Today, Chris Davin, an engineer and a self-taught master of all things Roth, joins Dr. Jim Dahle on the podcast. For anyone who has ever wanted to get all the way into the Roth weeds, this episode is for you. We talk about Roth IRAs, the Backdoor Roth, the Mega Backdoor Roth, Roth conversions, and what all of those things mean. We discuss how to determine if you should be doing pre- or post-tax contributions and why, and we talk about how your taxes and tax rate should be considered when deciding what kind of contribution to make. We start with a 101-level discussion before moving to a 201-level discussion and then diving into the graduate-level tips and tricks. If you are someone who loves this topic, we really recommend reading the full transcript below.


 

Tax Deferred vs. Roth 101 Explanation 

Before getting into the Roth weeds, Dr. Jim Dahle and Chris Davin wanted to make sure everyone understands the difference between traditional (or tax-deferred) accounts vs. Roth (or tax-free) accounts, and they spent some time on a 101-level discussion. Traditional accounts allow individuals to defer taxes on their earnings until withdrawal during retirement, while Roth accounts require taxes to be paid upfront on contributions but offer tax-free growth and withdrawals later on. Over time, various retirement plans, including 401(k)s and IRAs, have introduced Roth options, giving people more flexibility in choosing their preferred tax structure.

Both Jim and Chris emphasize the benefits of utilizing retirement accounts over taxable brokerage accounts due to tax-deferred growth and favorable asset protection and estate planning benefits. Despite the complexity, they highlight that both traditional and Roth accounts offer advantages compared to taxable alternatives. The discussion then shifts to Roth conversions, which involve transferring funds from a pre-tax account to a Roth account, making the converted amount taxable income for the year. While the process differs between IRAs and workplace plans, there is more flexibility with IRA conversions compared to workplace plans, where rules may vary. Roth conversions can be advantageous during low-income years or early retirement, allowing you to take advantage of lower tax rates and potentially reducing future Required Minimum Distributions (RMDs). Chris cautioned against waiting until the very end of the year to do your conversion, as it can take some time for the conversion to go through.

Jim clarified the difference between Roth conversions and Backdoor Roth IRAs and Mega Backdoor Roth IRAs. These processes involve converting after-tax contributions to avoid additional taxes. The Backdoor Roth IRA provides a way to contribute to a Roth IRA even if you exceed the income limits for direct contributions. The Mega Backdoor Roth is a feature in your 401(k) or 403(b) that allows you to contribute after-tax money to the retirement plan and immediately convert that after-tax money to either the Roth account within the plan or convert that after-tax money to your personal Roth IRA.

More information here: 

Should You Make Roth or Traditional 401(k) Contributions?

 

Understanding Your Tax Rate

Understanding tax rates is crucial for making any informed financial decision, and that is especially true when planning for retirement savings. Jim shared that one of the biggest misconceptions when deciding to do a tax-deferred contribution or a Roth conversion is that somehow the amount of tax you pay matters. In reality, what really matters is the tax rate at the time of contribution compared to the tax rate at the time of withdrawal. Chris expanded on the misconception that you should focus solely on the dollar amount of taxes paid rather than considering the tax rate at different stages of contribution and withdrawal. This oversight ignores the time value of money, where paying taxes today vs. decades later can significantly impact your financial situation. The goal should be to maximize after-tax income during retirement to enhance your overall quality of life.

You need to assess your marginal tax rate, which is more than just your tax bracket. Marginal tax rate refers to the tax rate on a small change in income, considering various factors such as phase-outs of credits and deductions, income sources, and pre-tax savings. These complexities require a lot of analysis, as tax planning involves attempting to predict future tax rates and optimizing contributions accordingly. While all of our crystal balls are cloudy and it is not possible to truly know what our future tax situation will be, we can do our best to make reasonable assumptions. People worry about potential future tax rate increases, but it is also highly probable that lower tax brackets are going to stick around. As long as there are lower brackets that can be filled up with pre-tax withdrawals, there will still be an advantage to saving pre-tax now, even if those rates go up.

More information here: 

Roth vs. Tax-Deferred: The Critical Concept of Filling the Brackets

How Tax Brackets Work for 2024

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Graduate Level Strategy and Misconceptions 

At this point, Jim and Chris dive into the complexities associated with tax implications during retirement, particularly focusing on factors like Income Related Monthly Adjustment Amount (IRMAA) and predicting future marginal tax rates. IRMAA, an additional fee for Medicare premiums linked to income, is often overlooked or misunderstood. Despite not directly appearing on tax returns, its impact parallels that of taxes, affecting your overall financial planning. Understanding IRMAA involves recognizing its tiered structure based on Modified Adjusted Gross Income, with payments increasing as income surpasses certain thresholds. Despite the nuances, adopting an average tax rate approach—typically around 5% for the dense income range subject to IRMAA—can aid in long-term planning.

Predicting future marginal tax rates requires a detailed approach, and Chris recommended creating a mock tax return based on expected income sources in retirement. Key components include pre-tax withdrawals, Social Security benefits, and deductions. Utilizing financial functions like Future Value calculations can estimate pre-tax balances and withdrawals. Considering factors like Social Security phase-ins and deductions enables a more accurate projection of taxable income and, subsequently, future tax rates. While the process may seem daunting, breaking it down into manageable steps makes it doable. By addressing the fundamental components and accounting for potential changes in tax laws, you can make informed decisions regarding pre-tax vs. Roth contributions, optimizing your retirement savings strategy for long-term financial security.

Jim and Chris spend some time addressing misconceptions. One prevalent misconception concerns the comparison between marginal and effective tax rates in retirement planning. Jim emphasizes the importance of considering the blended marginal tax rate when making decisions about contributions and withdrawals from retirement accounts. He again points out the significance of evaluating marginal rates for each dollar contributed or withdrawn.

Another misconception they tackle is the idea that deferring tax payments as long as possible is always advantageous. The math doesn't support this idea. Chris emphasizes that the government ensures it receives its share of taxes, regardless of when they're paid, through mechanisms like Required Minimum Distributions or taxation upon withdrawal by heirs. Aiming for the lowest tax rate, whether through traditional or Roth contributions, is a more prudent approach.

They also dismiss the notion of an optimal ratio of pre-tax to Roth assets for retirement. They argue that there's no universal formula and that the best approach depends on individual circumstances. For instance, someone with a high current tax rate and a shorter time horizon to retirement may benefit more from pre-tax contributions, while those with substantial pensions might find Roth contributions more advantageous. They emphasize the importance of analyzing each situation individually to determine the most beneficial savings strategy.

If this all feels like a bit too much to track, just remember this rule of thumb: in anything other than your peak earnings years, you should make Roth contributions, and in your peak earnings years, you should make tax-deferred contributions. If you have a financial plan that you are sticking to and if you are saving a high enough percentage of your income, you really don't need to worry too much about Roth vs. tax deferred. You do the best you can. Make some reasonable assumptions and then don't worry about it.

 

If you want to get a lot more in depth about all things tax-deferred vs. Roth, see the WCI podcast transcript below. 

 

Milestones to Millionaire

#162 — Ophthalmologist Acquires $50 Million

This doc recently retired after a 40-year career that he loved with a nearly $50 million portfolio. He has been living and preaching the WCI methodology long before WCI existed. He tells us part of his secret to success is to choose where you live wisely and own your own business. He said owning his own surgery center made a massive difference to his happiness and his wealth, because he got to control the way the practice was run, how efficient it was, who worked there, etc. He is a testament of what can happen if you live below your means and invest wisely. He wants us all to remember to find joy in all stages of life and not just live for retirement.

Finance 101: Estate Taxes

Estate planning serves several purposes, like ensuring assets are distributed according to your wishes and avoiding the complexities and costs of probate. Minimizing taxes is another significant aspect for many people. Estate taxes typically don't affect the majority of people, including most within The White Coat Investor community. Currently, the federal estate tax exemption is $13.61 million per individual, doubling for married couples. However, assets exceeding this threshold are subject to a hefty 40% tax rate. To mitigate this, people often employ strategies like gifting assets during their lifetime, utilizing the annual gift tax exclusion of $18,000 per recipient, or directing funds toward charitable giving—which doesn't count toward the taxable estate.

One notable method is the Spousal Lifetime Access Trust (SLAT), which provides both asset protection and tax benefits. Assets transferred to a SLAT, either as gifts or in exchange for a promissory note, grow outside of the estate, avoiding estate taxes on the appreciation. Over time, this can significantly reduce or eliminate potential estate tax liabilities. It is crucial to implement this kind of strategy early to maximize the effectiveness.

It is also very important to consider future changes in estate tax laws. Starting in 2026, the federal estate tax exemption is set to decrease, which will potentially impact your estate planning strategies. While estate taxes may seem a distant concern for many, understanding these principles sheds light on advanced financial planning strategies and the importance of tailored estate plans, even for those not immediately affected by current estate tax thresholds.

 

To learn more about estate taxes, read the Milestones to Millionaire transcript below.


 

Today’s episode is brought to you by SoFi, helping medical professionals like us bank, borrow, and invest to achieve financial wellness. SoFi offers up to 4.6% APY on its savings accounts, as well as an investment platform, financial planning, and student loan refinancing featuring an exclusive rate discount for med professionals and $100 a month payments for residents. Check out all that SoFi offers at whitecoatinvestor.com/Sofi.

Loans originated by SoFi Bank, N.A., NMLS 696891. Advisory services by SoFi Wealth LLC. The brokerage product is offered by SoFi Securities LLC, Member FINRA/SIPC. Investing comes with risk including risk of loss. Additional terms and conditions may apply.

 

WCI Podcast Transcript

Transcription – WCI – 359

INTRODUCTION

This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high-income professionals stop doing dumb things with their money since 2011.

Dr. Jim Dahle:
This is White Coat Investor podcast number 359 – Tax Deferred versus Roth Contributions: A Deep Dive.

Today's episode is brought to you by SoFi, helping medical professionals like us bank, borrow and invest to achieve financial wellness. SoFi offers up to 4.6% APY on their savings accounts, as well as an investment platform, financial planning and student loan refinancing, featuring an exclusive rate discount for med professionals and $100 a month payments for residents. Check out all that SoFi offers at whitecoatinvestor.com/sofi.

Loans are originated by SoFi Bank, N.A. NMLS 696891. Advisory services by SoFi Wealth LLC. The brokerage product is offered by SoFi Securities LLC, member FINRA/SIPC. Investing comes with risk, including risk of loss. Additional terms and conditions may apply.

All right, welcome back to the podcast. I hope you're having a great day today. From our annual survey, I now know that most of you are commuting, but some of you are walking the dog or working out and a few of you are just doing chores. And that's pretty much what you guys do when you listen to the podcast. So I hope you're having a good day doing that. If you had a crummy day, I hope it gets better from here.

And if no one's told you thanks for what you do, let me be the first. Because your work is important. That's why you're in the White Coat Investor community. Because you have a hard job. High income jobs almost always are hard jobs. They're hard because they take a lot of training. They're hard because there's a lot of risk. They're hard because there's often an icky aspect to them. But they all deserve appreciation because when we need somebody in this community, we really need them.

 

QUOTE OF THE DAY

Our quote of the day today comes from Benjamin Franklin who said, “Beware of little expenses. A small leak will sink a great ship.”

All right. Those of you out there who have not yet tried paid surveys as a side gig, you might want to check that out. A lot of White Coat Investors have tried this and had success with it. You can go to whitecoatinvestor.com/physiciansurvey and find our recommended resources there. But you'd be surprised some docs are making tens of thousands of dollars doing these surveys. So, check that out. You can do it maybe not while you're driving commuting, but if commute is on a train or something, then it's something you could probably even do while you're listening to this podcast.

All right, our guest today is somebody I was really impressed with. I was impressed with him when he submitted his talk for WCICON. I was impressed with him when he gave his talk at WCICON. I was impressed with him when he corrected something I did wrong in my talk at WCICON and I was super impressed with him when we recorded this interview.

 

INTERVIEW: CHRIS DAVIN

Chris Davin is going to be a force, I think, in the online personal finance community, and I think you're going to enjoy this interview with him. We get into the nitty gritty in this interview. We're going to start really basic. But we're going to ramp it up pretty quickly and get to some pretty complex topics. But even if we lose you at some point in this podcast, hang on, as we get down to the rules of thumb and the general things you need to know, even if we lost you halfway through the podcast, stick around to the end and we will talk about those things.

Our guest today on the White Coat Investor podcast is Chris Davin. Thanks Chris for being with us.

Chris Davin:
Thank you very much for having me.

Dr. Jim Dahle:
All right, for those who are not aware, Chris was a speaker at the Physician Wellness and Financial Literacy conference this year and did a fantastic job. I was super impressed with this talk and I said, “Man, we've got to get that guy on the podcast and talk about this subject to a much larger audience.” You had a pretty packed room in there, but even so, that was probably only 250 or 300 people. And there'll be 30,000 plus listening to this podcast. So, we're going to get this message out there a little bit more.

But I'm not sure anybody out there listening actually knows who you are. So, why don't we start? You're not a doctor, yet, you've spoken at WCICON. How did you find yourself in the White Coat Investor community?

Chris Davin:
Yeah. Well, thanks again for having me. It's been a bit of a long journey to get into the personal finance community. I'm an engineer by training and trade. I work full-time for a large engineering company. I think around the mid-2010s was when I really became interested and serious about studying personal finance.

I first became aware of White Coat Investor when I started to date the woman who's now my wife. She'd just started a residency when we met and I remember we went on a ski trip up in Keystone, Colorado with a bunch of her residency classmates.

And I went up there, we rented a big house there to ski for the weekend, and one of the guys who was there was talking about White Coat Investor, and he's saying something about a backdoor Roth IRA and I had no idea what he was talking about. But I knew IRAs and I would contribute to my Roth IRA every year. And I thought, “Oh, this just sounds interesting enough, I should go check it out.”

And I found your blog and read about the backdoor Roth IRA and by serendipity that year was the first year my income had crossed the threshold to contribute directly to a Roth IRA. So, the timing worked out really well. I read the message and, again, I'm coming to this as an engineer, and the methods that you sort of put forth on the blog really resonated with me. I think the very systematic approach reminded me a lot of the approach we use in my profession. You're not recommending anything crazy, but it's just very straightforward and well thought out standard financial advice for people.

And I believed in the message, as well. I think that's another thing is that when I was younger, I had had several interactions with financial professionals who were more of the salesman variety. And I had some recommendations made to me that were not going to be the best. And in hindsight were really just trying to get commission. The overall message of trying to connect people with the good guys in the financial industry, that also really resonated with me.

I'm still an engineer. I ended up marrying my wife and, as our relationship got more serious, we got married and now we have a couple kids. I took it more seriously. And now I'm out to the point where I prepare all of our taxes and I'm active in the online financial community. Yeah, it's become a hobby. But your blog is the one that got me started on it, and it's one that I still read regularly whenever I have time, which these days isn't that often.

Dr. Jim Dahle:
Yeah, pretty awesome. It's true what you say, though. This whole saving up for retirement thing is really an engineering problem.

Chris Davin:
Yeah.

Dr. Jim Dahle:
So, an engineering approach is really the right approach to take to it. I'm not surprised that lots of engineers gravitate toward this process and get into it and love to dive into the spreadsheets and probably get too far into it most of the time, which is what we're going to try to do today. I think we're really going to go deep today.

Chris Davin:
I may be guilty of that. I'll let your readers be the judge.

Dr. Jim Dahle:
Yeah. Well, awesome. We'll get there gradually, so hopefully we don't lose anybody at the beginning anyway. But we had something like 250 presentations this year for WCICON that were submitted. And it was a really competitive process. We took less than 50 and your presentation was chosen. I'm curious why you decided to apply to be a speaker and how you chose your subject when you did apply.

Chris Davin:
Yeah. Why did I choose to apply in general? Well, I'm a regular listener of your podcast and you mention the conference quite a bit. One of the things I enjoy in general, if it's online or with friends and family, is helping people once you learn it and understand it. At least for me, and I think this is also true for you. I think you've mentioned talking about it before. You have this feeling like, “I've got to go share this with the world. This is so useful. Oh, if only I had known this back when I was younger, then I would've been able to make these better decisions.”

I'm interested in it. I feel like at least this piece I understand pretty well, and I want to share that message with people and help other people out. That's really a big part of the reason why I chose to apply. And then of course, there's the fact that I've been a long time reader of the blog and listener of the podcast, and it got me started. So I have a little bit of a special relationship with WCI for that reason.

And then the subject, there are a variety of reasons that I've really studied it quite a bit. I have tried to solve this problem, and I say problem, answer this question in my personal life because in our family, we're teetering right on the edge of whether pre-tax or Roth is the best option. And I decided, “Well, let me see if I can take a math approach to this and start from first principles and work it out.” And I came up with this method that I use, and there's a lot of rules of thumb out there, which are good, certainly, but it's a very difficult problem. I think that's one of the things I really like about it. It's almost fun for me to tackle it, which is that it's very complicated. There's a lot of factors in it that have a lot of uncertainty, your future investment performance, your future tax rates. Who can predict these things?

But if you take this complex problem and you break it down into a bunch of smaller pieces, then you can solve those pieces, or at least a lot of them, individually, and that's easier. And then the ones that you can't solve, you can take a reasonable guess at, “Hey, let's just assume tax rates are going to stay the same.” And then at the end, you can pull it all back together, and then you get an answer. And that's the way that I've done it in my own financial life.

And then that general method of breaking a complex problem down, solving it as all these little piece-wise, solving it in pieces and then putting it back together. That's a very common method for dealing with these problems. And it's one that I thought would be a valuable subject for a talk.

Dr. Jim Dahle:
Yeah, for sure. For those who haven't figured it out yet, we're talking about deciding whether you're going to do Roth contributions or tax deferred contributions. It's really a very similar decision to whether to do Roth conversions, as well. But there aren't a lot of people on the planet who have thought about this more deeply than I have, and one of those is Chris. And so, I was very impressed sitting there in his presentation. I'm like, “Wow, he's put a lot of time into this, spent a lot of time on assumptions, understands what's actually going on, and I think has made a few breakthroughs in it that ought to be shared with the world, quite honestly.” And so, this is the best way I know how to do that.

Chris Davin:
Well, thank you.

Dr. Jim Dahle:
Now we're going to get into the weeds today. There's no doubt about it. We're here on the WCI podcast to start with, and my guest is an engineer. We're going into the weeds, there's no doubt about it. But before we do so I want to make sure we cover all the basics, too. Chris, can you start by just explaining the difference between a traditional or tax-deferred retirement account and a Roth or tax-free retirement account?

Chris Davin:
Sure. Yeah. The two terms I think are interchangeable, either traditional, tax-deferred or pre-tax. Those are all three terms for basically the same thing, which is that when you earn money, and you have to have earned income, when you earn money, you can avoid paying tax on it in the year that you earn it. And instead of paying tax on it and then having it come out into your checking account, it can go into a retirement account, where it will then grow tax-deferred for decades, potentially. And then when you are ready to retire, you can withdraw that money and when it comes out, it counts as taxable income.

The reason it's called traditional is because this was the original type of retirement account. This was the 401(k). And there's a lot of benefits to it. Most people, most of the time, are going to have a higher tax rate when they're working than when they're retired. This is sort of the standard or default choice, and it's the one that's been around the longest.

The opposite of that is the Roth account, and sometimes people do call that tax-free. The contributions that you make go in as after-tax dollars. Even though you contribute it, you're still taxed on that money and you have to pay tax on your tax return. But once it goes into a Roth account, then it will grow tax-free. Then when you withdraw it, as long as you meet the eligibility requirements, like being over 59 and a half, and I think having an account for five years, there's several five year rules, but that's one of them. Then when you withdraw the money, it's tax free. It's really this choice between “Do I want to pay taxes now?” and that would be the Roth option, or “Do I want to wait and pay taxes later?” and that's the traditional option.

And most flavors of retirement accounts now have a Roth option. Originally it was the Roth IRA. Then, I looked it up, the Roth 401(k) started in like 2006, and then there's Roth versions of 403(b)s, 457s. And now with the Secure Act 2.0, there's a Roth SEP IRA. So, a lot of different retirement accounts now have a Roth option. So, most people are going to have a choice of which tax structure that they want to choose.

Dr. Jim Dahle:
Yeah, and I think it's important, too, at this point to point out that both of these are excellent things. Comparing these to a regular non-qualified taxable brokerage account, they're both better. Because your money grows without you having to pay taxes as it grows. You're not paying taxes every time your investment pays a dividend. You're not paying taxes every time you buy and sell something inside the account.

Plus, in just about every state, these retirement accounts get an incredible amount of asset protection. You can declare bankruptcy and still get to keep what's in your retirement accounts. Plus there's all these great estate planning benefits. They can be stretched by your heirs for up to 10 years. You can just designate beneficiaries and avoid probate. There's all these great reasons to use retirement accounts. So, don't let the fear of not being able to choose the right one to use keep you from using one of them, because they're both almost always going to be better than using just a regular taxable account. So, keep that in mind as we're talking about these.

Chris Davin:
Yeah, I completely agree.

Dr. Jim Dahle:
The next basic we have to cover before we get into the weeds here is we need to talk about a Roth conversion. Can you explain what a Roth conversion is, how one might do one, and why one might want to do one?

Chris Davin:
Sure. Yeah. A Roth conversion is whenever you move money from a pre-tax account to a Roth account. Generally speaking, that amount that you move becomes taxable income in that year. I think it's worth thinking about this in terms of IRAs and then workplace plans because the rules of how these work, the finer points are different between the two.

If you have pre-tax money in an IRA, you can move it into a Roth IRA at any time. There's no restrictions on income, there's no restrictions that the plan is going to put on you. You basically have an unlimited ability to convert to Roth.

For a workplace plan, it can get a little bit more complicated. Let's say you have $100,000 in a pre-tax 401(k). If you're continuing to work, then there is only an option to convert that to Roth if the plan allows it. Usually the two choices are, you can either do an in-plan Roth rollover, which is you move it within the workplace plan from the pre-tax account to the Roth account, and then they send you a 1099. Or you could do a rollover into a Roth IRA that's outside of the plan.

Those are usually the two choices. But if you're working, a workplace plan does not have to allow either of those two. It can get a little more complicated if you want to do Roth conversions and you're working and all of your pre-tax money is within a workplace plan like a 401(k).

Now that said, you do have some options when you separate from that employer, and that's usually a more common time when people want to do Roth conversions, is when they're leaving a job. If you're between jobs, you have a period of unemployment in between, your income is going to be lower that year, that may be a time to do Roth conversions, and then you can take some of that money out. But generally speaking, that's what a Roth conversion is.

How do you do one? Well, the short answer is you contact the firm that's holding the money and you can ask them. And most firms now, whether they're IRAs or 401(k)s, they usually have, at most, a form you have to fill out and send in. A lot of times you can just do it online. They have an online form.

One caution that I would share is that if you're going to do Roth conversions toward the end of the year, which that's a really common time for people to do them, you have a really good idea of what your taxable income is going to be and you've gotten the tax-deferred growth for as long as possible.

Just be careful about doing it in the last couple weeks of the year because a lot of brokerages are inundated with withdrawal requests and there have been stories of people trying to put in a conversion request on the 29th of December and it goes through the next tax year. You want to give it at least a week or two.

And then also add in if you have to sell some investments, if you've got money in mutual funds, you want to leave a couple days to be able to put the sale in, to have the order go through, get the cash in the account, and then to convert the cash. That's generally what it is and how to do one.

So, why would you want to do this? Well, a Roth conversion is a really powerful tool that lets you basically take advantage of a low tax rate any year that you might have one, as long as you have pre-tax money. Again, this could be if you are switching jobs and you have unemployment or if you're taking time off for any reason. Or if you're even moving to a lower tax state and you decide that the tax rates are favorable and you want to do some conversions to avoid the state taxes that you might pay later, there's a thousand reasons why you might want to do them. But Roth conversions are a way to take advantage of a low tax rate whenever you have one.

And if you sort of think about the big picture, we have a progressive tax system in this country. There are exceptions to this, but generally speaking, as your income goes up, your tax rate goes up. The Roth conversion lets you balance that out over your whole lifetime. Between the time you're working, any time you have off, early retirement, later retirement, you can use Roth conversions to fill up lower brackets in any of those years that you might have them.

Usually the typical times that people will convert are, as I mentioned, if you have a low income year. That's a good time to check to see if it's worth doing. A caution on that, though, is that low income does not always equal low tax rates. There are a bunch of tax credits that can apply if your income drops, earned income tax credit, savers credit, things like that. You want to actually check and make sure your low income is giving you a low tax rate where the Roth conversion is going to be favorable. But that's a common thing that people do throughout their career to take advantage of any of those lower income, low tax years.

And then the other time is an early retirement. The general standard advice, which is one that I subscribe to, is unless you have health issues or if there're other uncommon situations, you probably want to take Social Security at 70. If you retire, let's say, at 65 and you're taking social security at 70 and you don't need that full withdrawal to live on to fill up all your lower brackets, you can do some Roth conversions in early retirement to fill up the lower brackets that are available to you and then that will reduce your RMDs later. And then if you're able to convert at a similar rate or a lower rate than what you expect to pay in the future, then you're going to come out ahead by doing that.

Dr. Jim Dahle:
And let's define RMDs as well. RMDs are required minimum distributions. This is the money you're required to take out of a pre-tax account starting, for most people listening to this, starting at age 75. So, if you don't have money in pre-tax accounts, you don't have to take RMDs out of them. That's another advantage of Roth conversions.

I think it's important to distinguish this, too, because a lot of people get confused between a Roth conversion and a backdoor Roth IRA and a mega backdoor Roth IRA. Now one of the steps in the backdoor Roth IRA process and the mega backdoor Roth IRA process is a Roth conversion. But the first step in each of those is making contributions that you don't get a deduction for.

And so, the cool thing about the conversion in those two processes is that you get a tax-free conversion. It doesn't cost you any taxes when you do the conversion step. Most of the time when you're doing a Roth conversion, you're converting pre-tax money, money that you are going to have to pay taxes on when you do the conversion. But in those two processes, the backdoor Roth IRA, which you do in an IRA, and the mega backdoor Roth IRA, which is probably misnamed because you do it usually in a 401(k) or a 403(b), you are not converting that pre-tax money. You're converting after-tax money and there's no tax cost to that.

So, it's important to distinguish those things. I have a lot of people email me and talk about backdooring things, but what they really mean is doing a Roth conversion. These are all separate terms. And part of financial literacy is learning the terminology and being precise when you use it. So, hopefully we can help you with that today.

All right, I think we need to talk about probably the most important thing before we really get into the nitty gritty here: tax rates. Because that's what really matters. One of the biggest misconceptions out there, when you're deciding to do a Roth or a tax deferred contribution, or when you're deciding whether to do a Roth conversion, is that somehow the amount of tax that you pay matters. People say you should pay on the seed and not on the full grown tree or not on the harvest. But in reality what really matters is the tax rate at the time of contribution compared to the tax rate at the time of withdrawal. How can we help people to better conceptualize this? Because this is probably the biggest misconception out there about this.

Chris Davin:
Yeah, I'd agree with that. The problem with just looking at dollars is that it ignores the time value of money. If you pay $10,000 in tax today versus paying it 40 years from now when you're retired in your 80s or whatnot, those are very different expenses. One of those is much better than the other for you. So yeah, it is a mistake to think about it in terms of just dollars. I would say in the big picture what we really want to maximize is our after-tax income, the after-tax value of our accounts when we're retired. That's what essentially you're going to live off of. And we try to maximize that because that's going to give us the biggest quality of life when we're in retirement.

The way to do that is by looking at the tax rate. It doesn't actually matter really whether you pay a fixed percent today or whether you are retired or anywhere in between. The timing of it, if it's just a fixed percent tax that you pay, doesn't matter.

The way to get the most money when you're retired is to find the time between now and then when you're retired, where you're going to pay that lowest rate. And that might be today. If it's a very low income year for you, you can make a Roth contribution today, pay the taxes now and then never again. Or maybe you do pre-tax now and then you are expecting to have lower income years in the future where you might be able to do a Roth conversion, pay the taxes then. Or maybe the best time is to just wait and pay the taxes when you're retired, if that's going to be your lowest rate.

You want to, as best as you can, try to think about what your whole lifetime tax situation is going to be, and then choose the time that you think is going to be the lowest rate and that will get you the most income when you're retired.

Dr. Jim Dahle:
All right. As a general rule, people are tax illiterate. They don't understand how taxes work. They don't understand the tax code. It is complicated. It's how many inches of pages in a book is the tax code and nobody can read the tax code because it's written in accountant speak. But people need to understand their marginal tax rate. And it's not just your tax bracket, is it? Your marginal tax rate is more than your tax bracket. Can you explain why that is?

Chris Davin:
Sure, yeah. Well, there's a couple terms we piece apart there. One of which is marginal. Marginal in economic speak means just a small amount of money or a small change. For instance, if you earn $100,000 a year, your marginal tax rate is not the total tax you pay on that $100,000. That's going to be like an average tax rate or something. And maybe that's useful for budget planning or something.

But when we're making these decisions, we really care about the tax rate on a change of income. Because that's what we're talking about. If you have $100,000 and you contribute $10,000 to a retirement account, we care about the tax rate that you pay on that $10,000 or whatever the number is.

Marginal means on a small amount of income, but the tax rate is a composite of all kinds of effects that come on, as you say, from this very complicated tax code. We think about it in terms of tax brackets. And some people, their tax bracket is their marginal tax rate, but there's a lot of other reasons why someone's actual tax rate may be different from their tax bracket.

I can think of some examples such as the phase out of the child tax credit. The child tax credit is $2,000 per dependent child you have. And then there is an income component to that. As your income increases above a threshold, the government starts to take back some of that credit. And the loss of that credit is really equivalent to paying a higher rate on your income.

There can be other examples, too. We'll talk about IRMA in a little bit, but there's phase-ins of different kinds of income. There's phaseouts of credits. There's all these complicated effects and there's probably a list of at least a dozen of them that are relatively common that will affect people's tax rates.

Money is fungible. If you're thinking about it, your total tax rate and everything that contributes to that, it doesn't really matter whether you're losing a dollar of credit or you're paying a dollar on your tax bracket scale. Those are really the same thing. This is really something that you need to measure with software. It's not something that you can just sketch out by hand. For instance, if you do your tax taxes with TurboTax, you can go in and, let's say, increase your income by $10,000 and then $20,000 and $30,000 and you can write down those numbers and you can see what the total impact of the taxes that you owe is. And most likely it's not going to be just your tax bracket.

Dr. Jim Dahle:
Yeah. Particularly in those middle tax brackets where so many of these phaseouts live, lower to middle ones. Once you're in the top tax bracket, there aren't very many phaseouts that affect you, but if you're in the middle ones and you're in the lower ones, there are lots of these phaseouts of credits and deductions and so on and so forth that can really have quite an effect making your tax rate very different from what your tax bracket might be. But basically, yeah, it's your rate at the margin. That's the way to think about that.

Chris Davin:
Yes.

Dr. Jim Dahle:
Okay. Everybody thinks tax rates are going up. “They have to go up. The government is spending so much money running these deficits, we have huge debt.” Tax rates are going to go up, so they say, “Oh, you have to do Roth because rates are going to be higher in the future.” Can you explain why an increase in the general tax rates might not matter as much as people think it does when it comes to these sorts of decisions?

Chris Davin:
Yeah. This is one of the very hard components of this question, which is “What are tax rates going to be in the future?” Obviously, that matters a lot. I think it's fair to say that most likely if there are changes in the tax code, there are still going to be these lower brackets and lower tax bases that you could fill up with a relatively small amount of income.

It's possible the government could eliminate that. I don't think that's likely at all. I guess if we go to a complete flat tax with no deduction, no standard deduction at all, that could be the case, but I think that's pretty unlikely. I think what's more likely to happen is that the rates on some of the brackets will go up or down, which is really what we saw in the Tax Cuts and Jobs Act that was passed in 2017 and became effective in 2018, where, for instance, the top tax bracket went down from 39.6% to 37%.

But as long as there are going to be these lower brackets that you can fill up with pre-tax withdrawals, there will still be an advantage to saving pre-tax now and having enough so that when you are withdrawing your reasonable percentage of that, I usually say 4%, that's sort of a standard withdrawal rate. If you're carrying a pre-tax balance into retirement and 4% of that is enough to fill up those lower brackets, then you've still gotten an advantage from saving pre-tax now, even if those rates go up.

Now, I will caveat that, though, which is that you have to think of it in terms of what your pre-tax balance is likely to be. For instance, in my talk, I gave an example of a couple in their 40s, they had already saved like $1.5 million of pre-tax money. That one and a half million is going to grow between your 40s and your 60s when you retire. Assume this couple is going to retire in their 60s.

And that was going to grow enough at a reasonable rate of return where that was already going to fill up those low tax brackets. If you're already ahead of the curve on your pre-tax savings, any additional savings that you would do is going to come in on top of the savings that you already have combined with the growth that you expect to get on that, between now and whenever you are going to withdraw it.

It is very likely that there will still be lower rate tax brackets in the future, but whether those are going to be available to you or whether your plan has already filled those up, and then now you're considering putting money that's going to stack on top of those, that depends on your individual situation and that's something that you really have to run the numbers to figure out.

Dr. Jim Dahle:
Yeah, there's other ways to fill up those brackets, too. Maybe you have a bunch of rental income from some real estate empire you've built, or maybe you have a pension coming, and social security can start filling up some of those, as well. So, lots of ways to fill those up.

Chris Davin:
That's right. Yeah.

Dr. Jim Dahle:
Okay. At this point I think we've run the gamut of the basic topics here and we're now moving into intermediate range. This stuff is starting to get a little bit more complicated. So, those of you that are just barely hanging on, do your best here to hang on to the rest of this discussion, but know that we're about to step it up a little bit, talk about some things that are a little bit more complicated here.

Now in most discussions of Roth versus tax deferred, including those I've done over the years, a number of blog posts we've talked about on this podcast before, I've talked about it in presentations. But people focus on the various qualitative factors that should make you lean one way or the other. This makes it more likely that you want to do Roth or this makes it more likely that you want to do pre-tax.

And what I loved about your WCICON talk is that you went one step beyond that. You actually tried to quantify all of this, but before we get into quantifying it all, which is when we move to the advanced portion of this podcast, let's talk about those factors. And there's probably a dozen or more of them. But can we talk about some of those and why they would make someone lean one way or the other toward Roth or toward tax deferred contributions?

Chris Davin:
Yeah, sure. We can talk about a few of those. Just by virtue of the way the tax code is written, there are some asymmetries in whether you should go pre-tax or Roth. Certain accounts have certain advantages that the other one doesn't.

Just to give an example, pre-tax money can be converted to Roth at a later time, at an opportunistic time. And there's no way to go backwards on that. Once you convert to Roth, that's it. There's no way to take money from Roth, move it into pre-tax and get a deduction; that's not allowed.

The future is uncertain, and it always is, to some degree. Then having a little bit of extra money in pre-tax I think is a good idea because it will give you some dry powder that you can use to capitalize on any opportunities to do Roth conversions at a lower rate in the future. And it could even be half a year in between jobs or a move or things like that, where you might have that advantage and that's not an advantage for Roth. That would be one example.

Another one would be RMDs, as we mentioned, required minimum distributions. Roth accounts do not have RMDs and pre-tax accounts do. If you're in the situation where you're expecting to have really large RMDs, more than you would spend, and what you expect to do is to reinvest some of that RMD in a taxable account where then it's going to have that tax drag and capital gains tax and tax on dividends, while it grows for potentially decades in your retirement, then I think it's good to lean a little bit more toward Roth.

Another thing is that if you're doing estate planning, there can be some significant estate planning benefits to one or the other. I don't think there's really a clear winner for estate planning. It just depends on your situation. If you're giving a lot of money to charity, pre-tax money is great because you avoid the taxes and the charity does, too. If you're leaving money to low income or lower tax rate heirs, then doing pre-tax is good. If you're leaving money to higher tax rate heirs, Roth is good. And there can be other special situations where you would want to do one or the other, if you're leaving money into trusts or if you have someone who has a need to keep their taxable income down because they're getting benefits of some kind that are income dependent.

Dr. Jim Dahle:
Like a disabled kid trying to qualify for Medicaid or who has an ABLE account, that sort of a thing.

Chris Davin:
Yeah, yeah. Exactly right. If you have somebody on some sort of assistance that would be phased out by income, that would be something that you'd want to do. Early retirement I think is another one worth talking about. If you're going to retire early, the tax code favors pre-tax savings because when you take money out of pre-tax early, you pay taxes on it, but you don't pay any penalties. If you try to do that with Roth, then the tax code will still tax you on the growth of that that you take out when you're younger than age 59 and a half. That's sort of a disadvantage.

I think especially in early retirement, there are other reasons why pre-tax is probably the best. Usually someone who's saving for an early retirement, they probably have relatively speaking a higher income when they're working and a lower income when they're retired just because they have to stretch that savings for more decades. Those things all tend to favor pre-tax. So, pre-tax is a standard suggestion if you're looking for an early retirement.

And then I think another one that is worth mentioning is this, contributing the maximum effect. Roth has an advantage because the dollars that you contribute into a Roth account are actually worth more than in a pre-tax account. For instance, the standard elective deferral limit if you're under age 50 in 2024 is $23,000. So, if you're contributing to Roth, you get to put effectively more of your own money into that account because you get to keep 100% of those dollars. Whereas if you contribute $23,000 pre-tax, the government owns a piece of those at some point. They're going to come and take it in the form of tax when you withdraw it.

So, you're able to get more money into the retirement account, you're able to get more tax protected growth for longer. And over a longer period of time that can actually make a difference in the value of your account. That would be a reason to lean toward Roth if you're contributing to maximum.

Dr. Jim Dahle:
Yeah. Another difference in the estate planning you mentioned is that you're allowed to stretch an IRA over 10 years, but it sure is a whole lot better to be able to not have to spread out the tax withdrawals from that from an inherited IRA over multiple years. You can just take out the minimum where you're required to take out each of the first nine years and then take it all out in the 10th year. If it's Roth, that's almost always going to be the right way to do it unless you need the money. But that's not necessarily the right way to do it if you have pre-tax money in that inherited IRA. And so, people might want to spread that out over more years and thus they end up with fewer years of tax protected growth in that stretch IRA period.

So, there's just all kinds of these. Another one is, you alluded to it earlier, it's what I call the super saver effect. If you're saving so much money that you're going to be in the same bracket in retirement or an even higher bracket, that's obviously going to make you want to lean toward Roth. These people, I meet them all the time. They've got a 45% savings rate and they're planning to work until they're 70. These are not people that pre-tax is going to favor. You've already filled up all those brackets many years ago, essentially, and you want to now favor Roth accounts.

I've even seen something when I did my asset protection book and looked at the asset protection laws for all 50 states. There's at least one state out there that protects IRAs in bankruptcy and doesn't protect Roth IRAs in bankruptcy.

Chris Davin:
Oh wow.

Dr. Jim Dahle:
There's all these little tiny things that can make you lean one way or lean another. Some of them are bigger than others and it can sometimes be difficult to quantify them. But I think one of those that you mentioned is a really big one that we really need to hone in on and focus on.

And that's the idea, and it's really unfair actually, that the contribution limits are the same for a Roth 401(k) as they are for a tax deferred 401(k). That's really not fair. You're putting more money into a Roth 401(k) than you are into a tax deferred 401(k) just because it's more after tax money and that's really the only money that matters. And so, you have to invest.

Now, if you're going to invest more to make these equal, if you've maxed them out, it's going to have to go in that taxable account where it won't grow as quickly because it's being taxed as it grows. It has that tax drag on it as you're growing. You really need to be aware of that because that can be a fairly big deal, can't it?

Chris Davin:
Yeah. One way to analyze that is to look at what your breakeven future tax rate would have to be to make a traditional and a Roth account equal.

Dr. Jim Dahle:
This is assuming you're maxing them out, of course. This isn't putting $10,000 of either one into a 401(k). This is maximum amount so you have to put additional savings into a taxable account to make them equal.

Chris Davin:
That's right. Yeah. And the amount that you put in the taxable account to equalize them is just the tax that you save by making that pre-tax contribution. Because that's the difference. And then you can calculate the value of those accounts as they go forward and you have to account for the tax drag and the change in basis of the taxable account. But there are formulas where you can do that, and then you can look at the future value and then you can find that break even point.

The simple case that we've been talking about, if you're not contributing the maximum is if you can contribute, let's say at 32% now, your break even in the future is 32%. If you're going to pay less than 32% in the future, you do pre-tax. If you're going to pay more, then you do Roth.

But that number, if you're contributing the maximum, it creeps down over time. In the talk, I presented a few cases, but I think for instance, for the 37% bracket, after 10 years, that break even drops down to 32%. And then at 20 years it's 29%, and then at 30 years it's 27%, and at 40 years it's 25%.

So, if you're in the 37% bracket now, and let's say you expect 40 years later, you're going to be in the 32% bracket, and if you didn't include this effect, you'd think that contributing pre-tax was the right way to go. But that's actually not true because you're going to lose more in the dividend tax and the capital gains of the taxable money than you're going to save on the tax rate arbitrage.

Only if you would be in the 24% or lower when you're retired should you then do pre-tax. But if you're going to be anywhere above, again, this is for 40 years, so this is a long time horizon, but if you're predicting you're going to be any higher than 25%, you should still do Roth even if you're at 37% today.

Dr. Jim Dahle:
All right. Well, we have now left Roth versus tax deferred 101. We have now left Roth versus tax deferred 201. We've now moved to the graduate level here and we're going to start talking about quantifying some of these factors here.

One of the recommendations in your talk that I thought was really interesting was for how to deal with IRMA. And for those who aren't aware of what IRMA is, IRMA is basically an additional fee you have to pay for your Medicare. It stands for Income Related Monthly Adjustment amount, IRMA.

Basically, if you have a high income, you have to pay more for Medicare in retirement. It's not all that dissimilar from the subsidy that you get when you buy an Obamacare health insurance policy on the exchange. That's kind of a progressive price structure that happens before age 65, and IRMA is a progressive pricing structure to healthcare insurance, for lack of a better word, that happens after 65.

But you gave a really interesting recommendation, I thought, which I had never heard before. And I think you came up with it on your own. It sounds right to me. But you talked about how to deal with IRMA both in the mid- to long range as well as in the short term range. Can you talk a little bit about that?

Chris Davin:
Yeah, let me just talk a little bit about what IRMA is first just to make sure that it's clear. As you mentioned, it's an extra premium that you pay on your Medicare premium starting at age 65. But there're some quirks about it that make it a little difficult to plan for. I will say it is technically not a tax, this is not something that appears on your form 1040. It doesn't go on your tax return. But it is strongly dependent on income and it behaves like a tax, again, going back to the concept we talked about earlier of your marginal tax rate.

This is an example of something that is not on your tax return that I would actually include in your overall marginal tax rate because it behaves exactly the same way. And again, a dollar in IRMA premiums that you would pay is no different than a dollar of extra tax on your 1040 or a dollar of a lost tax credit.

The way IRMA works, there's a two year delay. The IRMA that you would pay, if you're over 65 in 2024, is a function of your 2022 modified adjusted gross income. This is your income two years earlier, and because it's your adjusted gross income, this is before any of your below the line deductions. This is before your Schedule A deduction, your standard deduction. If you're still earning and running a business, your 1099-A deduction. This is basically your adjusted gross income. And the first tier starts at, for single filers it's $103,000, and for married filers it's $206,000. It's double that.

And then once you cross that threshold, you're going to pay about an extra $1,000 per person over the year in Medicare premium. And then there are additional tiers. There's one at $129,000, $161,000 and $193,000 for single, and then double those, $258,000, $322,000 and $386,000 for married joint filers. And then, of course, if you're married filing joint, then you're going to pay double that because you have two people. So, those are going to increase.

And this is something that is a little bit misunderstood and that's why I wanted to mention it in the talk. I've seen misunderstandings go both ways for this. Some people just choose to ignore it, which I don't think is the right thing to do because they say, “Well, if you're between any of these tiers, then effectively your marginal tax rate is zero when you're moving in between any of those tiers. But when you cross into the next one, you pay the full price for that new tier.”

Technically speaking, if you're making small changes in income, it's not affecting your tax rate, but over a wider range of income, it does affect it. What I presented in the talk is it's about 5%. If you look at the four tiers there that are between this, either $100,000 and $200,000 income for a single or $200,000 to $400,000 married, the first one is about $1,000, and then it's about $1,500 for the next three. That's about $5,500 that you pay over a range of income of about $100,000. That works out to be just about 5%.

My suggestion, what I suggested in the talk and what I've suggested to other people, is that if you expect to be in this IRMA range, and probably a lot of your listeners are going to be, this is sort of a very common range for a high income professional, what their taxable income is going to be when they're retired, then you should include the fact that you're going to be moving through these tiers and paying this average sort of tax rate of about 5%.

Now, I have also seen misunderstandings go the other way and people say, “Oh my goodness, this is something I should absolutely avoid. And then I'm just going to do tons of Roth conversions in my account and get my pre-tax account so I don't have to deal with IRMA.” I don't think that's the right answer either. If you're doing Roth conversions at 30, 40, 50%, that's probably a lot more of an overall tax rate than you're going to pay just by paying some IRMA. But that was the standard recommendation.

Now, if you go above that range, there's actually one more IRMA tier and it's really small. It's about $500 per person. That's for single. It's $500,000 per year of income and it's $750,000 for married joint filers. But that one I think is worth ignoring. It's so high up and the price is much smaller than the other tier. That one you can sort of ignore. But this most dense range of income is, yeah, between $100,000 and $200,000 single and $200,000 to $400,000 married. I think it's worth treating it like a tax and adding in the appropriate tax rate, which represents the average tax cost for this, which is about 5%.

Now, if you're doing very short range planning, for instance, if you're already retired and you're trying to decide how much to Roth convert, then you can do a little more tactical planning and say, “Okay, well, I want to come in just under one of these spikes.” And there's some difficulty in that, too, because there's this two year delay.

So, you don’t know, when you're doing a Roth conversion this year, what the thresholds are going to be because the government hasn't come up with the inflation indexes for the next two years yet. If you want to wait until the end of the year, I think they're usually published for the next year around October or November. If you're doing a Roth conversion in December, you can have half the data that you would want, but you still don't know what the inflation adjustments are going to be for the second year. You have to take a guess at that. And then you can use that.

But usually if you're trying to tune your income that way and you're doing it in the two or three year time range, then you can try to come in just under one of those tiers. But for long range planning, there's not enough info, or I should say there's too much uncertainty in all the variables. So, you just take your best guess, assume you're going to be in that range and add 5% if you are. That's the way that I do it.

Dr. Jim Dahle:
Yeah, the tricky part about it is you can't use tax software for this. You've got to do this manually because it's not a tax. And so, you've first got to use the tax software to figure out what your marginal tax rate is, and then you've got to add this to it. You've got to have this manual process on top of an automatic one. So, it's particularly challenging there.

Chris Davin:
There is a piece of tax software that is available for free that will include IRMA, and if you go on Bogleheads, it's called the Personal Finance Toolbox. It's basically a huge spreadsheet that somebody over on the Mr. Money Mustache forums came up with, and it will fold in the effective IRMA. If you put in your age, and if your age is within the range where you're going to be paying Medicare premiums, it will tack that on and it will fold that into your future tax rate. So, that can be a nice shortcut for people who are trying to see if this is going to be an issue for them.

Dr. Jim Dahle:
Very cool. Thank you for sharing that. All right, the next part of this does not lend itself very well to a podcast. This would be much easier for you if you were able to show people slides in a presentation, if this were a blog post sort of format or a forum format. But we're going to do the best we can with this particular format. Everybody loves podcasts because you can listen to them while you're working out or while you're on your way to work or whatever, but it does have some limitations, and a complicated discussion like this I think is one of the limitations. But as best you can, can you explain to us your method to predict your future marginal tax rate?

Chris Davin:
Yeah. In a nutshell, what I suggest to people is to prepare a mock tax return for what you expect your tax return to look like when you're retired as best as you can. Again, I don't suggest making assumptions about huge changes in tax law. I really suggest keeping things simple and making the minimum number of assumptions that you can. But if you look at your tax return, you can see the different categories for income that get taxed and look at each one of those and try to predict what you expect that income is going to be.

For instance, if you're a big real estate investor, you're probably going to have some real estate income and if you're retired, maybe a lot of that is not going to be sheltered by depreciation anymore. Maybe you're going to have a lot of income from that. If you're working in a job where you're going to get a pension, then you could assume you're getting pension income.

The big one that's tuned is the the pre-tax withdrawals, and that's one that you can tackle by just using the standard financial function called Future Value or FV. What I presented in the talk was that you take your current pre-tax balance and you can just look that up by going to all of the different brokers or firms that hold pre-tax money or your workplace plan, your IRA, wherever it may be.

And then assuming some sort of reasonable rate of growth, assuming whatever your future contribution plan is going to be if you're working, you're contributing pre-tax, you can put that in, and then you're going to get a number for what your pre-tax balance is going to be when you're retired. And then you can take a reasonable withdrawal rate of that, like 4%, and then that will be what your pre-tax withdrawals are going to be, that will go on to your tax return.

And then another big one is social security. Social security taxation has some weird effects where if you're in this phase in range, where the portion of your social security income is taxable phases in rapidly up to the maximum of 85%, then you can get really high marginal tax rates in that. I think a lot of your listeners are going to be above that range, but certainly not all, but you can include that. And then if you're above that range, then you should just put 85% of your expected social security benefit on.

I recommend doing this in real dollars. Social security is indexed to inflation; you can use a real rate of return. Maybe if you're invested mostly in stocks, maybe 4 or 5, 6% annual rate of return would be reasonable to assume for that. And then you can subtract any deductions.

A standard deduction. The standard deduction for taxpayers who are over age 65 is higher, so you can take credit for that higher deduction. If you're giving a lot of money to charity, you can put that in there and then you're going to get a taxable income and then you can look that up in a tax bracket scale. And if you assume the tax bracket stay the same from where they are now, then you can estimate what your future tax rate is.

It sounds scary, but again, when you take this complex problem, you break it down into these little pieces, you solve each one on its own, and then you fold those all back together, then you can get an answer.

And fortunately, I think the tax code is a little bit simpler for taxpayers who are retired than when they're working. There’s a lot of these credits and things. Child tax credit is probably gone, 199A deduction is gone, the earned income tax credit, if that applies to anybody, that's gone. In my judgment, I think you should look at the normal tax brackets. And then the two effects you need to be aware of are this phasing of social security and then IRMA.

And then if you do those, check those three things, you can get a pretty good estimate for what your future tax rate is going to be. And then you can just compare that to your rate now, and that will inform your pre-tax versus Roth decision. Again, it is complicated in a way, but I think if you take a really systematic approach to it, I think it is doable. I think it should be within the reach of a lot of your listeners.

Dr. Jim Dahle:
Yeah, I think it is within the reach of a certain percentage of our listeners. I think we just lost a whole bunch of listeners. I think that just went over their head and they're like, “That's way too much work. Isn't there a calculator? Isn't there some simple way I can just make this decision?”

And I've tried to use a rule of thumb over the years where I basically told people that in anything other than your peak earnings years, you ought to make Roth contributions, and in your peak earnings years you ought to make tax deferred contributions. And always with the caveat that there are some exceptions.

What do you think about that rule of thumb? Do you think that works most of the time? Or do you think that's committing the sin of making things simpler than they can really be?

Chris Davin:
I think it's a good rule of thumb and it’s one that I've used and it's one that I recommend to people. Like any rule of thumb, there are exceptions to that. And we can talk about a few of them. I think one exception would be if you're already in the top tax bracket and if your income and your wealth is so high that you expect to be in the highest tax bracket for your whole life, then that really leans things toward Roth.

One of the normal advantages of traditional pre-tax contributions is that most people, most of the time, have a lower tax bracket or are in a lower tax bracket when they're retired than compared to when they're working. And there are some strong reasons for that. Most people need a little bit less income, and then they've got forms of income coming in when they're retired that are not taxed. Social security is almost only partially taxed, Roth accounts, return of basis from taxable accounts and things like that.

It's fair to say that the normal suggestion is that being in your peak earnings years, pre-tax is best, but if you're always going to be in the top tax bracket, then you are losing that advantage. Then it's really just “How much money can I contribute and get tax protected growth on?” And in that case then Roth wins because you're able to contribute effectively more dollars in when you're contributing to maximum.

But overall, I think that's a pretty good rule of thumb. You have to think about the other factors that we've mentioned, that can skew it one way or the other. For instance, if you have an heir or you have a child who has a much higher or much lower income than you, then maybe you want to lean in that direction if you're expecting to leave a lot of money for them.

And again, all the other things we've talked about, if you are expecting to have a bunch of years where you're going to be able to Roth convert with really low rates, then maybe you want to lean more toward pre-tax now even if your tax rate isn't quite as high. So, yeah, there's, of course, exceptions to that, but I think as a good rule of thumb, that one holds up pretty well.

Dr. Jim Dahle:
Let's talk about some of the misconceptions. And we've briefly discussed a few of these, but I want to go over all of the ones you went over in your talk. The first one due to my low skill level in communicating sometimes I think I've been guilty of, as well, and that is this misconception that you're supposed to compare your current marginal tax rate to your effective tax rate in retirement or your average tax rate in retirement.

And I think what I meant when I would say that in the past, and I have a number of times, is that marginal tax rate in retirement has to be a blended marginal tax rate. If you're taking enough out of a tax deferred account then to fill up multiple tax brackets, you have to consider the blended marginal tax rate on those withdrawals.

And the same thing, really, when you contribute. If you're contributing over multiple tax brackets because you have some huge cash balance plan that you can contribute pre-tax dollars to, you have to consider both of those, on both ends, that blending effect of it. But it really is the marginal. It's not your effective tax rate that you're comparing to.

Chris Davin:
Yeah, I think it is fair to say you should always use marginal, and the reason is that you can make the decision on whether to contribute pre-tax or Roth for each dollar. For instance, if this year, you're in 2024 and you're trying to decide whether you should do pre-tax or Roth this year, most likely you already have some pre-tax savings. That savings is going to grow. We hope it will, between now and when you retire. And any additional money you save in the current year and then in future years will stack on top of that.

Thinking about the future average rate, of course, if you're averaging over and including all these low brackets in there, you're going to get a lower number and that's going to make pre-tax savings seem very attractive. But I think the way to think about that is that if you have this blended rate, if you have all these low brackets in the future, that is reflecting the benefit of doing the first amount of pre-tax savings. It's going to fill up all those lower brackets.

And then once those brackets are already filled up, and again, I take a plan-centric approach to this. If your plan is going to include your current money you have now, any growth on that and any future contributions. If you have that plan that's already going to fill all those up, any additional money that you contribute on top of that, is going to go all the way at the very top of that stack. If you're trying to decide how much to contribute for this year, it's really your marginal rate in the future versus your marginal rate today. And that's the appropriate comparison to make.

Dr. Jim Dahle:
Yeah. Well said. We talked a little bit earlier about taxing the seeds versus taxing the harvest. I think we probably beat that one to death, but that is a very common misconception out there. So, I wanted to mention that briefly.

But another one you talked about in your talk that I have heard people say before, and I think you're right, that it's wrong, is that people say it's better to defer paying your tax as long as possible. Why is that wrong?

Chris Davin:
Yeah. The reason is the math just doesn't work out to suggest that. Again, we've talked about the seed-harvest misconception. You're going to come out ahead paying basically the lowest tax rate as a percent, and it doesn't matter where along the timeline that tax gets paid. If you have money now, you take half of it now, versus letting it grow to the full amount and taking half of it later. You're still going to end up with half of what you would have if there weren't any tax. The idea that, “Oh, I don't want to pay tax now, I want to defer that until later”, doesn't hold up from a math perspective.

The other reason it doesn't hold up is that the way pre-tax retirement accounts are set up, the government makes sure that they're going to get a piece of that, no matter what. Now that may be when you take withdrawals from it, that might be if you're taking RMDs when you're retired, that may be if you leave it to your children or your heirs, they're going to take withdrawals, those are going to be taxed.

I think it's worth comparing this to a taxable account. With a taxable account, you can get the step up in basis when you die, but there is no step up in basis, or the equivalent of one, for a pre-tax account. The government is always going to get their piece. What I think about it more in terms of a pre-tax account is you want to choose a lowest rate.

And then if you have the opportunity to contribute Roth now or to do a Roth conversion now, one way to think about that is you're locking in the percentage that you're going to give to the government. And I think if you have reasonable confidence that the rate that you can contribute or convert at now is going to be less than what you could conceivably pay in the future or that your heirs would pay, then I think Roth contributions are worth doing.

The math works out differently for a taxable account. Like I said, for a taxable account, you can get the step up basis. Deferring capital gains, I think, is usually the right answer, and that's the standard financial advice. The other difference is that for capital gains, let's say you have, I don't know, $1,000 of unrealized gains in your account. If you defer paying taxes on that, you're paying the same tax on the same $1,000 with future dollars.

So, it's more of a fixed dollar tax. Do you want to pay $150 now or do you want to pay $150 in 20 years? Well, obviously the future payment is going to be better because you get 20 years of tax protected growth on it. But that's not the case for a retirement account because the percentage is really what matters. It really is just the game of “Do I want to pay the tax rate now at whatever percentage is available, or do I want to wait and expect to pay a lower rate in the future?”

Dr. Jim Dahle:
Your next common misconception that you brought up in the talk is one that I love to hear because I am a total believer in this one, and I get this question all the time, but people think there's an optimal ratio of pre-tax assets to Roth assets that you want to have going into retirement. And sometimes they include pre-tax to Roth to taxable assets that you want to somehow make changes throughout your career to arrive at your retirement date with this optimal ratio. Why is that a misconception?

Chris Davin:
Yeah, there's nothing about the math that says that there's some sort of best ratio. I can give you examples where somebody is best off with 100% pre-tax, and I can give you examples where someone is best off with 100% Roth.

An example of 100% pre-tax is let's say somebody who maybe they're getting a late start on their savings. They're in their 50s already, for whatever reason they haven't started saving and they have a high tax rate now. They may only work for another 15 years and saving 100% pre-tax and getting all that pre-tax savings now is going to pay off because their taxable income is going to be low when they're retired and they're going to be able to fill up all those lower brackets. They're not going to go up into the higher brackets when they're retired.

If you give me an example of a person like that, I would say this person should be doing 100% pre-tax wherever they can now. For instance, if it's like an IRA, and your deduction is phased out and your only choice is the backdoor Roth, it's that or taxable, the backdoor Roth is going to win. So, you'll have some Roth money in that regard. But that person should be contributing pre-tax if they can.

And then another example on the other side is somebody, let's say they have a great pension. They've got a $150,000 pension or something. And any pre-tax savings that you're going to make is going to come in on top of that $150,000, and you might pay a really high rate on that.

So, if that's the case and you're able to pay a lower rate now, or even a similar rate, if you're contributing the maximum, then you'd be better off doing 100% Roth and you can go into retirement with zero pre-tax dollars, if you have that pension. And there's absolutely nothing wrong with that. It's just whatever the math says is going to be the best thing to do.

Dr. Jim Dahle:
I love it. You don't get a pass on math. Speaking of somebody who likes to say you don't get a pass on math, Dave Ramsey likes to say that, but you know what else he says that is another common misconception about this? He tells people pretty much every time when they ask him this question that they should do Roth. That Roth is always better. Why is that such a misconception out there? Are people just ignorant? Is that why they're making that recommendation?

Chris Davin:
I can't get inside Dave Ramsey's mind, so I don't know whether he doesn't understand it or whether he's making a very simplified recommendation for his target audience. On a mathematical level, I would say no, that's not correct. There's lots of situations where pre-tax is best. And again if you look at the average American, the average person who has a normal career progression and a normal retirement, pre-tax is going to be the right answer for that person.

Especially if you look at the average population, I think I read that the average net worth of somebody who's in their 60s is like $400,000 or $500,000. Well, if all of that is in a pre-tax account and you're taking a 4% withdrawal or so, that's barely enough to fill up the lowest brackets. The standard deduction for a married couple is like $30,000. If you have $400,000 and you're taking 4% of that, you're not even going to get above the standard deduction. So, you're going to be paying no tax in retirement. Pre-tax is going to be the best option there.

I think what Dave may be going after is that there is a behavioral aspect to finance and to this decision. And if the choice is to contribute either pre-tax and spend the money that you save on taxes on something that is not valuable for your life, or you save it in Roth, then in that case Roth is a better choice. We've talked a lot about numbers in this. I'm an engineer, I love the numbers. You're an enthusiast on this topic, too, but at the end of the day, the behavior really matters 80, 90% and the math just gets you that last little bit.

If Dave is thinking that he's trying to work around the behavioral tendencies of his audience, and if they may be tempted to spend the tax money rather than do what we talked about in this podcast, which is to save it in a taxable account and invest it very tax efficiently and maybe leave it preferentially to your heirs so you get the step up in basis and do all those things. If somebody's not doing those things, then the Roth is a way to actually trick them into saving more.

And most people don't have close to optimal financial behavior. And if that's the situation, then that's probably what I would recommend, too, if I were approaching somebody that I thought that was a possibility for. There may be some more wisdom to that than you think, but yeah, it's hard to really know what he's thinking with that.

Dr. Jim Dahle:
Well said, well said. All right, one of the other things that I thought was really cool from your talk and you got to it toward the end is you talked about splitting contributions. Now, I've often told people that they're not sure what to do, do half tax deferred and half Roth, and at least they'll be minimizing the regret, only with half their money did they do the wrong thing. But you pointed out at least one scenario where that can actually be the optimized move to put some money into pre-tax and some money into Roth. Can you describe what that sort of a scenario might look like?

Chris Davin:
Yeah, sure. Your marginal tax rate is best thought of not as just one number, but as a curve over the range of income that you have. And the simple example is if you're sort of toward the bottom of your tax bracket, let's say you're in the bottom $10,000 of the 32% bracket, and then let's say you look up your tax rate is 32%. Okay, that's high enough. I want to contribute pre-tax. So, you contribute the $23,000 elective deferral limit this year. You're not actually saving that 32% on that whole contribution, you're getting a lower rate on more than half of that.

My suggestion to people who are trying to sort of take this problem seriously is to look at the whole curve of your tax rate over the range of contribution options you have available to you. And a lot of people will find that there's some tax cliffs as they go down where they're going to end up saving less taxes than they expect. So, if you're in that situation, you can split your contribution, you can contribute enough to get you down into the next lower bracket, and then once you're in that lower bracket, then you can contribute the rest to Roth. And that's a way to get a mathematical advantage from splitting contributions, not just sort of a psychological one.

Dr. Jim Dahle:
Well, Chris, we've lost a ton of people in this discussion. We're way out in the weeds here when it comes to personal finance and investing and taxes. You and I love to nerd out on this. We think it's awesome, super fun, it's our hobby, but that's not the case for everybody listening to this podcast. And they're wondering, “What if they make a mistake? What if they do Roth when they should have done tax deferred or done tax deferred when they should have done Roth?” How big of a deal is it?

Chris Davin:
Yeah, most likely it's not that big of a deal. I think you hit the nail on the head earlier, which is that to acknowledge that retirement accounts are a great option that the government gives you to save for your own retirement. And they give you these big tax benefits, big asset protection benefits, big estate planning benefits in exchange for saving for your own retirement and taking care of yourself when you're older so that the government doesn't have to come in and take care of you. That's sort of the way that I think about it.

This is really a big advantage to either pre-tax or Roth compared to just saving in a taxable account. I definitely recommend for everybody if you can contribute the maximum, you should be doing it. And it's better to save in retirement accounts than it is in taxable most of the time.

That said, when I look at numbers, I've run the numbers for my own case, for my own family, and then for a lot of other people, the difference ends up usually being pretty small. I think it's around 5%, the difference. If you look at maybe let's say 24 to 32%, that's like 8%. That'd be on the high end, but most of the time you're probably within, if it's like a reasonably close call and you're not saving at 12% and you're going to pay 40% later on, if it's not one of these sort of extreme cases, then that I think is a good rule of thumb for what you can expect to save by doing really good tax planning on this.

I think about it in terms of how this stacks up with your other financial priorities. I would say priority number one is to just save a big percentage of your income so that you have, for a high income earner, a six or seven figure portfolio. If you're not saving, you have to just work on your budget.

Second priority I would say is getting your asset allocation right. If you're looking at the difference between let's say an 80% stock portfolio and a 20% stock portfolio over 35 years, it’s about half. Getting your asset allocation right, that's like 50% of your nest egg.

I'd say probably third priority would be getting your fees down. A 1% fee will eat up, over 35 years, about 20% of your portfolio. Once you've done those things, then I think pre-tax versus Roth is probably the next thing that should be considered. Again, if you go with that 5% number, that ends up being equivalent to about a 25 basis point difference in your investment performance over 35 years.

And so, to put that in perspective, I'm actually not a huge nerd when it comes to the actual investments. You could, I'm sure, teach me a lot about small cap growth versus small cap value, but let's say somebody has a 10% small cap allocation and they're trying to get an extra 1% growth out of that, that's only like 10 basis points over your whole nest egg, and that is less significant than pre-tax or Roth. That's sort of where I see it sort of stacking in.

But one of the other things I'll say is that this is a problem that involves a lot of uncertainty. There's uncertainty about future tax rates, about your future investment growth, about your career. How much am I going to be earning? What state am I going to be living in? All these things are very difficult to predict, and we've all had unexpected changes and all those things that affect this analysis.

I think it is worth putting in some effort and trying to do it right. But if something changes, if your income goes way up or goes down, then there's really nothing you can do about that. And I don't think that's worth having regret over. I think that you should tell yourself that you made the best decision that you could at the time with the information you had available. And that should give people comfort.

Dr. Jim Dahle:
That is just awesome advice, Chris. That is just perfect. The wonderful thing about it is the harder this decision is for you, the less it matters. If it's not completely obvious that you should be doing one or the other, it doesn't matter as much. So, that's a beautiful thing about it for those who are really on the fence and not sure exactly what to do or what assumptions to use.

Well, Chris, I think in this discussion, you have established yourself as a force in the online personal finance community. I think it's been really impressive how much thinking you've done on this topic and how well you've encapsulated your thoughts and simplified them enough to be able to teach the rest of us about them. Thank you so much for doing that. Thanks for being a speaker at WCICON and thanks for being on the podcast.

Chris Davin:
Thank you very much. It's been an honor.

Dr. Jim Dahle:
All right, I hope you enjoyed that interview as much as I did. I actually got several things. I'm not sure I had a very concrete understanding of clarified through my discussions with Chris and watching his talk and doing this podcast. I hope it was just as helpful to you.

His best recommendation for online written material to check this out is on the Bogleheads Wiki on this topic. It's very long, very extensive, but goes over a lot of these same topics. We also have a number of posts on the White Coat Investor blog. Tax deferred versus Roth. If you search those terms, you'll come up with three or four different blog posts that can help you to think more about this topic.

 

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We appreciate that review and we hope some of you feel it was worth giving Chris a similar five star review for this podcast. You can do that wherever you download your podcast, and it will help others to find this podcast and bring them financial literacy and discipline. And the combination of the two in our financially illiterate world is like having a superpower. It really does make it possible to create a pretty incredible life for you and help a lot of others along the way.

Keep your head up, your shoulders back. You've got this. We're here to help. Thank you for being in the White Coat Investor community, and we'll see you next time on the White Coat Investor podcast.

 

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Milestones to Millionaire Transcript

Transcription – MtoM – 162

INTRODUCTION

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

Dr. Jim Dahle:
This is Milestones to Millionaire podcast number 162 – Ophthalmologist acquires $50 million.

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This course is the material that should have been taught to you in college, medical school, or residency, but never was. Fire Your Financial Advisor also has a version eligible for CME credit. Get your financial life in order today. Go to whitecoatinvestor.com/courses to sign up. You can do this and the White Coat Investor can help.

This is the Milestones to Millionaire podcast. What we do on this podcast is rather than answer your questions and bring on fascinating authors or whoever to interview, is we bring you on, the audience, and we celebrate with you the financial goals you have reached, and use your accomplishments to inspire others to do the same. You can come on the podcast and share your milestones by applying at whitecoatinvestor.com/milestones.

By the way, if you need help with taxes, a financial planner, student loan advice, mortgages, real estate investing, whatever, we try to find the good guys in the industry and put a list of them together. So, when you have a need for a financial service provider, your search method is dramatically easier. Just go to whitecoatinvestor.com/recommended. It has all our recommended lists there, and you can figure out who you need, what you need, and learn what you need to know about each of these people knowing that we've at least looked into them a little bit and found the good guys, avoided the bad guys, and will be there to help you reach your financial goals. We view that as part of the mission of White Coat Investors, connecting you with the best financial resources and professionals out there.

 

INTERVIEW

All right, we've got a pretty interesting guest on the Milestones podcast today. And we've done blog posts with docs that have acquired quite a large net worth before and occasionally see a comment on the blog from guys like this. But what occasionally I find surprising is that people don't believe them. They think they're lying. They think they're just trolling me or trolling the WCI community. They don't think it's even possible for a doc to acquire a net worth of 20 or 30 or 40 or 50 million.

That is obviously not the case. I've met enough of them that they are out there. They're somewhat rare, obviously. It takes a high income combined with financial literacy and financial discipline, but it certainly happens, especially if you're willing to work a full 30, 40 plus year career and apply the principles we teach at the White Coat Investor to a high income. Pretty incredible things can happen. In addition, sometimes people start a successful business. If you've got 30 docs and APCs working below you in your clinic, that clinic's pretty valuable and can be sold for a pretty high price, and that can also get you up into those sorts of net worth ranges.

At any rate, we're going to bring on a doc today that's acquired a net worth of nearly $50 million during his career, and he's going to share with you some of the secrets about how he did it. Stick around afterward, we're going to talk a little bit about one of the problems he's dealing with, which is estate taxes.

Our guest on the Milestones to Millionaire podcast is a recent retiree that we're going to call Fred. Fred, welcome to the podcast.

Fred:
Thank you very much. It’s a pleasure to be here.

Dr. Jim Dahle:
I understand you recently retired. Congratulations. When was your retirement date?

Fred:
17 months ago. July.

Dr. Jim Dahle:
Very cool. Well, congratulations. And thank you for what you did for your career. Let's talk about your career. What did you do?

Fred:
I was an ophthalmologist. I'm about 40 plus years out of school and really enjoyed the career in medicine in general.

Dr. Jim Dahle:
Okay. And did you own your own practice? Were you in a partnership? Were you an employee? What'd your career pathway look like?

Fred:
I was at one practice my entire career. I was a partner and actually the managing partner for the practice. And along with three other doctors co-founded a surgery center and I was the managing partner for that surgery center also. We were the highest volume eye surgery center in our state and perhaps in our region.

Dr. Jim Dahle:
Okay. So, pretty successful business. You owned it with several other docs it sounds like. Did you sell your share out to them? Did you all sell out to private equity or are you still an owner of that practice?

Fred:
Well, after owning it for about a dozen years, we sold 51% of the surgery center only to private equity. And then when I retired recently I sold the remainder of my shares to my partners and some to the private equity.

Dr. Jim Dahle:
Okay.

Fred:
The practice stayed on its own.

Dr. Jim Dahle:
Okay. Very nice. We haven't mentioned yet what milestone we're celebrating. Retiring itself should be a milestone, but you managed to retire with a pretty substantial net worth. Can you tell the audience what your net worth is?

Fred:
Almost $50 million.

Dr. Jim Dahle:
Almost $50 million. And how much of that came from the sale of the surgery center and any ownership in the practice you might have done versus money you accumulated from your income along the way?

Fred:
Of that, about $6 million came from selling the surgery center and the rest of it was working hard and investing wisely.

Dr. Jim Dahle:
Now, the White Coat Investor started in 2011. Clearly it was not me that taught you how to do this. You were doing this long before the White Coat Investor came along. How did you become financially literate and disciplined?

Fred:
Let me tell you a good story. When I was 13, which was way back in 1969, I inherited $15,000 in a single stock from my grandmother. My parents turned over that stock to a family friend who was a full cost broker at the time. He of course promptly sold it for another single stock. A year later he called and said that single stock was falling precipitously and it was time for me to sell it. I declined to do that. And I said to my parents, “Why would I buy high and sell low when I didn't need the money at 14 years old?”

That's when my journey began. That was about 1970 when I was 14, and I don't think Bogle came out with his 500 index fund till 1976. It took me a while to find Bogleheads, find the theory behind index, but along the way it was important I read Larry Swedroe, Bill Bernstein, I'm sure, of course, Benjamin Graham, to try to educate myself. At 14, I realized that the professionals often didn't know what they were doing. And now in retrospect I know that a stockbroker, many of them are just full commission non-fiduciary salesmen. And that's when my journey started.

And as soon as the index funds really hit Vanguard, I made the switch over. I still have some legacy funds and individual stocks that I had along the way because they did well also and it was too painful to sell them and suffer the capital gains. But well over 95% of my holdings are in index funds.

Dr. Jim Dahle:
What kind of income range did you see over the course of your career? I imagine it's substantial given the effects of inflation over 40 years, but what incomes have you seen?

Fred:
I was fortunate in my office practice from the surgery center, I would make $1 million to $2 million a year. Currently I have our investment portfolio and two components. The first is the index funds that we talked about, and the second is in very high quality single or double tax-free municipal bonds.

Once I realized that I had this income, I realized that I would be able to create a portfolio that would basically be immune from sequence of returns risk once I retired. What I did was invest a significant amount in individual high quality municipal bonds. Right now I have about $17 million in individual tax-free municipal bonds. Those bonds as well as the dividends that I get from the index fund generate about $1.3 million mostly in tax-free income. It's what we live on in my retirement and I don't have to care what the market does. My feeling is that all of my equity holdings will pass to my children at a step up in basis at my death. And the only reason that I will go into them is if we make the decision to buy a warm weather second home while we're in retirement.

Dr. Jim Dahle:
Well, you can certainly afford to do so if you choose to do that. It's interesting, I look at salary surveys all the time and the salary surveys show that ophthalmologists on average make $300,000 or $400,000 a year, yet you're making $1 million or $2 million. What advice do you have for an ophthalmologist that's making $350,000 a year and would like to do what you did in your career?

Fred:
I've got about seven keys to doing that. The first is geography. In choosing for us to deliberately live near family, I also got to practice in an area where demand for my work was essentially unlimited. That's the key. There wasn't really the competition. I could work all day, all night if I wanted to. As a huge bonus by living in this area, expenses, a great home, superb recreational and entertainment activities were far less expensive than if we chose to live on the coast.

The other thing that's really, really important, own or buy their own surgery center. Since I started practice, Medicare eliminated assistant fees, which used to generate about $1,000 for the main surgeon and they cut reimbursement for cataract surgery by 80%. By owning the surgery center, I actually made more owning the center than doing the surgery itself. In addition, by owning the surgery center, I had great control over the quality of the surgery center, the efficiency, the scheduling, and most importantly, I was able to hire the staff that I worked best with and were best for the patients. Those two things for ophthalmologists are the most important. I've got other things that I consider secrets to success, which as an ophthalmologist, those are the two most important things.

Dr. Jim Dahle:
Maybe we ought to hear what some of your other secrets to success were.

Fred:
A long time ago when I met with an advisor about buying term life insurance and disability insurance, I was still a resident. He said, “I've got one word of advice for you. If you follow this advice, don't do anything else foolish. By the time you're 60, you'll be able to have a comfortable nest egg and retire.” Those words were one house, one spouse. I think that's a very critical thing to building wealth and being happy.

The second was to really invest in the way that the White Coat Investor advocates. And that is to invest using diversification asset class and low cost index funds. I think that's very key. And as the White Coat Investor suggests, really know the difference between investing and speculation. To me speculation is gambling and there's always perhaps a part that you can invest in a small portion of your portfolio just to make it fun.

Over the years, I was actually lucky to be in Seattle in 1992 and walk into a coffee house when they didn't exist anywhere else and called home to my wife. This was at the American Society of Cataract Refractive Surgeons meeting in 1992 in Seattle. I said, “There's coffee houses here. Do you think those could take off?” In 1992, I was a very early investor in Starbucks. Similarly I was intrigued with Tesla, but those are speculation, gambling, not investments, but they can add spice to your invested career.

It's key like White Coast Investors to write an investment strategy. It will keep you on track when the market is either euphoric or when the market is crashing. Those market crashes are golden opportunities. And after 40 years, I was lucky, I was there after September 11th in the market crash, there in 2008 and there in COVID. And since I was working and making a good income while everybody else was running afraid and pulling money out, I kept putting money in month after month. And that was the key to building the nest egg that I have now.

The other thing that I think everybody needs to know is strive to be content, strive to be grateful and find joy in the years before retirement. If you really enjoy medicine, then retirement is a stage to plan for. It's not the number one goal. Being a physician in my mind is truly a privilege and it's really, really an honor. I can't think of any other career where we get the self-respect, people ask for our opinions and listen to us. And the self-worth that it generates is really hard to beat. And in all of that we're allowed to make a good income to support our family. I really can't imagine a better career choice than going into medicine. I know some people don't feel that way, some people get frustrated with different aspects of medicine, but for me it was a career that I still cherish to this day.

Dr. Jim Dahle:
Can you tell us a little bit about your spending? Before you retired and now that you're retired.

Fred:
Our spending before retirement was about $420,000 per year. Again, I was making $1 million to $2 million. As you have always advocated, live within or below your means. Now that I've reached this age, our spending has changed only in the sense that we spend more in travel. Now about $90,000 a year. And as we move into more detailed estate planning, we are giving much more money to our children and our grandchildren and also charity. And we're trying to get our head around and get comfortable setting up SLATs, spousal lifetime access trusts, still trying to get comfortable and moving ahead with that. Even with all of that, we are still spending probably one third of what I'm currently making in retirement.

Dr. Jim Dahle:
Yeah. Just the income, not even counting the principle, which is continuing to grow. Clearly spending $400,000 when you have $50 million you're going to die with far more than you have right now. Giving it all away during your life. You've got an estate tax problem, that's clear. And I'm curious how you chose to divide up what you will leave behind between charity and between heirs. Have you made those decisions yet or are you still struggling with those?

Fred:
We're still struggling with them. Most importantly, my wife and I are trying to come to agreement on that. The vast majority of it will be left to our three daughters and our eight grandchildren. However, we are enrolled in legacy programs for charitable organizations in our community. I'm active in multiple charitable organizations and on the board of directors of multiple charitable organizations, including the board of trustees of an entity that has over 250 donor advisor funds in it. I'm proud to say it gives over $16 million a year to charity.

Dr. Jim Dahle:
I'm curious what role debt played in your financial life over the last 40 years?

Fred:
I'm debt free and I paid off my student loans within probably five years, four years, of practice and our mortgage on our house within five years of starting practice. I also paid for three weddings and I put three daughters through both undergrad, graduate, and medical schools 100%. And they graduated debt free too.

Dr. Jim Dahle:
You certainly haven't been borrowing money to invest, it doesn't sound like.

Fred:
I have never borrowed money to invest. No.

Dr. Jim Dahle:
Well, very cool. All right, let's say there's somebody just like you 40 years ago. They're coming out of residency and they've got some student loans. They want to have a great long practice. They love practicing, but they also want to accumulate wealth. What advice do you have for them?

Fred:
Read and turn to sources like the White Coat Investor in order to become educated and be a do-it-yourself investor. There's more on the White Coat Investor website than just how to invest. It includes how to live. So, read books like Bernstein's and Larry Swedroe on how to do things. Understand why term and disability insurance are good and why for whole life insurance you have to have a really good reason to invest in. Know what investing means in comparison to speculation and hearing the latest tip.

Find the right life partner to make the journey with. That's as critical a decision as going into medicine or how to invest. And along the journey, enjoy the journey itself, seek balance and make a commitment to your community, to charity and most of all to your family because in the end that's what's really important.

Dr. Jim Dahle:
Awesome. Great advice for life and for your finances. Thank you so much Fred for coming on the podcast. We're super grateful for you and your success and what you've shown us is possible for a White Coat Investor to accomplish in their career and with their finances. And thank you for sharing your wisdom.

Fred:
Thank you very much. I appreciate the opportunity.

Dr. Jim Dahle:
All right. I don't think I can preach it any better than he did. I've been telling you this stuff since 2011. He learned it before then and has been applied in his life for 40 years. He invested a big chunk of his income. He made a good income. He managed debt wisely. He stuck with this plan through thick and thin instead of selling out in the tech crash, instead of selling out in 2008, instead of selling out in the pandemic, he put more money in. And guess what happens?

Now ownership is great. He got a nice $6 million boost to his retirement nest egg when he left. Now in his case, he was such a good saver and investor, it really didn't move the needle all that much. But for lots of people, that takes him from having $2 million or $3 million net worth to having a $10 million net worth.

And so, ownership is also I think a pretty important aspect of this success story. I'm a big fan of ownership. Now it doesn't always make sense to own your job or own your house or whatever. But in the long run, most of the time the owners make out better than the non-owners. And so, consider that as you go through your life.

 

FINANCE 101: ESTATE TAXES

All right, I promised you we're going to talk a little bit about estate taxes. When you think about estate planning, there's multiple reasons for estate planning. One of which is just to make sure your money and your stuff goes where you want it to go when you die. You may be trying to avoid probate, which can be an expensive and time consuming process and it can also be a public process. But for a lot of people it's minimizing taxes is the reason they're doing estate planning. And a lot of people worry about the death tax, but it actually doesn't even apply to them. Most White Coat Investors are not going to have $50 million when they die. Most White Coat Investors are going to have $5 million, something like that maybe. $10 million maybe.

And the nice thing about the estate tax is that at least federally speaking, and it differs by the 10 or 15 states that have an estate or inheritance tax, but for most of us, the federal one is the only one that applies. And it has a big exemption. Right now the exemption is 13.61 million. Double that if you're married. That's how much of your wealth you can pass to the next generation without paying any estate taxes at all. That works out to be over $27 million you can pass on without paying estate taxes.

The problem is, once you get above that amount, very rapidly, within a million dollars of additional wealth, you get to a 40% tax rate. In this case, if you died with $50 million, you pass on $27 million, that leaves you $23 million. $23 million times point four works out to be what? I don't know, $9 million or something. $9 million in taxes. That's what it's going to cost Fred when he dies if he doesn't do anything about it.

And so, the main thing people do is they give their money away. You either give your money away to the next generation, and in 2024, you can give $18,000 a year to any person you like. You and your spouse both. So, if you got married kids and they got three grandkids, you and your spouse can each give each of them $18,000 a year. That adds up in a hurry. And that can help decrease that amount of your estate above the estate tax exemption. You can do that directly, you can do that by putting the money into trust, et cetera. Also, money giveaway to charity doesn't count for that estate that will be taxed. So those are kind of the main techniques.

Now he mentioned a SLAT, a spousal lifetime access trust. And this is the mainstay of our estate plan. Not only does it provide substantial asset protection, but basically what it does is it allows you to get growth in your net worth out of your estate. Once the money is into the SLAT, whether you gift it in there, whether you sell assets into it in exchange for a promissory note, further growth on those assets is not in your estate. So, estate taxes aren't due on that. And over the course of a number of years, we're hoping to completely eliminate in the estate taxes that we may owe.

And so far I think the plan is going to work. It's not quite there yet. If we died today, we would be paying some estate taxes. But I think over time it is going to work. We're basically spending down our estate using it for taxes, using it for charitable giving, while the value in the SLAT increases. And so, that's what he's looking into. Probably would've been better if he'd done that 20 years ago, maybe he didn't realize he was going to have an estate tax problem then.

Be aware by the way, that starting in 2026, that federal estate tax exemption amount is going to be cut in half. It is indexed to inflation but if Congress doesn't make any changes in the laws between now and the start of 2026, it's going to be about $14 million total between the two spouses rather than $14 million each.

All right, enough on estate taxes. It just is not an issue for the vast majority of White Coat Investors. I'm sure when you hear about a doc with $50 million making one to $2 million a year, it doesn't feel like a very easy person to relate to. But I think it's still useful to bring somebody like that on the podcast every now and then just to show you what's possible.

 

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And then on the other end is someone that just goes out and hires a financial planner to help them draft their financial plan, maybe implement the plan and maybe even manage their investments going forward.

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All right, that's the end of another great episode of the Milestones to Millionaire podcast. I hope you enjoy these. If you want to come on, apply at whitecoatinvestor.com/milestones. You do not need $50 million to come on. Heck, if you got back to broke, we'll celebrate with you. If you paid off your car loan, we'll celebrate with you. You could have paid off your credit card. I'll celebrate it with you and we'll use it to inspire somebody else to do the same.

Keep up the good work. We appreciate what you do. Let us know what you like about the podcast and what you don't, and we'll keep being here to walk alongside you in your financial journey to reach your financial goals.

 

DISCLAIMER

The hosts of the White Coat Investor podcast are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.