Category: Physician Retirement Planning

This is the twelfth and last 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 this post, I’ll summarize the key points from the last 11 posts.

Retirement planning for physicians is different than for everyone else. You make a lot more money. You have a lot more educational debt. Because of how long you trained, you have less years to save for retirement. Because of your income, your children are not going to be eligible for financial aid in college. And you have different insurance needs. Here is my list of the 13 rules to invest by for your retirement.

Start saving for retirement as early as you can afford to. Compound interest is a beautiful thing and you need to make it work it’s wonders for you.

Know your tax rate. It is not your income tax bracket that is important, it is your effective income tax rate and these are very different numbers. You also need to know your capital gains tax rate and which types of income are susceptible to income tax versus capital gains tax. Also, realize that changes in tax laws and tax rates are inevitable and the rates today will very likely not be the rates when you retire.

Tax-deferred investments are almost always better in the long run. Financial advisors who tell you that you will be in a lower tax bracket when you retire and so you should invest in post-tax investments are wrong – your goal is to retire in the same or a higher tax bracket than you are in now. Tax-deferred investments outperform other types of retirement investments.

If you have access to a defined benefit pension plan, take it. We’ve all heard about defined benefit pension plans that went belly up during the great recession and many people got scared of these pension plans. But the reality is that all investments went belly up during the recession. Unlike a blue collar worker or high school teacher for who the pension plan may be the only retirement plan that they have, you will have a lot of additional options and a defined pension plan is a fantastic component of a well-diversified retirement portfolio.

Set a priority list for retirement investment options. Each different plan has different tax implications and some are going to be better than others in the long haul. Employer-matched 401(k) or 403(b) plans are a no-brainer because the you can basically double your money from the outset. 457 plans have an advantage of no penalties for early withdrawal compared to 401(k) and 403(b) plans. If you are at a university, you may be able to invest in BOTH a 457 and a 403(b) plan. Once you become eligible for a 415(m) plan, you will likely have to make a one-time irrevocable decision about whether to contribute to it and how much to contribute to it – I recommend you choose to contribute the maximum percentage of your salary that you can; even if you can’t afford to do that now, you can always reduce your 403(b)/457 contributions for a few years until you are financially able to do both the 415(m) and your other tax-deferred investments. If you have self-employment income (from consulting, etc.), then open an SEP and put the maximum contributions that you can into it. Every year, put money into a traditional IRA and then immediately convert it into a Roth IRA – this gives you additional diversification in the types of retirement accounts that you have. After you have done all of that, then start putting retirement savings into regular investment accounts (i.e., those made up from post-income tax money). Don’t put money in a traditional IRA unless you are going to convert it into a Roth IRA.

Buy term life insurance.  But only buy as much as you need during the time in your life when other people who depend on you need it.

Buy a $1 million umbrella insurance policy. Remember, as a physician, you have a big red bull’s eye on your back that every personal injury attorney in the United States can see.

Seek no-load mutual funds with low expense ratios. The easiest options will be index funds.

Pay off your student loans on time but don’t try to pay them off too early. Being debt-free is always desirable but if you are careful with your personal budgeting and finances, then you will be better off contributing to a tax-deferred retirement plan than making additional early payments on your student loans.

If you use a financial advisor, pay him/her by the hour. Avoid using financial advisors who get paid by investing your money. No matter what they say, they are going to be motivated by making as much money off of your investments as they can. By paying by the hour, you avoid the conflict of interest that comes with getting advice from advisors who work on commission. Some investment companies (such as TIAA-CREF and Vanguard) will have free financial counseling by advisors who are not on commission, take advantage of free advice that comes without a conflict of interest.

For your children’s college savings, open a 529 plan and make regular monthly contributions to it. The tax advantages of 529 plans are huge and the control you have over the account puts these plans far ahead of other college savings options.

Diversification is the foundation for a strong retirement portfolio. Know the right percentage of stocks versus bonds in your portfolio for your age. Your goal is to have the optimal balance between risk and returns – when you are younger, take greater risks in order to get greater long-term returns – when you are older, take less risks in order to get more predictable short-term returns. Don’t forget that a defined benefit pension plan is the ultimate in predictable returns and this gives you a great foundation for portfolio diversification.

Above all, realize that you can be your retirement fund’s best friend or its worst enemy. Knowledge and patience are your most powerful tools in investment for retirement. If you try to beat the market, you most likely won’t since even professional stock analysts usually don’t. You need to make a long-term plan and stick with it. When the stock market crashes and everyone is in a panic, that’s the time for you to put a little extra into your retirement funds rather than pull money out of stocks because even though stock markets go down, they always eventually come back up and as a physician, you are going to have a secure enough job and high enough income to weather economic declines compared to people in just about any other profession.

September 7, 2016

This is the eleventh 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 this post, I’ll be covering the pros and cons of state teacher’s retirement systems. This post will mainly apply to those physicians pursuing an academic career at a university.

Most states have a special pension program for teachers and university professors, including physicians who work at universities. In Ohio, we have STRS, the State Teacher’s Retirement System. Although each state’s teachers’ retirement program will be different, I’m going to discuss Ohio’s STRS. If you work at a university in a different state, you’ll need to be familiar with the specifics of your own state’s system to decide if it is right for you.

In Ohio, STRS is currently financially healthy but that is not currently the case for every state. During the recent great recession, most pension plans really suffered and lost a lot of their value. But they still needed to pay out a fixed amount in pension payments every year. So Ohio STRS, like many other state teacher’s retirement systems, came dangerously close to having projected future liabilities exceed projected future income. This made state legislators and taxpayers nervous since they did not want to have to bail STRS out with taxpayer money. It also made new physician faculty nervous since they were worried that they might end up putting money into STRS and not getting it back out again once they retired. Now that the recession is over, STRS is healthy again but it does illustrate that a pension is an investment and like any other investment, it has risk. Its just that the risk is relatively low compared to most of the other things you can invest in.

One thing to keep in mind about Ohio STRS: it is a substitute for Social Security. In other words, you will not have Social Security payroll tax taken out and consequently, you will not be getting Social Security checks when you turn 65 or 70 if you are a teacher in Ohio. If you have other income, for example, you worked enough years and contributed to Social Security before becoming employed at a university, or maybe as a professor, you have some outside income from consulting, etc. that is subject to Social Security payroll tax, then you may be eligible for Social Security benefits in addition to your STRS pension benefits in retirement. However, the federal government will look at the amount that you get from your STRS pension and your Social Security monthly payments will be reduced, fairly drastically. In my case, because of my work history, I’ll have STRS retirement benefits and will be eligible for Social Security benefits. But my annual Social Security benefits will not even be enough to make 4 months’ worth of mortgage payments.  Bottom line, if you have STRS, don’t count on much (or maybe anything) from Social Security.

When we first become employed as faculty members in Ohio, we have some irrevocable decisions to make. The first is whether to participate in STRS or in the “alternative retirement plan” or ARP. In the ARP, you can put your money into an investment of your own choosing, a lot like a 403(b) or 457 plan. When you take the money out in retirement, you can take it out however you want but when you have taken it all out, it is gone. So, unless you have other investments, you could find yourself at age 70 or 80 and broke with no income.

If you decide to go into STRS as opposed to the ARP, then you have to decide whether to do the “defined contribution plan” or the “defined benefit plan”. For details about the differences between these, refer to the 2^nd in this series of posts. The vast majority of physician faculty will choose the defined benefit plan with the result that you (or your surviving spouse if you die) will get a fixed monthly income for the rest of your life. My father was a physician and university professor who died when I was in college – STRS helped support me in my last year of college and in medical school and I am eternally grateful for that support.

There are federal contribution limits for STRS that are currently set at $265,000. That means that you can only contribute to STRS up to that amount of salary and anything over $265,000 needs some other retirement investment option. For many universities, that will be a 415(m) plan that will kick in if you make more than $265,000 per year. The 415(m) plan will typically be with an investment company, such as TIAA-CREF, and it is not with STRS.

If you go the defined benefit route, then you do not get the maximum benefit until you have a certain number of years of service. That used to be 30 but when the recession hit, the number in Ohio was increased to 35. Therefore, if you leave academics to go into private practice, you will not get the maximum retirement benefit.

With any defined benefit pension plan, you are, in essence, taking a gamble that you will out-live other people in your age range and ensuring that no matter how long you live, you’ll always have at least something to live off of. As physicians, there are two variables that make us different than most other teachers in STRS. First, the average teacher starts his or her career after completing their master’s degree at about age 23 or 24. The average physician does not start his or her career as a professor until after completing residency or fellowship between the ages of 27 to 31. Since the years of service to get full retirement benefits in Ohio is 35 years, the average teacher will be eligible to retire at age 57 whereas the average physician with a 3-year residency will need to be age 62 (although in some residencies, you can start contributing to STRS during residency and this will lower the retirement age). Therefore, a physician will typically have a shorter life in retirement to fund than the average teacher. On the other hand, physicians tend to have healthy habits: we have access to good preventive medicine, we rarely smoke, and we usually exercise and eat right. So we hopefully can live to an older age than the average American.

One other aspect of STRS to be aware of is where the contributions come from. There is an “employee contribution” of 14% to STRS and also a “university contribution” of 14% to STRS. On the surface, it looks like the State of Ohio and consequently the Ohio taxpayers are funding university physicians’ retirement accounts to the tune of 14% of their salary. BUT, the Ohio State University, like most other universities, gets the funds to pay for the “university contribution” from the physician practice plans and not from state government. Therefore, in essence, we the physicians fund the “employee contribution” by a 14% reduction in our gross salary and we also fund the “university contribution” by transferring the equivalent of 14% of our salary from our clinical practice income to the university. Thus in reality, the physicians are paying for the entire 28% STRS contribution and the taxpayers of Ohio pay nothing.

So, should you choose STRS or the ARP? If you think (like I do) that you are going to live a long, long time in retirement, then having a fixed income that you can count on every year is an advantage but if you think you are only going to make it 5 or 10 years after you retire, the ARP is the better option. STRS has the ability to contract with health insurance companies for good group prices on health insurance policies and this can be a plus if you are going to retire before you are eligible for Medicare; no one knows if “Obamacare” will be repealed by politicians in the future so no one really knows if health insurance exchanges will continue to be available in the future – having the confidence that you can get access to affordable health insurance no matter what happens in the future can be a plus. If you think you are going to stay in academic medicine for your whole career, then STRS is a good option but if you think you may leave to go into private practice after a few years, then the ARP is the better option. If you are a control freak and you can’t stand someone else overseeing your investment, then the ARP is better for you since STRS will make all of the investment decisions regarding your retirement account. Lastly, if you are risk adverse, go with STRS – even though STRS (like all investments) has risk, in the long-run, that risk is a lot less than putting your money in the stock market yourself.

So, what is a new faculty member to do? My own advice is that if you have access to a defined benefit pension plan (such as STRS) as one component of a diversified retirement portfolio, do it. As an academic physician, you are going to have a lot of additional investment options including a 403(b), 457, and a converted Roth IRA that will give you that diversification. You may not have Social Security. Having the relative security of a fixed monthly STRS pension for the rest of your life will allow you to be more aggressive in your other retirement investments by not needing to have as high of a percentage of your retirement portfolio in low-risk bonds. This will allow your retirement portfolio to have a higher percentage of stock that are both riskier than bonds but in the long-run, will pay off more.

In the final post of this series, I will summarize the key points from all of the previous posts.

September 5, 2016

This is the tenth 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 this post, I’ll be covering the types of insurance that you need to get yourself safely to retirement.

You can buy insurance to cover almost anything you can imagine, and there are salesmen out there that will try to. Most physicians will need several types of insurance: home, car, health, malpractice, disability, life, and umbrella.  I am going to focus on just the last 3 types of insurance.

Disability insurance. You’ve likely invested more than $200,000 and between 11 and 15 years in your education to become a physician so you had better protect that investment. The amount and type of disability insurance you need will depend on your individual circumstances. For example, early in your career, you have a lot more to lose if you suddenly find yourself unable to work whereas if you are close to retirement and already have a sizable retirement fund, then you may not need to depend on disability payments to get by. Also, you will need to consider your specialty. A friend of mine who is a general surgeon had to stop operating in his early 50’s due to arthritis in his thumb and that pretty much ended his practice career. On the other hand, another of my colleagues who is an endocrinologist became paralyzed from the waist down and dependent on a wheelchair after a diving accident as a young adult; she practices full-time and is one of the most highly regarded physicians in her field nationally. Many group practices and hospital employers will provide a standard disability insurance policy and you will need to look at your own circumstances to determine if that is enough or if you need to purchase additional disability insurance on your own. Disability insurance policies can have a lot of differences. For example, some will cover student loan payments and some won’t; some are subject to income tax and others are tax-exempt.

Life insurance. This is a tricky one. If you are single with no dependents, you may not need any life insurance since if you die, no one will be left unsupported. But most of us have at least one person other than ourselves who depend on our income. The amount of life insurance that you need will vary depending on how many people depend on your income and for how long they will be depending on it:

1. If your spouse does not work, you need more life insurance
2. If you have children, you need more life insurance
3. If you are early in your career and have not built up a sizable retirement fund, you need more life insurance
4. If you have a lot of debt (mortgage, loans, etc.) that you don’t want to leave to your heirs, you need more life insurance
5. On the other hand, if your spouse works, your kids are out of college and you are near retirement, you may need little or no life insurance

There are essentially two types of life insurance, term and whole life. For physicians, term life insurance is the better deal and I would stay away from whole life policies since whole life policies are considerably more expensive and provide coverage that you will not need for your entire life.

Umbrella insurance. This is a policy that provides coverage over and above your regular insurance policies. When asked why he robbed banks, Willie Sutton famously replied, “Because that’s where the money is”. The same could be said for why personal injury attorneys sue physicians: because that’s where the money is. As a physician, you have a big red bull’s eye painted on your back and if you are involved in an automobile accident or someone slips on your sidewalk and gets injured, there is a pretty good chance that they and their attorney are going to go after you for more than your regular automobile or home owner’s insurance policy. I think that all physicians after residency and fellowship should have an umbrella insurance. $1 million in coverage is usually sufficient.

So, in summary, don’t just buy a lot of disability insurance, buy the right amount that you are going to need based on your specialty and how far along you are in your career. Don’t just buy a lot of life insurance, buy what you need when you are younger and when your family is dependent on your income. But do buy umbrella insurance.

In the next post in this series, I’ll go over the advantages and disadvantages of state teacher’s retirement systems for those physicians who are eligible for them.

September 3, 2016

This is the ninth 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. For most physicians, you will have three major investments over your lifetime: your house, your retirement, and your children’s education. It this post, we’ll examine the options that you have to save for your children’s college education. Although it is not exactly retirement planning, it does impact your retirement plans since if you don’t prepare for college expenses now, you may find yourself either unable to contribute money into retirement when college expenses come due or even worse, you may find yourself having to takes loans or early withdrawal from your retirement account to pay for your children’s college expenses.

If you are a physician, I’ve got some good news and some bad news for you. The good news is that you are going to have a very good income. The bad news is that your kids are not going to be eligible for financial aid when they go to college because you make too much money. So, unlike most Americans who send their kids to college, you are probably going to have to pay the sticker price… and that price is high. This year, the cost of tuition, room & board, books, and fees for the Ohio State University (a public university) is $22,753 for an Ohio resident. My wife’s and one of my daughter’s alma mater, Notre Dame (a private university) is $65,093. And this doesn’t include the cost of transportation and personal expenses. For 4 years of college, that adds up to $91,012 for a public university and $260,372 for a private university.

Even scarier is the fact that the cost of going to college has been increasing at about 5% per year, in other words, twice the regular inflation rate. That means that if you have a child born today, then in 18 years, a public university is going to cost you $54,758 for the first year and $236,013 for the entire 4 years of college. If your newborn child goes to a private university 18 years from now, that freshman year will cost $156,654 and the entire 4 years will cost $675,199. If you have 4 kids, like I have, then you’ll end up spending more on their education than you will to buy your house, so you have to start saving early.

Fortunately, you have several ways to save for your children’s college education: regular investments, Coverdell educational savings accounts, uniform gifts to minors accounts, and 529 plans. Let’s look at the advantages and disadvantages of each.

Regular investments. This would mean putting money in stocks, bonds, or mutual funds in your name and then drawing the money out when you eventually pay college expenses. The only advantage of this is that the money is yours so if your child ends up getting a full-ride scholarship or not going to college, then you can use the money for whatever you want with no penalty since you did not use it for college expenses. The disadvantage is that you have to pay taxes on the earnings: regular income tax on interest income and capital gains tax on dividend and capital gains income.

Coverdell educational savings accounts (ESAs). These used to be known as education IRAs back when I was saving for my kids’ education. The contribution limit is $2,000 per year and the initial contribution is not tax deductible. The money grows tax-free and if the investment is eventually used for education purposes, it is not taxed when it is withdrawn. You can put almost any kind of investment of your choosing including stocks, bonds, and mutual funds in the ESA. An important limitation is that If your taxable income is greater than $110,000 per year filing single or $220,000 if married filing jointly, then you cannot contribute to an ESA. For most physicians, the $220,000 income limit and the $2,000 annual contribution limit make ESAs either not possible or, if possible, then an inadequate vehicle for college savings.

Uniform gifts to minors. This allows you to give money to your children and then it can be invested in any kind of investment that you (or the child) wants. You cannot deduct any contributions from your taxes and as the money grows, you’ll have to pay regular income tax on the interest and capital gains tax on the dividends and capital gains – under the current tax law, the first $1,000 of income is not taxed, the second $1,000 is taxed at the dependent child’s tax rate, and anything over $2,000 is taxed at the parent’s tax rate. Also, once the child reaches the age of majority (18-21, depending on the state), the money is theirs to do whatever they want with. So, if your idea was that they would spend it on college and their idea is that they would by a Corvette, you’ll be seeing a nice new Corvette in the driveway when he or she turns 18. Because of the lack of tax advantages and the lack of control that you have over the money once your child becomes an adult, uniform gifts to minors is not a good option for most physicians.

529 plans. These plans allow you to invest money into an account to be used for your child’s college education. The money in a 529 plan grows tax-free and as long as you use the money for college education expenses, you don’t have to pay any taxes on the withdrawals. Additionally, in some states, you can deduct contributions from your state income tax; for example, in Ohio, we can deduct up to $2,000 in annual contributions per child from our state income tax. There is no limit to the amount of money that you can put into a 529 plan but if you contribute more than $14,000 per year ($28,000 if married filing jointly) then there are tax consequences since you will have exceeded the maximum amount that the IRS allows you to “gift” to one person in one year. There are 2 types of 529 plans: (1) prepaid tuition plans that allow you to purchase tuition in selected colleges at today’s tuition rates and (2) savings plans that allow you to invest the money in state-approved investments, usually mutual funds. I’m a bit leery about the pre-paid tuition programs because if you are buying this for your newborn son, you don’t even know what state you are going to be living in 18 years from now, let alone what college he is going to want to go to. Each state has a different 529 plan that uses different mutual funds. Of note, you can invest into any state’s 529 plan that you want; for example, when these plans first came out, I invested into Iowa’s 529 plan even though I lived in Ohio and had never set foot in Iowa in my life. At the time, Iowa’s 529 plan used low-cost Vanguard mutual funds and I wanted access to them. Once Ohio switched to Vanguard funds for Ohio’s 529 plan, I moved the funds from Iowa to Ohio. The state income tax advantage that you get may only apply if you invest in your own state’s 529 plan. If you don’t need to use all of the money in the 529 account for one child, then you can very easily move the money into another child’s 529 account. If there is still a balance in your 529 accounts after you have put all of your kids through college, you can withdraw the balance of the account and use it for whatever you want but you will have to pay a federal 10% penalty on the earnings from the residual account balance. That 10% penalty may seem like a lot on the surface but it really isn’t when you figure all of the tax advantages that you have had with the money in the 529 plan over the years.

So in summary, college is expensive and will get more expensive. There are several options for saving for your children’s college education and my personal opinion is that the 529 plans are the best option for physicians. What I did with my own children was to put $5,000 into each child’s college fund account when they were born (that would be $10,000 in today’s dollars). I then put additional money into each child’s account each month. For Ohio’s 529 plan, that was easy – I set up a regular monthly direct deposit from my checking account into the 529 fund so that it happened automatically at the beginning of each month. That way, I didn’t have to think about it and I was not tempted to use the money for other purposes. At the end of the day, we put 2 of our children through private colleges and 2 through public colleges from the money in their 529 plans.

In the next post, we’ll look at insurance for physicians.

September 1, 2016

This is the eighth 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 to invest your post-tax money for optimal returns in retirement. In this post, we’ll look at whether it is better to pay your student loans off early or invest in retirement.

First, let’s just get this out of the way, if you have the option, the best way to manage your student loans is to get someone else to pay for them. There are a few ways of getting your student loans paid off. If you are pursuing a career in medical research, there are NIH loan repayment programs that will pay up to $35,000 a year on your loans. There are loan repayment programs if you join the military or if you agree to practice in certain underserved parts of the country. Lastly, when you get your first job out of residency, ask if the hospital or group practice will pay off some of your loans – most won’t but some will (particularly if they’ve been having a hard time recruiting into the position) and the only way to find out is to ask.

The average medical student graduates from a public medical school with $172,751 in loans and from a private medical school with $193,483 in loans. That is a lot of debt for a resident making $50,000-$55,000 a year. If you can’t get someone else to pay off your loan, then you’ll be making monthly payments for a long, long time. The jump in annual income from being a resident to being an attending physician can seem like a lot, and it is, but it comes with a rapid ramp-up in the loan repayment requirements. Plus, as a medical student and resident, you may have been driving your grandmother’s hand-me-down 1998 Honda Civic and living in a one-bedroom apartment… you’re 30+ years old and you’re ready for a lifestyle upgrade. So, it is easy to find yourself spending all of that new income on stuff and not on your future retirement.

Above all, do not get behind in your regular student loan payments. The cost in penalties is just too high and you’ll just fall further and further behind. So, we’ll assume that you are making your regular monthly payments on your student loans and then you have to decide if it is better to make a few extra payments on your loans or if it is better to put some extra money into a tax-deferred retirement plan?

As a general rule, I am pretty debt-adverse and just feel better getting out of debt but if you are disciplined (and to get through 11-16 years of college, medical school, residency, and fellowship presumably you do have personal discipline), then you can use some strategic financial planning and budgeting to give you the best long-term financial outcome. So, let’s make some assumptions in a hypothetical case:

1. You have $150,000 in student loans. You probably have more than this but it is an easy number to use as an example.
2. The average interest rate on your loans is 6%.
3. You have a 15-year repayment period for your loans. This will equate to $15,316 of payments per year ($1,276 per month) of which about $9,000 per year is interest.
4. You can deduct up to $2,500 of annual interest payments off of your income tax each year.
5. Your tax deferred 401(k)/403(b)/457 has an 8% annual return on investment.
6. Your taxable income is $258,000 ($255,500 after the loan interest deduction).
7. You are married and filing jointly.
8. We’ll use 2015 income tax and capital gains tax rates.
9. We’ll compound interest monthly on the loan and we’ll compound capital gains monthly on the tax-deferred retirement account.
10. You are financially responsible and you project that this year, you will have $20,000 in pre-tax income that you can use to either (1) put in your tax-deferred retirement account or (2) pay income taxes now on the $20,000 and use it to make extra payments on your student loans.

Now let’s take a look at what your financial picture will look like if you make extra payments on the loans versus if you invest the money into a tax-deferred retirement account.

The first thing to notice is that with either choice, your taxable income drops to $255,500 because you can deduct $2,500 of your $9,000 in interest payments off of your taxable income for that year. The $20,000 in pre-tax money that you decide to use for extra payments for your student loan becomes $15,3116 after you pay an effective income tax rate of 23.42%. On the other hand, if you put the money into a tax-deferred retirement account, then after 1 year, that $20,000 becomes $21,660 and the value of that money if you were to retire after a year at your current effective income tax rate would be $16,743.

Next, look at your overall financial picture at the end of the year if you make extra payments on your student loans. We’ll define the overall financial picture as your total assets (salary that year + the projected value of your tax-deferred retirement fund [after you pay taxes on it when withdrawing it in retirement] minus your debts (the balance remaining on your student loan). In this scenario, your effective income tax rate will be 23.42% and your overall financial picture will be $37,349.

If, on the other hand, you decide to put money into a tax-deferred retirement account, your effective tax rate will drop to 22.70% and your overall financial picture will be $38,922. In other words, you come out ahead $1,573 by putting that $20,000 in a tax-deferred retirement account as opposed to making early payments on your student loans.

Now let’s assume that your student loan interest rate is a little higher, say 7% rather than 6%:

Note that the value of the loan changes due to the effect of the higher interest. If you make extra payments on the student loan, your overall financial balance is $35,920 whereas if you put the extra money in a tax-deferred retirement account, your financial balance is $37,330. In other words, you come out $1,410 ahead by putting the money in a tax-deferred account.

Finally, let’s take a worst-case scenario and assume that you have an exorbitant student loan at 9% annual interest:

Now, your overall financial balance will be $33,022 if you make extra payments on your student loans versus $34,103 if you put the money into a tax-deferred retirement account for a net advantage of $1,081 to put the money in the retirement account. The bottom line is that you always come out ahead by putting the money into a tax-deferred retirement account instead of making extra payments on your student loan.

Finally, let’s assume that you do not have the flexibility to put money into a 401(k), 403(b), or a 457. Should you put money into a regular investment after you have already paid income tax on that money?

If the student loan is 6% then you come out only $145 ahead by investing the money (for all practical purposes, break-even). If your student loan is 7% (analysis not show), you come out only about $18 ahead by making an extra payment on the student loan (also, essentially break-even). If your student loan is 9% (analysis not shown), you come out $1,428 ahead by making the extra payment on the student loan. In other words, unlike the situation with a tax-deferred retirement fund where you always come out ahead by investing in your retirement fund, the situation with a regular investment funded out of your post-tax dollars is more complicated. If your student loan interest rate is high, then you are better off making extra payments on the loan and if the student loan interest rate is lower, it doesn’t make a lot of difference which choice you make.

Every physician’s situation is a little different and you have to take into account the nuances of your own particular circumstances in deciding whether to put additional money into your retirement account versus make additional payments on your student loans. What is not taken into account in the above analysis is the peace of mind that you get when your student loans are finally paid off and from my own past experience that peace of mind is priceless.

In the next post, we’ll take a look at options for investing in your children’s college expenses.

August 30, 2016

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%.

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

This is the sixth 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 the basics of how Americans are taxed. In this post, we’ll cover whether physicians should put their money into a 401(k)/403(b)/457 or should they instead go ahead and pay income tax now and then put the money in a regular investment account in order to maximize the eventual value of that investment in retirement. If the goal is to use that money in retirement, then the answer is almost always to put it into a tax-deferred investment (401(k), 403(b), or 457). The reason is that the tax-deferred investment gets taxed once and the regular investment gets taxed twice.

As an example, let’s make a couple of assumptions:

1. You want to save $20,000 of your pre-tax income this year
2. Your current taxable income is $258,000 (current average pulmonologist salary per the 2015 Medscape compensation report)
3. Your effective income tax rate is 23.2%
4. You project that your annual income in retirement will be $200,000 in today’s dollars
5. Your post-retirement effective income tax rate will be 21.3%
6. Your capital gains tax rate is 15%
7. You project that your investments will appreciate by 8% per year
8. You plan to retire in 30 years
9. You are married and file joint income tax with 0 exemptions (you won’t really have 0 but it is easier to do the calculations and doesn’t affect the outcome of the analysis)

 

What the analysis above shows is that there are several things happening from a tax standpoint that most investors don’t take into account. First, by reducing the take-home salary from $258,000 to $238,000, the income tax bracket of 28% does not change but the effective income tax rate does drop from 23.5% to 22.7%. This drop in the effective income tax rate results in a $1,918 reduction in income tax that year. Second, if instead the investor had paid the regular effective income tax rate of 23.5% and put the $20,000 in a regular (post income tax) investment, then the investor would have to pay tax a second time in the form of capital gains tax when the money is withdrawn in retirement. The net result is that the investor is better putting the $20,000 into a tax-deferred account from the beginning and ending up with $173,833 when they retire versus $144,514 if they had paid regular income tax on the $20,000 up front and then put it in a mutual fund investment.

You can even further improve your financial picture if you take the $1,918 that you saved from having a lower effective income tax rate and investing it in a regular investment account or (better yet) in a Roth IRA.

But many physicians (including yours truly) hope that their annual income in retirement will be the same or even more than their annual income during their working years. So, would they still be better off putting their retirement money in a 401(k)/403(b)/457? The answer is yes and to show you why, let’s take an extreme example of a physician who plans to have a post-retirement income of much, much more than their current income; consider these assumptions:

1. You want to save $20,000 of your pre-tax income this year
2. Your current taxable income is $258,000 (current average pulmonologist salary per the 2015 Medscape compensation report)
3. Your effective income tax rate is 23.2%
4. You project that your annual income in retirement will be $700,000 in today’s dollars
5. Your post-retirement effective income tax rate will be 31.6%
6. Your capital gains tax rate is 20%
7. You project that your investments will appreciate by 8% per year
8. You plan to retire in 30 years
9. You are married and file joint income tax with 0 exemptions (you won’t really have 0 but it is easier to do the calculations and doesn’t affect the outcome of the analysis)

What this analysis shows is that you still come out ahead by putting your retirement investment in a tax-deferred account, even if your income will be much higher in retirement.

Some physicians will have a choice between a regular 401(k)/403(b) and a Roth 401(k)/403(b). The decision about whether to put retirement in one or the other can be a tough call and really requires careful analysis of the individual’s personal tax situation. The traditional wisdom is that if your post-retirement annual income tax rate will be higher than it is now, then you are better off with the Roth 401(k)/403(b) and if your post-retirement annual income tax is lower than it is now, then you are better off with a traditional 401(k)/403(b). What these recommendations don’t take into account is what the effect of taking a Roth 401(k)/403(b) will do to your current effective income tax rate, namely, that it will go up since your taxable income goes up by the amount of the Roth 401(k)/403(b) contribution. As I mentioned in a previous post, you can’t predict what politicians will do to tax rates 4 years from now, let alone 35 years from now. My own take on it is that unless you expect your post-retirement income tax rate to be considerably higher than it is now, you are better off with a regular 401(k)/403(b) and not a Roth 401(k)/403(b).

The last situation to consider is whether your employer offers a matching 401(k) or 403(b). If they do, then this is an even stronger reason to put your retirement savings into a tax-deferred 401(k) or 403(b) since the matching funds are free money and who in their right mind would ever turn down free money?

The bottom line is that for the typical physician, you will almost always be better off putting your retirement funds in a tax-deferred investment. This includes the 400-group of investments (401(a), 401(k), 403(b), 457, or 415(m)), a pre-tax traditional IRA (as a physician you will likely make too much money to qualify for one of these), or an SEP. In the next post, we’ll examine the question of where you should put your post-tax investments: a traditional IRA, a Roth IRA, or a regular investment.

August 26, 2016

This is the fifth in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training at the upcoming ACCP meeting. Whether you do your own income taxes or you pay an accountant to do your taxes for you, you have to understand the basics of how taxes work in order to maximize your yield from your various retirement accounts. In the last post, I discussed some of the common mistakes physicians make in their investment decisions that can erode total returns. In this post, I’m going to give a very general overview of income taxes and capital gains taxes to set the stage for future posts about the best retirement investments for physicians.

Let’s start with income taxes. I am continually amazed at how much misconception there is about the American income tax system. The first thing to understand is that although we have tax brackets, we operate on a marginal tax system. This means that as your income goes up, your tax rate also goes up but it does so incrementally so that you pay a different tax rate for each successively larger chunk of income that you have. The table at the right shows the 2016 regular income tax brackets.

One of the problems with tax brackets is that you can’t predict where they will be in the future. Presidential candidates love to run on promises to change tax rates, generally by either increasing the taxes on the rich or by decreasing the taxes on the rich. One of the common ways that politicians change taxes is on what the income tax rate is on the top income tax bracket. This number has fluctuated considerably over the past 30 years, depending on who was president. As you can see from the graph below, the biggest change occurred during Ronald Reagan’s term when the tax rate on the highest tax bracket fell from a tax rate of 50% at the beginning of his presidency to to a tax rate of 28% at the end:

To understand how the marginal tax system works, let’s take an example of a single physician who makes $250,000 in taxable income. For the first $9,275 of her income, she pays 10% income tax ($927). For the next $28,375, she pays 15% income tax ($4,256). For the next $53,500, she pays 25% income tax ($13,375). For the next $99,000, she pays 28% income tax ($27,720). For the last $59,850, she pays 33% income tax ($19,750). Her total income tax is the sum of each of the components from each of her tax brackets ($927+$4,256+$13,375+$27,720+$19750 = $66,028). Many people have the mistaken belief that if they have a taxable income of $250,000 (the 33% tax bracket), that they have to pay 33% income tax on the whole $250,000 (i.e., $82,500). You will pay income tax on your income from your regular salary and on your income from interests (for example, from bond investments).

The other tax that most physicians will pay is capital gains tax. This is tax that you pay for income you get from dividends and the profit that you get from what you sell a stock for compared to what you originally bought it for. The capital gains tax rates are lower than the regular income tax rates. Unlike regular income tax, the capital gains tax is not a marginal tax, in other words, whatever your total taxable income is, that dictates your capital gains tax rate for all of your capital gains. The table above to the right shows the 2016 capital gains tax rates.

So if we put all of this together for several hypothetical taxable incomes, for a married couple filing jointly, here is the tax bracket (the amount you pay on the highest portion of your income) versus the effective tax (what you actually pay overall for your entire salary) versus the capital gains tax:

As you can see from the table, the income tax bracket is not what is really important, it is the effective tax rate, since what you are really going to pay is the effective tax rate. The table also shows that for the range of typical physician incomes, you are better off paying a capital gains tax than a regular income tax if you can. This will become important in future posts as we look at how to select investments for a physician’s retirement portfolio.

Another feature of taxes is when you pay them. For some taxes, you pay during the distribution year, that is the year that you take the money, for example, withdrawing money from a 401(k). For other taxes, you pay during the contribution year, that is the year that you actually earned that money. Of note, Pennsylvania is unique in that state income tax is paid during the contribution year rather than the distribution year**.

Now that we’ve covered the basics of taxes, we can determine the best place to put your money in order to maximize the amount that you will actually have in your hand when you retire. The next post will examine this in more detail.

August 24, 2016