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Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 9: Saving For Your Children’s College Education

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

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Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 8: Pay Off Student Loans Versus Save For Retirement?

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.

tax analysis 5

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%:

tax analysis 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:

tax analysis 7

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?

tax analysis 8

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

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Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 7: Choosing Post-Tax Investments

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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Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 6: Should I Do A 401(k)/403(b)/457?

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)

 

tax analysis 1What 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)

tax analysis 3What 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

Categories
Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 5: Taxes 101 For Physicians

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.

tax bracketsLet’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:

Tax brackets 1984-2015

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).

Capital gains tax brackets 1The 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:

Marginal v effective v capital gains rates 1

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**.

When taxes are paid

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

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Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 4: Maximizing Your Annual Return?

This is the fourth in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training. In the last post, I demonstrated how reaching a goal of a $9,000,000 retirement fund is achievable in 35 years if you invest $40,000 per year and get an annual rate of return of 7.5%. On the surface, this sounds so simple, but in reality, many physicians never get this rate of return due to the pitfalls that get in the way. In this post, I’ll outline some of the common pitfalls.

Physicians are in one of the highest paid professions on the planet and so they have a lot of money to invest. But we usually know a lot less about investment than other professionals in business or law. Consequently, there are a lot of people who would like to get paid to steer us toward our retirement goal. Although you are going to need some advice, it is up to you to be sure that you are not being taken advantage of. Here is where we often go wrong:

  1. Expense ratios. Lower is better. If you are investing in a mutual fund, for example, there will be a certain percentage of the total fund balance that you pay each year to the investment company for them to manage that mutual fund. This is called an expense ratio. These can vary from as little as a tenth of a percent to as much as 2%. Let’s assume that you have $100,000 to invest and you anticipate an 8% annual rate of return and you’re going to leave the money in for 20 years before you use it. Now let’s look at two mutual funds: Fund A has an expense ratio of 0.21% and fund B has an expense ratio of 1.15%. The cost to manage fund A over the next 20 years will be $19,000. The cost to manage fund B over the next 20 years will be $96,000. In other words, when you get ready to take the money out of this account in retirement, you’ll have $77,000 less if you paid the higher expense ratio.
  2. Index v managed fund returnMutual fund category. Index funds are better than managed funds. With an index fund, the investment company buys stocks based on the proportion of various companies in some index, for example, the S&P 500. It is all done by computer and the investment company does not have to hire a lot of expensive analysts and stock-pickers to choose the stocks that are in that fund. With a managed fund, there are analysts, managers, and stock pickers that try to outwit other investment companies’ analysts, managers, and stock pickers in order to get a higher annual rate of return. As a general rule, index funds have lower expense ratios than managed mutual funds and so right away, you’ll have more money in your retirement account when you retire if you invest in index funds. On the surface, you might think that the managed funds would perform better than the index funds because they are backed up by all of this human brainpower to choose better stocks to put in the fund. However, as it turns out, humans are pretty fallible in the stock market just like they are in other professions. Although there will always be some winning funds that outperform everyone else, you won’t know for sure now which funds will be winners. Over time, index funds outperform managed funds as a whole..
  3. Commissions. No load is better than a front load. Some mutual funds will require a “front load fee” which is essentially a commission that you pay when you first put money into that fund. This reduces the amount of your investment and over time, this results in a reduction in your total retirement fund amount. Let’s go back to the example of $100,000 invested for 20 years with an 8% annual return. If a mutual fund has a 1.5% front load fee, the ending value of that investment will be $485, 290. If the mutual fund does not have a front load fee, the ending value will be $492,680. That is a $7,390 difference that you ended up paying over the course of that investment.
  4. Value of $1 invested in 1965Stocks versus bonds. In the long run, stocks perform better than bonds. In the short run stocks are more volatile than bonds. In the 50 years since 1965, the average annualized rate of return in stocks has been 9.91% whereas the average annualized rate of return of bonds has been 6.58%. In other words, $1 invested in stocks in 1965 was worth $112 by 2014 whereas $1 invested in bonds in 1965 was worth $24 by 2014. The problem is that the value of stocks can vary wildly from year to year whereas the value of bonds varies relatively little from year to year. Therefore, if you have a long investment horizon, stocks are a better investment but if you have a short investment horizon, bonds are safer. But remember, when you retire, you are not going to be taking all of the money out of your retirement fund the day you retire; some of that money is going to need to stay invested until you die 15, 20, or 30 years later. Therefore, it is best to have a mixture of stocks and bonds in your retirement fund with a higher percentage of stocks when you are younger (say 80-90% when you are age 30) and a lower percentage of stocks when you are older (say 50% when you are age 65). An important caveat to this is that if, in addition to your retirement fund, you also have a pension or an annuity and can expect a fixed income from that pension or annuity for the rest of your life in retirement, then you can afford to have a greater percentage of your other retirement portfolio in stocks since that pension or annuity will give you some insulation from the inevitable year-to-year volatility in stock prices.
  5. Stock turnover. Less is better. If you are purchasing stocks in individual companies for your retirement fund, then every time you buy and sell a stock, you are going to have to pay a stock broker a fee. If you are buying and selling frequently, then those fees add up and you can end up with less money in your retirement fund than if you bought a stock and held it. This has to be tempered with not holding onto loser stocks forever but you have to be judicious. Beware of the financial advisor who periodically sends out sell and buy advisories for the stocks that you own; although it is possible that he (or she) is some kind of stock market oracle with a unique ability to see into the future of stock prices, it is also possible that he needs to make a boat payment on his new yacht.

In the next post, I’ll show how the tax implications of different investment options affect your final net retirement fund value.

August 22, 2016

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Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 3: How Much Money Do You Need To Save For Retirement?

This is the third in a series of posts made in preparation for a presentation I will be making for physicians in fellowship training. In the last post, I made the argument that a physician making $250,000 per year now will need about $9,000,000 in retirement savings 30 years from now in order to maintain the same standard of living that he or she has now. In this post, I’m going to outline the path for getting to that $9,000,000 number.

A $9,000,000 retirement fund is not that difficult for a physician to achieve, as long as the physician starts saving early in their career, saves regularly and invests wisely. And it is all due to the wonder of compound interest.

Let’s again start with an example of a new physician making $250,000 a year currently. Assume that the hospital or group practice employing that physician has a retirement plan that automatically puts away 10% into a retirement plan. That is $25,000 per year right away. Now let’s assume that the physician also puts away an additional $15,000 per year in a 403(b) plan each year. That is a total of $40,000 per year in retirement savings each year. In other words, 16% of your annual income is going into saving for retirement. Let’s further assume that the physician is 30 years old and plans to retire in 35 years at age 65.

Because retirement is a long way away, you can tolerate a lot greater year-to-year volatility in the value of the retirement fund than you could if you were 5-10 years away from retirement. This means that your retirement fund should be primarily invested in stocks as opposed to bonds at age 30. Historically, over the past 90 years, the stock market has averaged a 10% return per year. However, this is an average and there is a lot of year-to-year variability and even decade-to-decade variability so a more realistic return is lower, for example, 7.5%.

At the optimistic 10% average annual rate of return, the $40,000 invested in a retirement fund today will be $1,306,000 in 35 years. At the more realistic 7.5% annual rate of return, that $40,000 will become $548,000 in 35 years. But you will not just be investing into your retirement fund this year, you’ll be investing every year up until retirement.

So, let’s assume that you invest $40,000 per year every year for the next 35 years. At a 10% annual return, the value of your retirement fund will be $14,000,000. At the more realistic 7.5% annual rate of return, the value of your retirement fund will be $7,360,000.

But the reality is that you are unlikely to just put $40,000 into retirement every year for the next 35 years. As inflation gradually increases your salary over time, the amount that you put into your retirement plans will also increase over time, even if your retirement contributions stay as a fixed percentage of your total salary. Therefore, if you keep up with your current investment contributions of 16% of your annual income, you will easily exceed the $9,000,000 retirement fund goal in 35 years.

The good news is that reaching your projected retirement fund balance is achievable. The bad news is that many physicians fall prey to the 2 biggest obstacles in achieving their goal: bad advice and bad judgment. In the next post, I’ll outline some of the common ways that physicians’ annual rate of return gets eroded, leaving them with less money in their retirement account than they had planned on.

August 20, 2016

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Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 2: Retirement Fund Options

This is the second in a series of posts about physician retirement planning that I created as part of a presentation that I am giving to fellows in training at the upcoming American College of Chest Physicians annual meeting. In this post, I am going to define some of the common retirement options that physicians may have available to them.

For many physicians, the decision you make on the first month of your job will dramatically affect your retirement decades later because some these retirement planning decisions are permanent. After going through medical school, residency, and maybe a fellowship, physicians are not trained in how to invest for retirement and when they finally sign a contract for their first job out of training, they don’t understand the nuances of the retirement options that they are about to choose from. This blog post is a primer on the different choices that you have. In future posts, I’ll go into some of the unique pros and cons of several of these different options that physicians face.

  1. Pension plans. In these plans, the employer, employee, or both put pre-income tax money into a pension fund and when the employee retires, he or she can draw down on the fund, paying income tax as the money is withdrawn. There are two general types of pensions:
    1. Defined benefit pension plans. In these plans, the employee and employer contribute a percentage of the employee’s income into the pension plan every year that the employee is working. The employer usually controls how the money is invested. Then, when an employee retires, they get a fixed annual income (the “benefit”) every year for life. The amount of the benefit is usually based on the amount of the employee’s final salary before retirement plus years of service to the employer.
    2. Defined contribution pension plans. In these plans, the employee and employer contribute a percentage of the employee’s income into the pension plan every year that the employee is working but the employee controls how the money is invested. Unlike a defined benefit plan, when the employee retires, they can determine how to withdraw money from their pension account but when that money is gone, they no longer have any benefits.
  2. Annuity plans. These are really an insurance plan for retirement income. In these plans, a person purchases an annuity and then when they retire, the annuity pays them a certain amount every year. In this sense, it is sort of like buying into a defined benefit pension plan. Some people who have a defined contribution pension plan with their employer will take the money out of their account at retirement and purchase an annuity to ensure that they always have some annual income for as long as they live. An advantage is that it gives the person a fixed annual income for life after retirement. A disadvantage is that annuities can have a lot of overhead expenses.
  3. Social Security. In reality, this is just a big defined benefit pension plan. It was originally created as a safety net to address the high poverty rate among older Americans by providing them with a minimum basic income. It is funded from payroll taxes. But the amount of income a retired person gets from Social Security is fairly low and barely enough to live on. For physicians, social security will only be a very small part of their retirement income. And for physicians who are employed through state governments that have state-affiliated pension plans (for example state teachers retirement systems), the Social Security annual benefits are reduced and in some cases, non-existent (since the government pension takes the place of Social Security).
  4. 401(k) plans. These are deferred compensation plans used by companies. They are a way for employees to carve off a chunk of their take-home income to save for when they retire. When you contribute to a 401(k), your taxable income for that year drops by however much you contribute to the 401(k). So, for example, if you make $200,000 and contribute $15,000 to a 401(k), then you only have to pay state and federal income tax on $185,000 that year. The 401(k) money can then be invested and grows but you pay no taxes on it until you retire. When you take the money out in retirement, you pay regular income taxes on it. So, for example, that $15,000 you invested today may be worth $250,000 when you retire due to interest, dividends, growth in stock prices, etc. If you take money out of your 401(k) before age 59 ½, then you have to pay a penalty for early withdrawal. Some companies will have a policy of matching some or all of your 401(k) contributions so if you put $10,000 in your 401(k), the company will contribute an additional $10,000 but if you don’t contribute to your 401(k), the company contributes nothing. The maximum you can contribute to a 401(k) in 2016 is $18,000 per year if you are under age 50 years old and $24,000 if you are over 50 years old. You can decide how much you want to put away into a 401(k) each year from as little as $100 or so to as much as the $18,000 (or $24,000) limit. You may have to pay local income tax on the money you put into your 401(k) even though you don’t have to pay state or federal income tax on it.
  5. 403(b) plans. These are very similar to 401(k) plans except they are used by not-for-profit companies. Like the 401(k), you contribute to the 403(b) pre-tax and then pay regular income tax on the withdrawals you make after you retire. The maximum contribution is also $18,000 per year (or $24,000 if you are older than 50 years old) for 2016 and there is a penalty for withdrawal before age 59 ½.
  6. 457 plans. These are also similar to 401(k) plans except that they are for state and municipal employees. They have the same contribution limits. The one important difference with a 457 plan is that there is no penalty for withdrawal before 59 ½ years of age.
  7. 401(a) plans. These are retirement plans that are set up by the employer and usually have a fixed percentage of the employee’s salary going into the 401(a) plan. These plans are tax-deferred so that the employee does not pay state or federal income tax when contributing to the 401(a) but do pay income tax when withdrawing money from the plan after retirement. 401(a) plans are for non-profit organizations, government organizations, and teachers.
  8. 415(m) plans. These are retirement plans for public employers (colleges, universities, etc.) that allow for additional pre-income tax money to be put into a tax-deferred account after an employee has exceeded the contribution limits set by the IRS for other retirement plans (such as a 403(b). The 415(m) plans do not get lot of press because they don’t really apply to the vast majority of employees, only the highest paid employees. However, at a university, physicians are often the among the highest paid employees so these plans may be available.
  9. Traditional IRA. This is money that you put away for retirement. Unlike the 401(k), 403(b), and 457 plans that usually have a limited number of mutual funds or other investment options, you have total control over what you invest your IRA money in. If you are single and make less than $61,000 a year ($98,000 if you are married filing jointly), then you can make the entire IRA contribution pre-tax and then pay regular income taxes when you withdraw money in retirement. If you make more than $71,000 a year ($118,000 if you are married filing jointly), then you can still contribute to an IRA but you have to pay income tax on the money first (i.e., use post-income tax dollars); when you take the money out in retirement, you pay regular income tax on however much the IRA appreciated over the amount that you initially put into the IRA. Most physicians have an annual income that is too high to allow pre-tax traditional IRA contributions but they can still contribute to a traditional IRA with post-tax dollars. The most you can put into a traditional IRA in 2016 is $5,500 per year ($6,500 if you are over age 50).
  10. Roth IRA. Like a traditional IRA, this is money that you have total investment control over. Unlike a traditional IRA, you don’t have to pay any income tax on it when you take withdrawals in retirement. Also unlike a traditional IRA, anyone who puts money into a Roth IRA has to use post-income tax dollars. There are limits of who can contribute directly to a Roth IRA: the income limit to do this in 2016 is $117,000 if you are single and $194,000 if you are married filing jointly. However, current tax law allows a person who would not normally qualify to put money in a Roth to open a traditional IRA using post-income tax money and then immediately “convert” it to a Roth. This is sometimes called a “backdoor” Roth.
  11. Self-employment plans (SEPs or SEP-IRAs). This is a retirement plan for self-employed persons. Physicians frequently have the bulk of their clinical income from either a hospital or group practice that they work for but may also have some income that they make on the side, for example, money from giving talks or from outside consulting. The SEP is an option for investing part of that self-employment income for retirement. Each year, the physician puts away a part of his or her pre-tax income into the SEP. The SEP money grows untaxed, similar to a 401(k), and then when the physician retires, they take money out of the SEP and pay income tax on the withdrawals. The maximum amount a person can contribute to an SEP in 2016 is 25% of their compensation for that year up to a maximum contribution of $53,000.
  12. Regular investments. These can take a lot of different forms, such as stocks, bonds, and mutual funds. The money you invest is all post-income tax. You may get annual interest or dividend income from these investments and you may sell them for a profit in the future. Interest income is taxed at your regular income tax rate. Dividend income and the profit from selling one of these investments at a higher price than you originally paid for it is taxed at the capital gains tax rate, which is generally lower than the income tax rate.

If you are wise, you’ll have retirement investments in more than just one of these and preferably, in more than half of these. In future posts in this series, I’ll tell you which options I think make the most sense for physicians.

August 18, 2016

Categories
Physician Finances Physician Retirement Planning

Planning For Retirement For Physicians Part 1: How Much Money Will You Need In Retirement?

I was asked to give a presentation on financial planning to fellows attending this fall’s annual meeting of the American College of Chest Physicians. In preparation for that presentation, I am preparing several posts about retirement planning for physicians. This is the first of these posts. As a disclaimer, I am not a financial planner but after more than 30 years of being a physician with 15 of those years spent as the treasurer of our Department of Internal Medicine, I have seen physicians make a lot of good choices and bad choices so I have a few thoughts on the subject.

The question everyone asks when planning retirement income is: “How much money will I need?”. The answer is… a lot. Before you can even begin to try to answer the question, you have to consider a number of variables including:

  1. How long will you live in retirement? Somehow, this one always gets me queasy whenever I have to consider it. Currently, the average life expectancy for an American who is 30 years old is age 77 for a man and age 81 for a woman. Since you are a physician, you can probably add a couple of years to that since you are likely a non-smoker and have reasonably healthy eating and exercise habits. So, if you are looking at retiring at age 65, then you’re going to need 15-20 years of income saved up. And if you’re planning on living to 100 like me, then you’re going to need to support yourself for 35 years.
  2. What is the inflation rate? The consumer price index goes up each year with an average inflation rate for the past 100 years of 3.1% per year. But remember, that is an average. The year I started medical school, the inflation rate was 13.5% and a couple of years of that rate will dramatically erode your retirement account. For the sake of simplicity, let’s assume the consumer price index goes up the same amount in the next 30 years when you get ready to retire as it has in the past 30 years when I was a resident. If that is the case, then an annual income of $250,000 this year will be equal in purchasing power to an annual income of $549,813 in 30 years.
  3. Will your fixed expenses change? Hopefully, you’ll have the house paid off, the kids out of the house and their college paid off. Once you retire, you won’t have to be setting aside a big chunk of your annual income for retirement savings since you’ll be drawing off of those savings. But things happen and it is possible that you’ll have different fixed expenses in 30 years. But for simplicity sake, subtract out your current mortgage payments, retirement contributions, and kid’s college savings contributions from your current income to determine what percentage of your current income is used for your activities of daily living in order to determine what you will need to maintain that level of daily living in retirement.
  4. What portion of your retirement income will be subject to income tax? As you will see in a later post, there are taxable and non-taxable retirement savings options for you but most of your retirement income is likely to be subject to income taxes, just like your current income is.

So, for the purposes of example, let’s assume you are a physician making $250,000 a year currently. And let’s further assume that you are spending $30,000 a year on your mortgage, you are putting $40,000 a year away for retirement, and you are saving $10,00 a year for your children’s college savings and all of those expenses are going to go away when you retire with your house paid off and your children graduated from college. That means that your effective current income is $170,000 per year. If the consumer price index goes up at the same pace as it has for the past 30 years, then in order to have the same lifestyle in 30 years as you do now, you’ll need to have $374,000 per year. The good news is that your annual income will likely be also going up each year for the next 30 years and presumably the amount that you are contributing into your retirement fund will also so it won’t be quite as much of a sudden shock to your finances.

There are a lot of formulas for estimating how much of your retirement account you should plan to take out each year. A commonly quoted number range is 3-5% of your total retirement portfolio.  Let’s go with 4% as your initial withdrawal rate and you estimate that you will live for 30 years in retirement. In order to have $374,000 per year, starting 30 years from now, you’ll need to have about $9,000,000 in your retirement account in order to fund yourself entirely out of your retirement savings.

If you are a physician and you and your spouse are making a lot more than $250,000 per year, then your retirement target may be closer to $15,000,000 or $20,000,000. These are really scary numbers but as I’m going to show you in the next several posts in this series, it is actually pretty do-able as long as you start saving early and you save smartly.

 

August 16, 2016