRAs (backdoor Roth) for 2015. Starting in 2016 we will be making about 400k a year between the two of us. I will be maximizing each of the following: Both IRAs, 403(b), 457 (all tax-deferred), and a program where I work called the RSP (retirement savings plan, which is also tax-deferred and matched up to a total contribution for the year of 18k). Also, at this point any money saved now by going with the tax-deferred route won’t be invested but will likely be sent to pay off student loans (at 6.875%). With 36k tax-deferred between RSP and 457 and another 11k backdoor Roth IRA, does it make sense to do the Roth 403(b) to have a more equal allocation between taxed and tax-deferred retirement accounts knowing that the tax-deferred savings won’t be invested now? Or should I still maximize my tax-deferred accounts because I’m likely to be in a lower effective tax bracket in retirement. I have read both of the articles you linked at the top of this post but would still like your opinion on the issue.
I’d do tax-deferred in your position, but it isn’t like going Roth is somehow “wrong” for everyone.
Sounds like a great start…except for that student loan. You should remedy that soon.
James – not sure if you’re still checking this feed, but thanks for the post. The whole blog is great. Very informative. Quick question – I am an O3 OCONUS military FP < 1 year out of residency – we are currently in the 25% marginal bracket and will be until I either a) get out of the Navy after my commitment (4 years) or b) take the MSP – at which point I would likely stay in for the 20 (we like to travel). We are currently paying off my wife's (refinanced) graduate school loans and maxing out our Roth IRA, and contributing what we have left to our Roth TSP, and taxable investment/savings account (for that future mortgage down payment, emergency expenses, etc).
My question is, how should I prioritize my contributions going forward for the optimal tax strategy? Continue to max out our Roth IRAs ( as I have done since starting residency) and contribute what I can budget to the Roth TSP? Or should I take a hybrid approach and continue to max out our Roth IRAs and contribute what I can to a traditional TSP/IRA? Or is it time to just abandon the Roth altogether? Also, I can't find a straight answer on this – can I contribute to a Roth IRA through USAA, the Roth TSP, and a traditional IRA through USAA (or another firm)? Sorry for the rambling post. Thanks in advance.
If you’re staying in, it’s probably time to start doing some tax-deferred…maybe. If you’ll be getting out, stick with Roth Roth Roth until you do. And even if you stay, Roth is still probably the right answer since you’ll then have a pension. The Roth TSP is the best thing that ever happened to military folks. I think there’s even a match now. At any rate, whether you do Roth TSP or Roth IRA first doesn’t matter much. I’d try to do both, of course, but if you can’t, well, the TSP ERs are slightly cheaper than what you can get at Vanguard, but there are fewer options.
And don’t use USAA for your IRAs. Go to Vanguard.
I definitely understand the case for tax arbitrage with a Traditional pre-tax contributions; however, if one has a long enough time horizon and is hoping for good appreciation of assets, would Roth contributions not make more sense? In other words with Roth, one pays a higher percentage tax on a smaller amount [Roth] vs a lower tax on a much larger amount[Traditional].
For example, say one were to keep money in an S&P 500 index fund – earning 6% this money could go up 8x over 36 years with just buy-and-hold.
Wondering if you had any thoughts on this?
It’s all about the percentages, not the amounts. Take a look at an example to see why this would be the case. Assume you are in a 25% tax bracket, all in. You have $10K pre-tax, or $7500 post-tax. If you put it into a pre-tax account, and it triples, then when you pull it out you’ll have $30K, and you’ll pay $7500 in tax, leaving $22,500. If you put it into a post-tax account, and it triples, you’ll end up with that same $22,500. So if no arbitrage or account limits, then it’s exactly the same thing whether it goes into a tax-deferred account or a Roth account.
For PGY1, what index fund do you recommend to start for the IRA ROTH?
After maxing out IRA ROTH, do you also recommend residents trying to max the 403b ROTH during training years (no match though in my program)? Is there a better option to invest other than 403b ROTH or maxing both IRA and 403b ROTH spaces during residency is the best investment option for residents?
There are lots of great options. A really easy one is the Life Strategy Moderate Growth Fund. A Target Retirement fund has an even lower minimum.
I guess if you can max out a Roth IRA and a Roth 403b, then sure, go for it. But bear in mind just maxing out a Roth IRA is an 11% savings rate for a resident. If you’re married, doing two is a 22% savings rate. I think you’re doing awesome if you can manage that. Most can’t. It was all we could do to max out Roth IRAs. One year we didn’t make it. The last year I took a 0% CC deal to do it.
Quick follow-up questions:
Q1. Is there an easy way to expect how much maxing both IRA and 403b during 6 yrs of residency training (for example, 33k from IRA ROTH and 90k from 403b ROTH during 6 yrs of training alone) will get me when I turn 59.5 yo (~30 yrs from now)? I am aware that the answer to my question varies depending on the market and what index fund you use. But, what is the average return can we expect for our money to grow, roughly?
Q2. Is there a cost to open VSMGX or VTSAX on Vanguard website? Is it a quick process to open? Do I have to have an income to open it? My plan was to open it close to before or after I earn my first paycheck during my internship. Any recommended timeline to open it?
Q3. For 403b ROTH, do I open through the Human Resource Department at my program? Do they choose the index fund for me or can I choose? If I can choose, what do you recommend, again?
Thanks!
They might be quick questions to ask, but not necessarily answer. They reflect a need to do some serious reading of investing books. I’d start with these: http://astore.amazon.com/whicoainv-20?_encoding=UTF8&node=64
That said, I’ll try to answer them as briefly as possible.
Q1. No. There is no easy way. But an estimate isn’t all that hard, and that’s really all you need at this point. I use the spreadsheet Future Value function to do stuff like this. So let’s first consider the first 6 years of the period, when you are putting in $5500+$18K =$23.5K per year. When running these estimates, I tend to use a real (after-inflation) annualized return of 5%. If you think that’s too low or too high, adjust as you feel appropriate. So, after 6 years, you have:
=FV(5%,6,-23500,0,1) = $167,837.20
After 24 more years of not adding anything to the pot, you have:
=FV(5%,24,0,-167837.2,1) = $541,291.74
That’s in today’s dollars. If you want to see a range, repeat the exercise using a value of 2% and a value of 7% and I think most would admit you’ll end up within that range.
Q2. No. No cost other than the ongoing cost of the funds called an expense ratio, which for Vanguard index funds, approaches zero. You do not need an income to open it, but you will need an income by the end of the year in which you fund it. So you could put in $5500 on Jan 2, 2017, but you’d better have at least $5500 in earned income by the end of the year. I would open it when you are ready to invest the money. Which is usually after you earn the money, but I suppose if you have some cash sitting around, you could do it a little sooner.
Q3. Yes, you open a 403(b), including a 403(b) by filling out paperwork when you are hired. The HR department typically administers that paperwork. In any self-directed defined contribution plan like a 403(b) or 401(k) you get to choose the investment, but you may be limited to the choices they offer, depending on the plan. Some plans also offer a brokerage window where you can buy any publicly traded security, but I’d say those are the minority of plans. Pray that someone in HR is a Boglehead. It is impossible for me to recommend a fund for you. Consider reading this post to understand why: https://www.whitecoatinvestor.com/150-portfolios-better-than-yours/
But if you’re going to force me into a corner at knifepoint and demand I name a fund, I guess I’d say Vanguard Target Retirement 2045. Whether or not that is actually in the 403(b) is up to HR.
Good luck investing. Ignore my snark. It’s late. Hope that helped.
Hi WCI !! Great website indeed..
I was also kind of struggling with traditional vs Roth Dilemma. I am in first year out of fellowship.
I was running some calculations assuming 28% marginal tax rate now and 14% effective tax rate on withdrawal in retirement.
If I put 1000$ in TIRA today , assuming conservative 5% gains, over 25 years, approx amount would be 4000 $. Tax I pay would be 560 $ then, but I save 280$ now, so effective tax I paid is 280$ which is approx 280/4000 = 7%.
However, if I put 1000$ in Roth IRA, it would also grow to 4000$ but tax I pay would be 280$ now – again 7% of 4000$.
In reality, probably Roth IRA would compound even more than 25 years ( I am 32) and hopefully more than 5%, in which case my effective tax rate may be more like 4-5%.
This lower tax than TIRA would also be in addition to all the other benefits and flexible withdrawal that comes with Roth IRA.
I therefore actually come to conclude that at least next 10 years or so, I should rather invest in Roth IRA rather than TIRA, ( to have more time for compounding), maybe later on I could change to TIRA when I am closer to retirement..
I wanted your opinion on my approach / calculation.. Is there any flaw or point I am missing in my calculations. Any input is appreciated !!!
Ha ha. You missed something important. $1000 in a Roth is more money than $1000 in a traditional IRA. Correct for that factor before running your numbers. Your conclusion is that if you invest more money you’ll have more money later. I agree with that! But you shouldn’t yet have concluded anything about the traditional vs Roth dilemma.
I was actually trying to see what tax I pay in either option (Trad 401K vs Roth) and did account for 280$ tax savings on initial investment. Also I compared this way because 401k ( most common investment option) limits the total amount invested ( 17500 total in either Trad vs Roth). I found it very encouraging that even though I pay 28% marginal tax rate now, but eventually overall tax on my savings even with Roth investment is 4-7% ONLY !! I did not think this way before and was more in favor of Traditional 401K earlier.
I think what you are trying to allude is the 280$ I save now ( on investing 1000$ Trad IRA) may be invested in another vehicle like Taxable account which may provide additional savings !! I kind of agree but wanted to clarify my own calculation !!
Still overall, paying 4-7% tax overall on either Trad 401K vs Roth ( similar) in both with obvious additional benefits of ROTH makes me favor Roth more than what I thought before.
I was thinking to try and have more like 50-50% savings each in Trad and Roth accounts !! Dont know if its reasonable !!
In any case, I sincerely appreciate your prompt reply and time. I am a fan of your retirement philosophy and have learnt a lot from your blog..Thanks indeed !!
Exactly. The question isn’t whether to put $1000 in a traditional IRA or $1000 in a Roth IRA. The question is whether to put $1400 in a traditional IRA or $1000 in a Roth IRA. If you take it out at the same marginal tax rate you put it in at, it’s all the same. If you take it out at a higher rate, then you’d be better off in a Roth IRA. If you’ll take it out at a lower rate, you’d be better off in a traditional IRA (or 401(k) or whatever). If you’re actually maxing out the account (so your extra savings with tax-deferred would be in taxable) the break even is actually at a slightly lower marginal tax rate at withdrawal due to the effect that the Roth option has everything in a tax protected account.
The general rule is that if you’re working part-time, in residency or fellowship, or in the military, go Roth. If you’re an attending in your peak earnings years, max out your tax-deferred. There are some exceptions though. For a really deep dive into this, I’d recommend James Lange’s Retire Secure.
I suspect 50/50 Roth will mean you’ve overpaid taxes during your peak earnings years. I’ve always done Roth IRAs and I think I’m closer to 30/70 Roth/tax-deferred and that gets worse every year. Financial advisors tell me it’s very unusual to see someone with even that high of a ratio.
I am also a fan, a co-worker suggested your website to me.
I recently started fellowship, and am transferring my pension (also pre-tax contributions, only earning 1.6%!!) over to my new employer’s 403b. My current dilemma is whether or not to contribute to a ROTH or leave it in the 403. I’ve read the comments, the big thing I guess is my retirement tax bracket compared to now. As people are retiring later and later, I’m not sure which will be higher. I just got married, and although I am still training, my husband is working as an attending hospitalist.
If one of is still in training, then my bracket is still lower than when we both start working as attendings. So in that scenario, do you suggest rolling that money over to a ROTH then?
It’s a closer call being married to an attending for sure. I’d probably do Roth for now though. I might even try to convert some or all of the tax-deferred stuff you already have this year.
Thanks for the response. Your blog has been super helpful. Did you happen to read the new article on Consumer Reports on Student Loans? There is also an episode on Reveal on this: https://www.revealnews.org/episodes/whos-getting-rich-off-your-student-debt/
I opened a Vanguard IRA & a Roth IRA! So will work on transferring my pension (that’s the only retirement investment I have made so far as everything else goes into paying off my student loans) into the IRA. I think I will concentrate on paying off student loans while making 10% contribution to my 403 (which I will start to get this January, a new benefit for our training staff). If I am correct, that way, when I want to roll-over, I don’t have to worry about “pro-rata” stuff, and at the same time, I can work on compounding with my pension money in a Roth IRA.
3 questions:
1) Does the above plan seem reasonable? It’s what I have come up with, with all my research on the subject.
2) When I roll-over my pension to the traditional IRA, and then the Roth IRA, will I have to figure out how much to tax myself or will the Vanguard site do it for me? If I estimate it myself, do I just estimate my joint tax bracket, and use that to withhold that amount?
3) Was there a blog entry where you went over how to choose what funds to invest in, in your Roth? I saw the entry detailing yours, I know some places (like my work) have Targeted funds based on your age, but don’t know if Vanguard has this or what not…
THANK YOU again!
Good job.
1) I’m not quite clear on what your plan is. It sounds like you’re going to put some pension money (pre-tax) into a traditional IRA. That, by itself, will screw up a backdoor Roth IRA contribution due to the pro-rata issue. You would need to either convert that money into a Roth IRA or roll it into your 403b to avoid that.
2) You or your accountant. Vanguard won’t figure it out. You can request they withhold some money, but you don’t want to do that. You want to pay that tax out of a taxable account.
3) An asset allocation tends to be very personal. However, there are reasonable asset allocations and unreasonable ones. Here is a list of reasonable ones:
https://www.whitecoatinvestor.com/150-portfolios-better-than-yours/
My goal is to get my pre tax pension into a Roth. But my 403b isn’t open until January 2017, so I was hoping to transfer from pension to Vanguard IRA and then directly to the Vanguard Roth IRA. I don’t have any existing retirement funds in any IRA so does the pro-rata still affect me? How is rolling over from a 403b different from rolling over from a traditional IRA?
It won’t affect you if you do that conversion. The conversion will cost you some tax money though. Going from 403b to Roth IRA whether directly or via a traditional IRA has the same effect, but it is a taxable conversion.
We’re in a similar situation and confused about what I should do.
Finishing surgical sub training, spouse an attending-Tax bracket this year 33%, next year 39.6%, state 6%.
We both contribute max to our 403b/401k and have been doing backdoor ROTHs for several years. However, with finishing training comes the need to either leave 403b/401ks where they are or roll them over into a traditional account (new employer I’m pretty sure doesn’t accept incoming transfers). I’m trying to get a 1099 income from personal medical consulting we both are doing this year and apply for an EIN for this business so we can open a solo 401k at put 20% of the profit into it and have a space to roll our 403b and 401ks into it.
However, I feel like I’ve spent a lot of time researching this and might be missing the point. Does the above plan seem reasonable?
Check with the new employer. You’ll probably be surprised. You may also be able to open an individual 401(k) at some point and roll them in there. At any rate, no big deal to leave them at the old employer for a while.
Your plan is just fine and a reasonable option.
WCI,
Just bought your book on Amazon and really looking forward to reading it. I have a burning question on this topic though and was wondering if you had some input.
I’m active duty military (1 year out of fellowship), currently deployed through the end of the year and taking advantage of my tax-free status by making the maximum Roth TSP contributions this year to $18K. My wife, also a physician, is about to finish up her fellowship but has been making Roth 401(k) contributions. I’m trying to figure out what our best options are for when I get home next year and she starts working as an attending. My military salary will be around $150K with ~ $30K coming from allowances, and I anticipate being able to moonlight for an extra $50K. If I am conservative and presume she’ll make under the median salary for her specialty in our location ($195), we are likely to end up in the 33% tax bracket next year. I budget that we should be able to max out my TSP and her 401(k) contributions plus both max-out backdoor Roth IRAs. I will be in a minimum of 8 years, so considering staying in for 20 years for the pension is definitely a consideration, and potentially changes the floor for my yearly income in retirement. All of that as a background, it’s not clear to me if traditional TSP / 401(k) is advantageous over doing Roth TSP / 401(k). It sounds like most of the advice for someone in my situation would be to do a traditional TSP / 401(k) + backdoor Roth and invest the tax savings into a taxable account rather than do straight Roth contributions (plus future option to convert to Roth and some tax diversification); however, there seems to be some advantages of maxing out a Roth TSP / 401(k) and letting a bigger pot of after-tax dollars grow over 30 years. Do you see any big advantages or one strategy over the other?
Are you doing tax-exempt money into the TSP and also the SDP? Those are great options for a deployed doc.
If you get out early, you’ll probably have been glad to do Roth TSP and you’ll be in an even higher bracket the rest of your career, even if you’re currently in the 33% bracket. But it’s reasonable to do tax-deferred given your higher bracket because you’ll likely get it out at a lower bracket. If you stay in and get a pension, that Roth TSP will be nice given that military pension is all taxable.
It would require a crystal ball to know the optimal strategy. Know this- that you’re choosing between better and best, and nobody can tell you which is which in your situation.
Thank you for this post. I would add something to the estate component. The Roth benefits the beneficiaries not just because it doesn’t require minimum distributions, but also because it gets a step up in tax basis at the time of death. Traditional IRAs/401Ks don’t. An heir is not required to take Roth distributions. If you have both it’s a trade off between maximizing money for your heirs (utilize traditional IRA/401K in retirement) or your own retirement income (use Roth funds). The tax liabilities on left over 401K money can be astronomical. Federal+state+estate taxes.
As to the unfunded liability comment from earlier, the current debt per citizen is around $61,345 and per taxpayer around $166,770. If we counted unfunded liabilities those numbers would be multiplied by a factor of 10. While our reckless spending politicians aren’t going to snatch this amount out of our check book all at once, what they will do in order to address future deficits is increase taxes. This is a mathematical guarantee. As with any investing strategy, do the external environment analysis first, then invest. It’s not looking rosy for the high income earners in retirement and probably for estate taxes as well. Those things bode less well for the traditional 401K.
I’m not sure you understand the inherited Roth IRA rules quite right. The heirs do have RMDs and there is no step-up in basis as it is all already tax free. However the trade off you mention is certainly true. Either you can pay the taxes for your heirs and leave them Roth money, or you can have them pay the taxes.
I disagree there is a mathematical guarantee. They may just inflate it all away instead of raising taxes. But if you’re really worried about it, pay your taxes now and go with more Roth money.
I believe there is still a tax basis on Roth accounts. The basis of a distribution, however, is the fair market value (FMV) of the distribution at time of sale:
https://www.irs.gov/publications/p590b/ch02.html#en_US_2016_publink1000231061
So the end effect is still the same – no taxes are paid on qualified distributions. As for the heirs, a spouse does not have RMDs if a Roth is inherited but they do have RMDs if a traditional IRA or 401K is inherited. For non-spousal heirs, RMDs do apply with either (oddly, several other websites I looked at said they didn’t apply for Roths). However, the tax treatment for non-spousal heirs of traditional IRAs/401Ks vs Roths clearly favors the Roth.
If someone is collecting mandatory payments (defined benefits, social security) and passive income to boot (never a bad idea) then the marginal effect of traditional IRA/401K withdrawals will be higher. Point is, there’s a lot to consider and it needs to be highly individualized.
As for the guarantee I mentioned, as long as the Fed has an explicit duty to maintain the value of the dollar and prevent situations like Zimbabwe or the Weimar Republic, I don’t see how our debt is going to be inflated away. Politicians faced with that reality and the reality of growing deficits and interest payments will do and can do only one thing – raise taxes. I think everyone with any significant degree of wealth/income should not just be worried about this – they should expect this and plan accordingly.
Excellent points.
Anyone with any significant degree of wealth/income should be just as worried about inflation, which in many ways is just another form of tax.