By Dr. James M. Dahle, WCI Founder
Paying attention to your taxes now AND your taxes later will give you the tax diversification and freedom you’ll want during retirement. A tax diversified portfolio should be made up of tax-deferred, Roth, and taxable accounts.
Most doctors are aware of the importance of diversifying their portfolios among various “asset classes” such as stocks, bonds, and real estate (and within those asset classes as well) to spread their money across a large number of individual securities or properties. This move prevents the investor from making the classic mistake of putting too many eggs into one basket, which could lead to financial ruin in the event of a market downturn in a single security or asset class.
However, too few of us have applied these same principles to the taxation of our assets when it comes time to spend them.
How Are Retirement Accounts Taxed?
The typical physician is taxed at a high marginal tax rate during their peak earning years. As such, we naturally look for tax-deferred retirement accounts that can give us relief from this tax burden, such as 401(k)s, 403(b)s, 457s, profit-sharing plans, and defined benefit plans. Each dollar contributed to these accounts is a dollar that isn’t taxed now at high marginal rates. Basically, this income is deferred into retirement when we can withdraw at least some of it at lower marginal rates, reducing our overall tax burden.
Occasionally, a good saver acquires a very large nest egg primarily in tax-deferred retirement accounts and then is surprised when they find a significant portion of their retirement income falls into the mid-to upper-tax brackets. This problem can be exacerbated when and if their required minimum distributions (RMDs) become larger than the amount they would prefer to withdraw from their tax-deferred retirement accounts or when marginal tax rates are increased.
Utilizing Roth IRAs and 401(k)s to Reduce Taxable Income
Roth IRAs were introduced to the retirement landscape in 1997, and a Roth option is commonly found in 401(k)s across the country. Instead of saving taxes now and paying them later, with a Roth retirement account, you pay taxes now and you and your heirs avoid paying income taxes on that money ever again, no matter how large it grows.
Similar to tax-deferred retirement accounts, Roth accounts also avoid annual taxation on capital gains and dividends. The obvious benefits to the retiree are no RMDs (on Roth IRAs; Roth 401(k)s still have RMDs unless you're still working and own less than 5% of the company) and the ability to preferentially take some of their retirement money from a tax-free Roth account rather than withdrawing tax-deferred money at high marginal rates.
The Taxable Investment Account
Many physicians can save money above and beyond their retirement accounts—whether in paper assets, like stocks, bonds, and mutual funds, or in income-producing assets like real estate or small businesses.
This investment account is also taxed in a different manner than a retirement account. Qualified dividends and long-term capital gains are taxed at lower rates. Real estate and business income can also be taxed in a more favorable manner than regular income thanks to depreciation and other tax breaks.
Although taxable assets provide less asset protection from creditors than retirement accounts, they benefit from a step-up in basis upon the death of the investor and can be tax-loss harvested in the event of a market downturn. Taxable assets also have fewer restrictions on withdrawals prior to age 59 1/2 for the early retiree.
Combining income from tax-deferred, tax-free, and taxable accounts can dramatically reduce the tax burden for a retiree.
Using a Backdoor Roth IRA
A physician who realizes the wonderful tax benefit of taking some of their income from Roth accounts is still left with a dilemma: what is the point of paying a high marginal tax rate during their peak earning years to avoid paying a similar high marginal tax rate later?
Although a doctor can use Roth accounts in the early, lower-paying years or in their last few years as they cut back to part-time work, it can be hard to save a significant amount of money due to lower total income.
Since 2010, Congress has provided a solution to this dilemma by providing a method called a Backdoor Roth IRA. High-income earners are not allowed to contribute directly to a Roth IRA. For 2022, this phase-out begins at a modified adjusted gross income of $129,000 ($204,000 married).
In 2010, this phase-out was eliminated for Roth IRA conversions. So while most full-time, attending-level doctors can’t contribute directly to a Roth IRA, they can convert an otherwise non-deductible traditional IRA to a Roth IRA each year for themselves and a spouse. They might not want to do it if they have money in a traditional IRA, SEP IRA, or SIMPLE IRA, though, due to a required “pro-rata” calculation that must be made for Roth conversions.
So now in 2022, a physician can contribute $20,500 ($27,000 if age 50+) of tax-deferred money into their 401(k), plus another $6,000 for themselves and $6,000 for their spouse into Backdoor Roth IRAs each year. Assuming an 8% return, after 20 years of making these contributions, these retirees would have about $1 million in tax-deferred money and about $600,000 in tax-free money, providing tax diversification in retirement.
Roth Conversions
Another opportunity to increase the size of Roth accounts occurs in years when total income is lower, such as sabbaticals, partial retirement, or early retirement prior to taking Social Security payments. A wise retiree may actually choose to pay taxes early at a relatively low rate by converting some of their tax-deferred money to a Roth IRA. Many 401(k)s with a Roth option also offer “in-plan Roth conversions,” simplifying this process.
Building a Taxable Investment Account
In the last years prior to retirement, especially an early retirement, a doctor may wish to increase the size of their taxable account. Since this money won’t have a lot of time to grow, the basis will be high so the tax burden created by liquidating these assets will be relatively low. It can be even higher if you continually flush capital gains out of your account by donating appreciated shares instead of cash to charity. This money won’t be subject to the restrictions and penalties that retirement accounts have on withdrawals prior to age 59 1/2. It can also provide a ready source of cash to pay the taxes due on any Roth conversions the early retiree may choose to make.
An Example of a Tax Diversified Portfolio
By having all three types of accounts, retirees can lower their overall tax burden. Consider these two 2021 portfolio scenarios for a married couple taking the standard deduction that wants $150,000 in retirement income prior to receiving Social Security benefits and (to keep things simple) withdraws from each available account equally.
Portfolio #1
- 100% in tax-deferred accounts
Portfolio #2
- 60% in tax-deferred accounts
- 20% in Roth accounts
- 20% in a taxable account with a high basis
Portfolio #1 will have a federal tax bill of about $18,975, or about 12.6% of their income. Thanks to tax diversification, Portfolio #2 will have a tax bill of only $7,390, or about 4.9% of their income. That is $11,585 more each year that can be used to take a cruise, spoil grandchildren, or support a favorite charity.
Paying attention to your taxes now AND your taxes later will give you the tax diversification and freedom you’ll want during retirement.
What did you think? What do you do to get tax diversification? Comment below!
I read your article about tax diversification. I think it is not fair to compare tax advantages at the withdrawal on your assets but not consider the tax advantages at the time of contribution. Let me first state that I too have the desire to maximize all opportunities to invest for retirement. But what is the benefit of paying taxes now at the ~40% rate when I could get a tax savings now and let a larger amount grow for 20 years compared to tax burden of withdrawing when my retirement income will be smaller than my current income (so hopefully have a lower tax bracket). This is question I have because I wonder if it is better to do a Roth now or non-Roth. I max out the total retirement plans at about ~$49k/year with a mixture of both.
I agree that it might not be a good idea for someone to pass up a tax break now in a high tax bracket in order to put money into a Roth account. It is much better to do Roth contributions during residency/fellowship/sabbatical/early retirement years. But in some situations, such as a Backdoor Roth IRA, it isn’t an either/or situation. If you’re already maxed out your profit sharing plan (it’s $51K this year, not $49K), and want to save more, you should probably do a backdoor Roth IRA. It sure beats a non-deductible IRA or a taxable account, no?
A couple of questions about backdoor IRAs.
I currently have an IRA that I created after rolling previous 401Ks from residency and fellowship (relatively small amount ~ 10% total retirement funds). I use that fund to diversify into alternative investments REITs and commodities as well as some low fee stock ETFs. I am employed by a hospital system and fully invest in the 401K/457 however the investment options are limited. I am reluctant to roll my IRA into the 401K because it would reduce my diversification, but would like to start a backdoor IRA.
1) Can I open a backdoor Roth for my wife while keeping my traditional IRA? She is not working at this time and we jointly file taxes.
2) Would it make sense to role my IRA into the 401K and open my own Roth IRA, despite the limited investment options?
1. Yes, you file the 8806 individually for both spouses. Your IRAs are in your name, so no pro-rata stuff for her. She needs to be working however in order to be able to contribute at all, I think; you didn’t mention if she was working.
2. Really depends on your situation. I posted a similar question last year on this blog and am still debating rolling IRA–>403b because of higher costs in the 403b through my hospital vs my rollover Vanguard IRA.
Wrong on a spouse working to contribute to an Ira. Google spousal ira, a wife can contribute with zero income as long as the husband has sufficient earned income to contribute.
I agree with Rabbmd. Your wife doesn’t need income to do a backdoor Roth. One other option besides rolling it into the 401K (probably a 403B), is to just convert the entire IRA. It will cost you a little in taxes, but you’ll have lower investment costs, better investment options, and more tax diversification.
If your ira is small enough, say $2000 or so I would go ahead and either roll it into my 401k or just convert to a roth and pay taxes on the small amount. The tax diversity benefit and years of backdoor roths really can add up. I have like $70,000 in a roth at 36 by doing yearly backdoors.
I didn’t know about the backdoor IRA until I had already rolled over my residency 401k into a Vanguard IRA. I have been contributing max to my tIRA since I don’t qualify for the work 401k until next year. I currently have about $40k in the tIRA account and $10k in Roth. Unfortunately, my work 401K doesn’t allow IRA roll-ins. Once I start participating in the work 401k, I will not be able to deduct my tIRA contribution.
I’m torn about rolling my tIRA into Roth and pay tax on the conversion now. Or I could lobby for my practice to choose a better 401k option/plan that allows IRA roll-in once I become a full partner.
I’d probably convert in the year you leave residency if I were you. That $40K will probably only cost you $10K in taxes.
Hi, please how exactly do these “back door Roth IRAs” work? You have mentioned “yearly conversions”. I currently have a Roth IRA along with my wife, am in my third year of residency, and am about to work as an independent contractor hospitalist. I estimate I will be over the limit to contribute to my current roth ira once I start. So step by step could someone tell me how to do yearly conversions as an independent contractor? Your advice is much appreciated.
Thanks to a change in the law, as of 2010 there is no income limit for Roth conversions.
So a back-door Roth has 2 steps:
1. Make your contributions to a non-deductible traditional IRA.
2. Convert the traditional IRA to Roth. I’ve read you can do this as early as one day after the contribution, or you could wait 30 days or a year, or come up with any conversion schedule you like.
The only complication is if you already have a significant amount of money in a traditional IRA. If you do, then to make the back-door Roth work correctly, you’ll need to convert all traditional IRA funds to Roth and pay taxes on any earnings or deducted contributions that are already there. Or you can roll over the existing traditional IRA to a 401k or similar plan to get those funds out before you start contributing to the “Back-Door” Roth.
Thanks for quick reply. I currently do not have ANY IRA account or 401k plans, So just to be clear,as a self employed doctor can i open up a self-directed non-deductible traditional IRA, contribute 5k to it (if thats the contribution limit), then subsequently convert that into the roth IRA that I currently have? And I can do the same for my wife? and I can do this every year going forward until the laws change?
My wife currently has a 403b plan via her employer, but no other pretax qualified plans.
You don’t need to be self-employed. The limit is $5500 each this year. You cannot have other traditional IRAs, SEP-IRAs, or SIMPLE IRAs. A 401K or 403B are fine. But yea, you’ve got it now.
K.C.
Of course you “can” do it as WCI points out, the question is always how much should you do it. If you are filling up all your other tax-advantaged options like your wife’s 403b, then I think your next plan might be a Solo 401k, where you can have both pre and post-tax options.
The one point I am making is when your income is so high that you can’t contribute to a Roth directly it is also so high that the math for the Roth does not always work out over other pre-tax options and you should use it only as a last resort.
Beware the deferred accounts at the time of spousal death.
Two deferred accounts owned by the survivor will bring on a tsunami of RMDs in a nosebleed new single filer tax bracket.
Agreed. Tax-deferred accounts are definitely better while both spouses are alive. Good thing to remember when considering Roth conversions, especially if spouses are dramatically different ages or if one spouse has much worse health.
Technically this statement is not correct:
“they can convert an otherwise non-deductible traditional IRA to a Roth IRA each year for themself and a spouse, so long as they have no other traditional IRA, SEP-IRA, or SIMPLE IRA. (This is due to a required “pro-rata” calculation that must be made for Roth conversions.)”
Because of the associative laws of math when you pay the tax on your traditional IRA funds doesn’t matter just as whether you invest in a Roth and pay taxes on the front end doesn’t win to the traditional IRA unless you make a tax rate distinction.
In other words, what it says is you “can’t” convert if you have other traditional IRA funds, which of course I know you know is not true. It only means you will be having an 8606 following you around until ALL tIRA funds are gone.
I don’t believe the “math” would suggest it is a bad idea.
The only math that suggests a conversion is going to not work out in your best interest is the one where your tax rate now is higher than when you are retired. In most cases this is unknown, and then so is whether it was “smart” to do the conversion in the first place.
I agree you could do the conversion, it would just be pro-rated and you would probably regret doing so.
WCI,
Yes, I know one person who fell into the trap a number of years ago of doing a backdoor Roth in Feb and then rolling over the 401k to an IRA in December without understanding the consequences. Once she understood the consequences she was happy to go to the trouble of “undoing” the backdoor Roth to avoid the hassle over the next 30 years.
30 years? Seems like it would be less trouble to just put that IRA into another 401k and then do the Backdoor Roths.
WCI,
The person had just retired, so the IRA was a rollover from the 401k, so no going back with the 401k.
If they just retired (completely), then no need to go back since you can’t do IRA contributions going forward anyway–no earned income. If they didn’t just retire, then maybe they have access to another one or solo 401k.
WCI,
Just to clarify, did the IRA contribution, completely retired, did the conversion all in the first half of the year with enough earned income to cover. Then later in December did the rollover of 401k. Then around Feb of the next year realized what had happened when doing taxes.
That’s a bummer. No great fix available for that.
re: tax strategies. I had invested in Origin QOZ in 2020 after your review/recommendation of Origin. Looking to do a similar QOZ strategy in 2021. Wondering if you have looked at Bridge Investment Group’s QOZ, and your take on that, vs further investment into Origin. Thanks in advance (not sure this is the right place for this question, but wasn’t sure where else to ask it).
No, I don’t know anything about that particular company. Sorry.
How do you get to taxable investments with “High Basis”? If you bought and held in your taxable account for 30 years, you’ll by definition not have a high basis assuming the markets keep growing.
Speaking of tax diversification, mine is:
32% Tax Deferred (I’m including HSA here)
43% Roth
25% Taxable
I’m kinda proud of myself haha.
@ Oye: I’d probably categorize your HSA portion with Roth; if you have any saved receipts or healthcare expenses, it will draw tax-free (however will behave like a tax-deferred if you don’t offset with healthcare expenses).
High basis in taxable comes from recently purchased securities with less time to grow (as stated in article with later contributions), or selecting low-basis shares to donate to charity (most easily thru a Donor Advised Fund), and using the cash you planned to donate to charity to replace/repurchase those shares, now at a higher basis.
While I save all my healthcare receipts, right now they don’t amount to more than a small fraction of the money I have in my HSA, so I listed it as a tax deferred. It might change in the future, but I hope not.
Sounds like you’ll still have some low basis stocks, unless you gave away quite a lot.
True & true. HSA can also be used tax free in future for Medicare premiums, and other health care expenses that may be more common later in life.
https://www.whitecoatinvestor.com/the-best-ways-to-use-an-hsa/
Depends. Money you just invested may have a high basis. If you didn’t earn much on the money you may still have high basis. If you continually flush out low basis shares with charitable giving you may also still have high basis.
43% seems like a high percentage of Roth (and that doesn’t even include HSA) . I suspect for most people that is not the best tax strategy. Is there something unique about your retirement savings that caused you to prefer so much Roth money? eg. did you go through some low-income years and convert lots of money to Roth? Is your target savings goal especially high? Are you saving for inheritance for your kids rather than just for you own retirement? I’m interested as I sometimes analyze my own Roth vs. deferred savings.
I had posted the percentages for how much I save each year. The distribution of my net worth right now looks like this:
5% Cash
36% Tax Deferred
46% Taxable
10% Roth
3% HSA
The percentage of my savings that goes into Roth accounts is high because my company started letting me do Mega Back Door Roth contributions a couple of years ago, and I thought, “Eh, this is a cool place to keep money, I’ll just max it out”. I don’t think it’s a bad strategy because, in simple terms, you have access to your principal in your Roth IRA even if you haven’t yet turned 59.5, if you need it. (In practice, there are some complications, like two different five year rules: https://www.kitces.com/blog/understanding-the-two-5-year-rules-for-roth-ira-contributions-and-conversions/ but shouldn’t really be a problem if you’re investing for the long term)
I’m single and don’t have kids. So I’m saving really for myself at the moment. The way I see it, I’m investing for the long term, and if I’m truly long term, Roth sounds like a no-brainer to have your money in.
Although still in the accumulation phase for at least another decade, I’ve been thinking about the specific mechanics of the decumulation phase for future planning. Any good recommended reading/books that dive into the weeds on this type of portfolio management during decumulation? Thanks!
https://www.whitecoatinvestor.com/investing-in-retirement/
https://www.whitecoatinvestor.com/investing-in-retirement-part-2/
https://www.whitecoatinvestor.com/investing-in-retirement-part-3/
https://www.whitecoatinvestor.com/investing-in-retirement-part-4/
https://www.whitecoatinvestor.com/common-questions-about-investing-in-retirement/
https://www.whitecoatinvestor.com/cracking-the-nest-egg-decumulation-strategies-in-retirement/
Just wanted to clarify that the Roth 401k is subject to RMDs at age 72. This article seems to suggest that it is not, as with the Roth IRA.
https://www.irs.gov/retirement-plans/roth-comparison-chart
It will be a tax-free RMD, but from what I can gather, they just don’t want you to be able to keep your money in that tax sheltered space.
Clarified.
Is the math right in this potion – ” physician can contribute $19,500 ($26,000 if age 50+) of tax-deferred money into their 401(k), plus another $6,000 for themself and $6,000 for their spouse into Backdoor Roth IRAs each year. Assuming an 8% return, after 20 years of making these contributions, these retirees would have $964,000 in tax-deferred money and $593,000 in tax-free money”
So that gives you a total of ~$1.5 million.
However, when I do the math on $51,000/year contributed for 20 years at 8%, I get ~$2.4 million. I used a couple online calculators to double-check and they agree. Or maybe I just missed an assumption somewhere else?
I bet the contribution amounts were updated for this post but the total wasn’t. So your math is probably right. Let’s do it together and see.
=FV(8%,20,-19500) = $892,358.30
=FV(8%,20,-12000) = $549,143.57
So no, they’re not right but it appears yours aren’t either. Not sure where you’re getting $51K a year from either though. $19,500 + $6,000 + $6,000 is $31,500 per year, not $51,000. If you use $51,000, you get
=FV(8%,20,-51000) = $2,333,860.18
Hope that helps.
WCI,
The only way I see $51k is if both spouses work and can contribute $25,500.
I think the more accurate calc for 401k contributions is at the end of each month, in which case For $51k that is $4250 per month or $2,503,337.
=FV(.08/12,240,-4250,0,0)
The fun part about assumptions is that everyone gets to make their own. If you don’t like the way I do assumptions and calculations, do them yourself in whatever way you prefer. It doesn’t really change the point I made in the article, which is that if you save a bunch of money for a long time it grows to a large amount of money. If some of that money is tax-deferred and some is tax-free, you’ll have significant tax diversification.
Whoops, I was getting $51,000 by assuming both spouses could max out a 401/403, so:
$19,500+ $19,500 + $6,000 + $6,000
And I just rounded up 2.3333 to 2.4 million because I’m generous with my imaginary retirement fund!