By Dr. Jim Dahle, WCI Founder
Anybody with a reasonable understanding of math, the US tax code, and the typical earnings cycle of a physician can quickly see that one of the greatest gifts the government has ever given physicians is the ability to use tax-deferred retirement accounts. Despite this, some would try to convince you otherwise.
Sometimes these people have ulterior motives, wanting you to pull money out of your retirement accounts to purchase an investment or insurance product that will pay them a big commission. Others, including at least one prominent radio host, advocate that you always use a tax-free (Roth) account preferentially when it's available. Even well-meaning folks may cause you to worry unnecessarily about large Required Minimum Distributions, investing fees, difficulties accessing money in retirement accounts prior to age 59 ½, and rising taxes.
Will a Doctor Benefit from Tax-Deferred Retirement Accounts?
The truth is, that for most physicians, the very best place to invest their next dollar is inside a tax-deferred retirement account, such as their employer’s 401(k), 403(b), defined benefit/cash balance plan, or 457(b). And, for the self-employed physician, it's an individual 401(k) or cash balance plan.
The Difference Between Tax-Deferred and Tax-Free
It is also critical to understand the difference between a tax-deferred account, such as a 401(k), and a tax-free account, such as a Roth IRA.
Tax-Deferred
When you contribute to a tax-deferred account, you contribute pre-tax money, which then grows in a tax-protected manner until it is pulled out. Then, you'll owe taxes on the withdrawal at your ordinary income tax rate.
Tax-Free
When you contribute to a tax-free account, you contribute post-tax money, which also grows in a tax-protected manner just like a tax-deferred account. However, it's then withdrawn completely tax-free in retirement.
The Physician's Earning Cycle
To understand why a tax-deferred retirement account is such a great deal, it is critical to understand the typical earnings cycle for a physician. A typical doctor has no significant income until their late 20s when they enter residency. Then, for a period of 3-6 years during training, they have a low income, which rises rapidly over the next 2-5 years to their peak income (usually by their late 30s or early 40s). Their income then remains high for 15-25 years before decreasing for a few years as they cut back on work and then retire completely (typically between ages 60 and 70). The vast majority of their retirement savings will come from earnings during the peak years of their late 30s, 40s, and 50s, when they are in the highest tax brackets of their life.
An Example Using EQUAL Marginal Tax Rates
If the marginal tax rate on the contribution and the withdrawal is exactly the same, the two accounts are essentially equivalent. Consider an investor with a 24% marginal tax rate now and a 24% marginal tax rate in retirement.
If the investor earns $5,000 and wants to put it toward their retirement, they may have the choice between a tax-deferred and a tax-free account. They can either put the $5,000 into a tax-deferred account, or they can pay the taxes due and put $3,800 into a tax-free account. After 20 years at 8% growth, the tax-deferred account has grown to $23,305, and the tax-free account has grown to $17,712. However, once you subtract the taxes due on the tax-deferred account ($5,593), you end up with precisely $17,712, the exact same amount as the tax-free account.
Despite the fact that you would pay over four times as much in taxes on that tax-deferred money ($5,593 vs the original $1,200), you would end up with the exact same amount of money after-tax.
An Example Using the Typical Physician with UNEQUAL Marginal Tax Rates
However, a physician will typically contribute money to their tax-deferred retirement accounts at a much higher tax rate than when they will withdraw it. A physician in their peak earning years is likely to see their marginal tax rate, including the PPACA-associated taxes but not state taxes, in the 24%-35% range. In retirement, particularly an early retirement before starting to collect Social Security, they can likely pull some of that money out at 0%, 10%, 12%, and 22%, filling the brackets as they go along.
Saving taxes at a 35% rate and then paying them later at around 12% is a winning strategy. Even if the tax brackets climb a bit, the fact that a large percentage of tax-deferred account withdrawals will be used to fill the brackets completely overwhelms the effect of the higher tax rates.
More information here:
Comparing 14 Types of Retirement Accounts
Why You Should Max Out Your Retirement Accounts
Lower Income Needs in Retirement
Even aside from the effect of filling the tax brackets, a retiree is likely to have and need a much lower income in retirement compared to their peak earnings years, even while maintaining the same lifestyle. As a retiree, this investor will have lower income taxes, no payroll taxes, no need to save for retirement or college, no child or work-related expenses, and hopefully no mortgage payment. Even if their healthcare and travel expenses go up, they are likely to find that they need 50% or less of their pre-retirement income to maintain the same lifestyle.
This is a good thing, since most doctors don’t save enough money and don’t invest their savings well enough to replace their entire pre-retirement income anyway. In fact, the less retirement savings you’ll have in retirement, the better deal a tax-deferred retirement account becomes.
What About the 10% Penalty If I Plan to Retire Early?
Some investors who plan an early retirement invest outside retirement accounts because they are worried about the 10% penalty applied to retirement account withdrawals taken before age 59 ½. This fear is dramatically overblown. There is an exception to that penalty for every reasonable issue that could cause you to need to access that money before age 59 ½.
There are exceptions for
- large medical expenses
- health insurance
- disability
- higher education expenses
- a first home of your own or a family member
- a tax levy.
In addition, the substantially equal periodic payment rule allows for an early retirement. It essentially allows you to withdraw from your retirement accounts for any expense without paying that penalty, so long as you take out the same amount each year for five years. A planned early retirement is no reason to pass on the substantial benefits of investing in a retirement account.
Will RMDs Push Me into a Higher Tax Bracket?
Other investors worry that large Required Minimum Distributions (RMDs) after age 75 will push them into a higher tax bracket. While this is possible for a supersaver, it is a wonderful problem to have. The IRS mandates you withdraw a reasonable amount of your tax-deferred money each year, starting at about 4% at age 75 and climbing to about 9% at age 90.
Most people will need to withdraw this much or more to provide the income they need each year anyway. If you don’t need all of that money to live, it can be reinvested in a taxable account and left to your heirs income-tax-free due to the step up in basis.
For the supersavers, the best solution to this problem IS NOT to avoid contributing to tax-deferred accounts but to make Roth conversions of some of that money (enough to fill the lower brackets) during late-career and early retirement years. Again, it'd be a great problem to have.
More information here:
Early Retirees Should Max Out Retirement Accounts
Wife vs. Husband: A Retirement Account Showdown
But My 401(k) Offers So Few Options
Some investors worry about the poor investment choices and high fees associated with some employer-provided tax-deferred accounts. This problem is rapidly correcting itself as employers are beginning to understand the fiduciary duty they have to their employees. Those who didn’t learn fast enough have since learned this lesson in court.
Even if your 401(k) is not ideal, the presence of a potential match and the likely opportunity to transfer it to a better 401(k), an individual 401(k), or even an IRA later still argues strongly to use it for your savings.
Even ignoring the likely difference in marginal tax rates between the contribution and the withdrawal, the tax-protected growth available in retirement accounts may add as much as 0.5% to your annual returns when compared to investing in a taxable account. Over the course of 50 years (including both earning years and retirement years), that difference can result in you having a 20% larger nest egg (and thus retirement income).
When Do I Use a Tax-Free Account?
This is not to say that there are not times to use a tax-free account. Retirement contributions during low-earning years—such as residency, fellowship, military service, and sabbaticals—are great times to contribute to tax-free accounts. If you cut back on work or go part-time, that may also be a great time to make tax-free contributions or Roth conversions.
Serious savers will take advantage of the Backdoor Roth IRA even during their peak earning years while also maxing out their tax-deferred accounts.
Of course, Roth conversions near career end and in early retirement can also make sense. But if you are in your peak earning years and have not yet maxed out your tax-deferred account contributions, that is clearly where you will see the most bang for your buck.
More information here:
How I Went from a Negative Net Worth in My 30s to Early Retirement
Retirement Income Strategies — And Here’s Our Plan for When We FIRE
Get Your Tax Break While You Can
In addition, retirement accounts in most states receive significant asset protection from your creditors. Even if you end up declaring bankruptcy due to the (admittedly minuscule) possibility of being sued for more than your insurance policy limits, you will probably still get to keep your retirement accounts.
Retirement accounts also provide for easy estate planning. Not only can you pass those assets to your heirs immediately outside of probate by designating beneficiaries, but the tax advantages can then be “stretched” for 10 years by your heirs themselves. For many doctors, leaving heirs a tax-deferred account instead of a tax-free account is a savvy tax move because the marginal tax rate for the heirs is lower than for the doctor.
Using a tax-deferred account for a charitable contribution at death and leaving the taxable account (with its step up in basis) or, better yet, a stretchable tax-free account to the heirs can also be a smart move. But none of these options are available if you do not contribute to the tax-deferred account in the first place.
The tax code may change in the future. Perhaps a flat tax or a value-added tax will replace our income tax system. Perhaps there will be an additional tax placed on Roth IRAs. However, these concerns argue FOR using a tax-deferred account. Get your tax break now while you still can. Take the bird in the hand instead of the two in the bush.
In early career, a physician typically has a high income, a low net worth, a high tax bill, and significant liability concerns. Large contributions to tax-deferred retirement accounts are the perfect solution. Don’t say the government never did anything for you.
What do you think? Do you use tax-deferred retirement accounts? Why or why not? What do you consider the valid reasons to not max them out each year?
[This updated post was originally published in 2016 at MDMag.com.]
We’re in our mid-50s, and Roth accounts weren’t available when we were residents or earlier in our careers. We’ve had the fortune of being able to contribute to 403(b), 457, and 401(a) accounts, such that we contribute around 120k per year. This is in addition to a state pension and SSI in 10-12 years. However, I frequently feel like an outlier when reading the WCI Forum, since many frequent contributors tout Roth-IRAs as if they’re mandatory for most physicians. Re-reading this older post always gives me some peace of mind.
Our plan is to start doing Roth conversions when I cut back to 1/2 time, and move from a high state income tax (9%!) to a no state income tax area.
Sounds like a solid plan to me.
In the original article, Jim points out that it is difficult for most docs to get anywhere close to $14M in tax deferred accounts. I am sure this is true because most don’t have enough tax deferred space over their careers to approach that figure.
However, that does not mean they could not accumulate $14M total, with $6M in tax deferred and $8M taxable. If the RMD on the $6M was ~210,000, add to that the income from an $8M taxable account, say 2% or $160,000. Assume married with both spouses working, Social Security could total over $70,000 even if one was a lower earning spouse.
That is $440,000 total. 15% of SS would not be taxable, so call it $269,000 of ordinary income plus $160,000 of dividends. Plus NIIT.
This puts the couple in the 24% rate for ordinary income in retirement. This couple would be in a higher tax bracket, 35 or 37% while working. Doing Roth conversions would be a bad move.
If they work past 72, there would be no low income years in which to do conversions.
Once they finally retire, they could start doing some conversions at 24% against the time when the survivor is in a high tax bracket filing single. Until then, conversions don’t make sense.
Of course, if they are predicting changes in the tax law such that there current bracket is lower than what is expected after retirement, then conversions might be worthwhile.
Yes, Roth conversions don’t always make sense, but due to the problem created by surviving spouses being thrust into a higher tax bracket due to RMDs, they could still make sense even in the scenario you describe, which is a great first-world problem to be in.
I keep going back and forth between the backdoor Roth and maxing out my 403b and 457b. I work at UC and luckily have access to a 403b, 457b, and a backdoor Roth option for up to 57k! I just started my attending job, so I was thinking since my income for this year will not be the full attending salary (more like 50% attending salary)…. it MAY?? make more sense to contribute more heavily towards the backdoor Roth since my tax bracket is not as high as it will be next year. Overall my plan is to have a diverse retirement portfolio in tax-deferred and Roth, but I’m not sure what the “optimal” allocation is right out of residency. Next year when my taxable income will be fully attending money, I plan to max tax-deferred accounts first. Any thoughts or suggestions? Thanks, team!
How does it work with spousal IRAs? Can me and my wife contribute to same Roth IRA and if so is the limit 6k for each of us meaning 12k total?
IRA stands for INDIVIDUAL Retirement Arrangements. So you each have your own, they each get their own $6K limit, and you each fill out an 8606 on your taxes each year when doing Backdoor Roth IRA.
The only thing a spousal IRA allows you to do is to still make a contribution without having any income as long as your spouse made enough earned income to cover both of your contributions.
Could someone please explain how one gets more money in retirement account, particularly 403b that is available through an employer? I max out my pretax contribution in 403b, which is 19.500$ per yr plus 4% match. I see people talking about maxing out contributions up to 57-60k and I am confused. My question is : could someone like me working for a salary and getting W2 maximize contributions beyond pretax 19.500 or it is only if one gets additional Locum job with 1099 pay and additional individual 401? I am playing catch-up and looking into increasing my retirement money. I am aware of IRA and HSA. My next thought is after tax investment account, however I have FOMO on sheltered investments.
The plan has to allow it and yours doesn’t. Sorry.
Remember you can always invest more in taxable.
Dr Dahle
I am following your blogs for a while and trying my best to save as much as I can.right now I am maxing out my 403b and 457. doing backdoor ROTH entry from the last 5 years now. my wife has 401 k from her employer and just last year she became a partner with a local dental practice which is offering SIMPLE IRA. she still goes once a month to her previous job and still contributes to her 401k. my questions is how can she handle her retirement accounts going forward?
1. Can she contribute both to 401k and SIMPLE IRA
2. can she do backdoor ROTH IRA?
I would appreciate your help.
1. Unrelated employers? Yes, she can have both. Two separate 415(c) ($66K) limits for two different plans.
2. Can she make a contribution to a non-deductible IRA? Yes. Can she do a Roth conversion? Yes. Will that conversion be pro-rated due to the SIMPLE IRA? Yes. Probably not a great idea for her to do the contribution at all, but definitely a bad idea to do the conversion.
I would thing “tax deferred” instead of Roth would be especially favored if in a short period of very high “earnings” or income (deferring while marginal tax rate is very high) while Roth would be favored during a period of modest income. Such as a “Poor Resident”.
Instead of comparing putting $5000. into “tax deferred” vs. putting $5000. minus tax paid into Roth I would compare to putting $5000. into Roth and paying the tax with additional money so that the entire $5000. goes into Roth. Will cost you more than $5000. but you end up with functionally more in your Retirement Accounts and compounding free of tax.
Keep in mind $5,000 in a Roth is more money than $5,000 in tax-deferred. So if at a 20% marginal tax rate, $5,000 in a tax-deferred account is like $4,000 in a Roth account. So when maxing out accounts, there is a bit more of an argument for Roth since the remainder in a comparable tax-deferred account situation has to be invested in taxable.
Actually you made a VERY important error in your calculation –
You calculated pre- and post-tax compounding. You did NOT calculate CG taxes. You owe CG on all your gains in the post-tax brokerage account which is another 10-15%. You do not owe those taxes in the pretax account.
For simplification, I live in CA. Let’s say total taxes 50% now and it’s the same later (including state taxes, etc).
For X$ I can invest X in pretax or 0.5X posttax. Let’s say it doubles for ease of calculations. I have 2X pretax and X post tax. At 50% marginal tax rate (obvi marginal is all that counts) I have X left over from my IRA but 0.5X + 0.85(0.5X) in my brokerage.
And if I move out of CA to any other state OR if my income is less in retirement it’s a considerable advantage. So because everyone forgets their gains are taxed as CG it’s very nearly certain the retirement account wins out. PLUS the retirement account may be protected from lawsuits depending on the state so it’s free protection.
Not sure who you’re referring to, but I’m certainly aware of and agree with what you’re saying.
I just want to add one point to this conversation. I have been saving predominantly in tax deferred accounts. I would consider myself a high saver. I save in a 403b, 457, 401a, backdoor roth and HSA and I will also have a pension as I am in an academic job. I am mid career and my account balances have grown substantially as I have been maxing all of those accounts for 15+ years. I have long considered my need to increase my tax free contributions by changing my 403b contributions to roth. The reason that I am now convinced I will start doing roth contributions to my 403b is for additional tax diversification. Not because of what might happen to tax codes or whatever the government decides, but rather what might happen to my own personal situation. The point that convinced me to do this is the tax implications if I switch from filing as married to filing single. This would obviously have major tax implication on my tax brackets. I doubt anyone wants to consider the possibility of one spouse dying at a much younger age than the other, but it is a possibility. And if it does happen, it changes the math on when to consider a roth contribution. Just another point to consider for the super savers like myself.
Being a supersaver is a well known exception to the rule of thumb to use tax-deferred retirement accounts during peak earnings years. More discussion here:
https://www.whitecoatinvestor.com/roth-contribution-or-conversion/
Agree if there is infinite pre-tax space vs infinite Roth space available, then pre-tax is usually the better move during peak earnings years. But often tax advantaged space is limited and additional savings needs to go into taxable. I recently realized that my annual contributions to my portfolio included my employee 403b contribution of $23,500 in pre-tax dollars plus $10,000 in taxable. At a 44% marginal tax rate for federal plus SALT, those contributions cost me the same amount of available dollars today as putting my $23,500 403b contributions entirely as Roth. Comparing the end result of $23,500 pre-tax plus $10,000 in taxable to $23,500 Roth turns out to be a near wash, due both to the tax drag of taxable and the 9% SALT added to the federal capital gains tax in my state. I think it is worth pointing out that the decision is often not “pre-tax vs Roth” but instead “(pre-tax plus taxable) vs Roth “, and that especially in moderate to high SALT, Roth may win.
I’m not sure you’re doing the math quite right, but you’re right that if some of your savings has to go into taxable if you use a tax-deferred account, that means Roth wins even if you contribute and withdraw at the same rate, or even a little lower rate. The Roth vs tax-deferred contribution decision is likely the most complicated financial decision most of us will ever face, as discussed here:
https://www.whitecoatinvestor.com/roth-contribution-or-conversion/