This is the seventh in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training at an upcoming ACCP meeting. In the last post, I discussed how tax-deferred investments outperform post-tax investments for retirement planning for most physicians. In this post, I will take you through the pros and cons of various post-tax investment options for retirement planning to use after you have maxed-out your tax-deferred options.

As a physician, you will have a myriad number of investment options and there are going to be a lot of people out there who are going to try to convince you that they have the best option for you. In previous posts, I went through some of the factors that should influence your investment decisions. In this post, I am going to focus on 3 general options for you to use with the money that is in your checking account after you have paid this year’s income tax on it:

  1. Regular investments. These could be stocks, bonds, mutual funds, money market accounts, etc. They consist of money that you have from your regular salary after you have paid income taxes for that year. As a general rule, these accounts will be taxed in three ways: (1) annual interest income, (2) dividend income, and (3) capital gains income. Interest income will be taxed every year as you earn it at whatever your effective regular income tax rate is for that year. Dividend income will be taxed each year at your capital gains tax rate. Capital gains income is taxed at your capital gains tax rate for the year that you sell your stock or mutual fund on the difference between the selling price and the original purchase price (i.e., you don’t have to pay capital gains on the amount that you originally invested when you opened the account).
  2. Traditional IRAs. You can put many different kinds of investments in an IRA: stocks, bonds, mutual funds, real estate, etc. Traditional IRAs are taxed at your effective regular income tax rate for the year that you withdraw money from the IRA. For a typical physician with a relatively high income, you will put money into an IRA from your salary after you have already paid income tax on it for that year. When you take the money out, you won’t have to pay income tax a second time on the amount of your original investment, only on the difference between the selling price and the original purchase price.
  3. Roth IRAs. For a typical physician with a relatively high income, you will not be able to invest directly into a Roth IRA. But, you can take advantage of a current loophole in the tax law that allows you to open a traditional IRA and then immediately convert it into a Roth. This is a so-called “backdoor Roth” that has been available since 2010 when a law governing IRAs expired. This is a surprisingly easy thing to do and most large investment companies will allow you to do it in just a few computer keystrokes from the comfort of your home. The great thing about a Roth IRA is that once you put money into it, you never have to pay any income tax or capital gains tax on it when you withdraw money from it in retirement.

So, which one should you choose? Let’s take an example of a physician who has $5,500 left over in her checking account at the end of the year and she decides she wants to put a little more into her retirement savings over and above what she put in her 401(k) that year. We’ll assume she is going to retire in 30 years and that when she retires, she is projecting an annual retirement income that will put her in the 15% capital gains tax bracket and that her effective regular income tax rate will be 21.3%.

tax analysis 4

In this analysis, her $5,500 grew to $60,147 in all three accounts. For regular investments and the tradition IRA, her taxable amount at the time of retirement is $54,647 ($60,147 – $5,500). On the regular investment, she pays capital gains tax. On the traditional IRA, she pays regular income tax.

At the end of the day, once she retires, she will have been much better off with the Roth IRA than with either a regular investment or a traditional IRA. What a lot of physicians don’t realize is that they are better off with a regular investment than with a traditional IRA. For many years, I was one of those physicians and I dutifully put money every year in a traditional IRA thinking that I was making a good investment. But here is the catch: you will pay capital gains tax on your investment income from a regular investment account but you will pay regular income tax on your investment income from a traditional IRA, and your regular income tax rate will almost certainly be higher than your capital gains tax rate.

The above analysis is pretty simplistic but it works if you are a young physician starting your career. It gets complicated if you’ve been around a while and have rolled investments into a traditional IRA. You see, the federal income tax law allows you to move money around from one type of tax-deferred account into another. This is a good thing because if you change jobs, you can end up with a bunch of different 401(a) accounts, 401(k) accounts, 403(b) accounts, etc. You’d be amazed at how many people lose track of all of their various retirement accounts and leave a few thousand dollars here and there in various pension accounts from different jobs that they have had in the past and never claim that money. So, the law allows you to transfer the money from (for example) a 401(a) pension account into your IRA or your 403(b) account when you change jobs. You have to be careful with transferring tax-deferred retirement account money into a traditional IRA or you can make your ability to convert that traditional IRA into a Roth IRA difficult. Here’s why:

About 15 years ago at Ohio State, we consolidated all of the various individual department practice corporations into a single multi-specialty practice company. So, the Department of Medicine Foundation, Inc. became a subsidiary of the larger OSU Physicians, Inc. I had a 401(a) pension with the Department of Medicine Foundation, Inc. and when we closed out that company to become OSU Physicians, Inc., we also closed out the 401(a) plan so I needed to move that retirement money somewhere. I thought I was being real smart by rolling the 401(a) money into my traditional IRA where I would be able to invest it in low cost index mutual funds. But then in 2010, the law prohibiting the conversion of traditional IRAs into Roth IRAs expired opening up the possibility of the backdoor Roth IRAs. The problem was that by that time, my traditional IRA account contained pre-tax money from my (tax-deferred) 401(a). Tax law requires that if you do a Roth IRA conversion, you have to consider all of your traditional IRAs together as a whole so movement of any money out of that traditional IRA has to be considered to consist of the same ratio of pre-tax/post-tax money that is contained in the entirety of your traditional IRAs. So for me to convert my traditional IRA into a Roth, I was going to have to pay regular income tax on the money in it from my previous 401(a) rollover during the year that I did the conversion. That was going to create a huge tax liability during the conversion year. Fortunately for me, the great recession occurred causing a massive drop in the value of the money in my traditional IRA so I was able to convert it into a Roth when the stock market price was close to its lowest in years, thus minimizing the amount that I had to pay in regular income tax on the conversion. If I had to do it all over again, I would have rolled the 401(a) over into a 403(b) account so that I could keep the traditional IRA account free of any tax-deferred account dollars and available to do an annual Roth IRA conversion each year without having to pay additional income tax.

So the bottom line:

  1. If you have extra $5,500 of spending money at the end of the year ($6,500 if you are over age 50), put it into a traditional IRA and then immediately convert that traditional IRA into a Roth IRA.
  2. If you have more than $5,500 ($6,500 if you are over 50) to invest at the end of the year, leave it in a regular investment account.
  3. Do not leave money in a traditional IRA; only use the traditional IRA as a vehicle to get that money into a Roth IRA.
  4. If you need to consolidate tax-deferred accounts, do not put them into a traditional IRA since that will contaminate your traditional IRA with pre-tax money that will be taxed at your regular income tax rate if you try to roll any portion of your traditional IRA into a Roth IRA in the future.

Most new physicians have a lot of college and medical school debt. In the next post, we’ll look at whether it is better to pay off that debt early or put money into retirement accounts.

August 28, 2016

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