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.
- 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a pension fund and when the employee retires, he or she can draw down on the fund, paying income tax as the money is withdrawn.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:
- 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.
- 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.
- 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.
- 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).
- 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.
- 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.
- 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.
- 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.
- 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.
- 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).
- 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.
- 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.
- 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