University-employed physicians (and all university faculty for that matter) have more retirement savings options than most physicians in private practice. Unfortunately, many of the decisions about these options have to be made at the time of hiring. This is a time in young physicians’ lives when they are least knowledgeable about personal finances and least equipped to make these decisions. This post will cover university faculty retirement planning with an emphasis on academic physicians at the beginning of their careers.
- Academic physicians have more retirement savings options than other physicians
- Contribute the maximum amount into your 415(m)
- Maximize 457 contributions before contributing to a 403(b)
- 403(b), 457, and 415(m) plans offer hidden tax advantages
- The decision about contributing to a state teacher’s retirement system versus an alternative 401(a) retirement plan is complex
The number of decisions that new university physicians have to make when they sign their employment contracts can be overwhelming. Will you be in the tenure track or clinical track? Who will be your mentor(s)? Which weeks do you want to block out for vacation over the next year? Where will your office be? What teaching assignments would you prefer? Fortunately, as months and years go by, you can change your mind about most of these decisions. But when it comes to retirement plan participation, some of the decisions you make initially are irrevocable and you cannot change your mind a few months later.
Understand your retirement options
Every university’s retirement plans are a little different and not all retirement savings options will be available to physicians at every institution. Here are the most common options:
- Base retirement plans (401(a) plans). These are generally qualified retirement plans covered by section 401(a) of the Internal Revenue Code. Each state will have different specific plans – here in Ohio, university physicians can choose between the State Teacher’s Retirement System (STRS) or the Alternative Retirement Plan (ARP). In both plans, a fixed percentage of the physician’s salary is contributed pre-tax to the plan with a matching contribution from the university. When contributed to STRS, the plan can function essentially as a pension with a fixed amount of monthly income for life. When contributed to the ARP, the physician selects among a number of investment options (typically mutual funds) that are controlled by the physician with no guarantee of monthly income in retirement (very similar to a 403(b) plan). Both of these plans serve as a substitute for Social Security so physicians are ineligible for Social Security for their income earned from the university.
- 403(b) plans. These are deferred income retirement plans for employees of non-profit organizations. Most universities are non-profit so 403(b) plans are available to most academic physicians. These are essentially the same as a 401(k) (deferred income retirement plan in a for-profit company). In 2022, you can put up to $20,500 per year into a 403(b) (up to $27,000 if over 50 years old). This is money taken out of your paycheck pre-tax and then you pay federal and state income tax on it when you take money out of the account in retirement.
- 457 plans. These are deferred income retirement plans for government employees. Faculty at public universities are usually considered state government employees and are eligible to participate in 457 plans in addition to the university’s 403(b) plan. The contribution limits are the same: $20,500 per year if under age 50 and $27,000 per year if over age 50. By contributing to both a 457 and 403(b), physicians at state-supported universities can put away a combined amount of up to $41,000 per year ($54,000 if over age 50). Although fundamentally similar to 403(b) plans, there is one unique advantage of the 457 plan in that unlike the 403(b) plans, there is no tax penalty for early withdrawal before age 59 1/2 years old.
- 415(m) plans. These are deferred income retirement plans for highly paid government employees earning more than $305,000/year in 2022 in salary and bonuses or with contributions more than $61,000 to the university’s base retirement 401(a) plan (STRS or ARP). Many physicians at public universities will fall into this category since physicians command relatively high salaries compared to other university faculty and compared to regular state government employees. Contributions to 415(m) plans can be made by the employee, the employer (i.e. the university), or both, depending on each university’s specific plan. In essence, the 415(m) plan allows physicians and other highly paid university employees to put away more for retirement after the annual base retirement 401(a) contribution limits have been reached.
- Traditional and Roth IRAs. These are not sponsored by the university but anyone can contribute to a traditional IRA. Because the income limit to contribute pre-tax money into a traditional IRA is $144,000 per year if filing single in 2022 ($214,000 if filing jointly), most physicians are not eligible to contribute pre-tax dollars into a traditional IRA, nor are they able to contribute post-tax dollars directly into a Roth IRA. However, physicians can contribute post-tax money into a traditional IRA and then promptly convert it into a Roth IRA (‘backdoor’ Roth). As I have posted previously, I think that everyone should have a Roth IRA as part of a diversified retirement portfolio, even if it requires doing a backdoor Roth.
The tax advantages of deferred compensation options
A widely discussed advantage of deferred compensation retirement plans, such as the 403(b), 457, and 415(m) plans, is that you can defer paying income tax on the withdrawals until you are in retirement when you will likely have a lower income tax rate. Although that may be true, it is impossible to predict what the income tax rates will be 35 years from now when you are retired. They may be higher, lower, or the same as they currently are and therefore, depending on the amount that you are withdrawing each year, your federal income tax rate could be higher, lower, or the same as it currently is. If your income tax rate is the same, then the amount of take-home money that you have after taxes will be the same whether you pay income tax now and invest the money or contribute the money to a deferred income investment and pay income tax later. But there are two often-overlooked advantages to using a deferred income retirement plan:
- Reduce your income tax rate today. When you contribute to a deferred income retirement account, you effectively reduce your taxable income that year. Thus, you end up paying less tax on all of your take-home income. For example, assume you have an annual income of $250,000 and you are married, filing jointly. Your effective federal income tax rate for 2022 is 16.81%. If you contribute $20,500 to a 403(b), your taxable income drops to $229,500 and your effective federal income tax rate drops to 16.16%. The difference in effective tax rates is 0.65% and this results in you paying $1,492 less in taxes on the $229,500 than you would have at the higher tax rate. In other words, by contributing to a 403(b), 457, 401(a), or 415(m) plan, you have in essence given yourself a tax deduction!
- Avoid paying investment taxes twice. If you were to put the $20,500 into a regular post-tax investment (such as a mutual fund) instead of contributing to the 403(b), then not only do you pay income tax on that money this year but you will also pay capital gains tax when you eventually cash-out the post-tax investment AND you will also pay taxes on the annual dividends and interest from those investments every year that you hold those investments. You can avoid the capital gains, dividend, and interest taxes by contributing to a backdoor Roth IRA but the contribution limit is only $6,000 per year ($7,000 if over age 50). So, unless you put that retirement money in a Roth IRA, you will end up paying much more in taxes by putting retirement money in a regular post-tax investment than you will by putting that money in a deferred income plan.
Maximize 415(m) contributions
The decision about whether or not to participate in a university 415(m) plan is usually made at the time of initial employment and is irrevocable (meaning that you cannot change your mind later). At the Ohio State University, the choices are 0%, 4%, 8%, or 12%. If the 0% option is chosen, then you are electing to not participate in the 415(m) plan.
The 415(m) plan only kicks in when you have reached the annual contribution limit to your 401(a) base retirement plan ($61,000 in 2022) or retirement eligible earnings over $305,000. Therefore, you will only be contributing to the 415(m) plan for the portion of you income that exceeds the portion of your income subject to 401(a) contributions.
My advice is to take the maximum contribution to the 415(m). Even at the highest option (12% at OSU), it will still be less than your contribution to the university’s base retirement 401(a) plan (14% at OSU). Also, you can always increase or decrease contribution amounts to a 403(b) and/or 457 in order to allow you to meet annual expenses such as a new home purchase or student loan repayment. But once you commit to a percentage contribution to the 415(m) plan, you cannot increase it in the future.
Think very carefully about base retirement plan selection
A second irrevocable decision at the time of initial employment is which 401(a) base retirement plan to choose. Most universities will have something like a state teacher’s retirement system choice versus an alternative retirement plan choice. Both options have advantages and disadvantage and the choice that is best for one academic physician may not be the best choice for another academic physician.
Many financial advisors will tell you that you can get a higher rate of return by investing your retirement money yourself than you will get from a state teacher’s retirement system (STRS) pension. And they are right – you can, if you invest that money in a portfolio with a large percentage of stocks. But you should think of a pension as the non-volatile fixed income component of a balanced retirement portfolio. In this sense, it will substitute for the bond or annuity component of your portfolio had you not contributed to STRS. Therefore, by contributing to STRS, you will have the ability to safely put a higher percentage of your other retirement investments in more volatile investments with higher potential rates of return (such as stock and real estate mutual funds). Most academic physicians will contribute far more to their 403(b), 457, and 415(m) plans than they will to their base retirement 401(a) plans and these physicians can then afford to put more of their 403(b), 457, & 415(m) investments into stocks and real estate than they otherwise would have been able to.
Once retired, the predictable fixed income monthly pension income reduces the amount that you will need to keep in cash. The cash portion of your portfolio after you are retired serves to cover sudden, unexpected expenses and serves as a buffer to having to withdraw money from volatile accounts when the stock and bond markets fall. By keeping less money in cash, you can put more money into investments that over the long-term will result in greater wealth.
Every state will have different options for base retirement plans. In Ohio, it is either the State Teacher’s Retirement System of Ohio (STRS) or the Alternative Retirement Plan (ARP). Because most states have plans that are similar, I will use Ohio’s options of STRS versus ARP as examples. Some of the factors to consider when choosing between 401(a) base retirement options include:
- How long will you be employed by the university? In order to get the maximum annual pension, you have to contribute to STRS for 35 years. If you leave the university to go into private practice or if you take a job at a university in a different state, then you can either withdraw your STRS contributions plus a 3% annual interest rate or you can take a rather small pension when you eventually retire. Some states allow you to purchase credit for some of the years that you worked as an educator in other states making STRS contributions somewhat portable. However, if there is a high likelihood that you will work at a university in your current state of residence for less than 35 years, then the ARP may be the wiser choice.
- Will you need health insurance? If you retire before you are eligible for Medicare (currently age 65), then you will need to purchase health insurance. If you purchase an individual insurance policy on the open market, it can be incredibly expensive. STRS participants have access to group health insurance with good coverage that is considerably less expensive. Once you are covered under Medicare, you will still need supplemental health insurance and once again, it will be less expensive to purchase though STRS. Dental and vision insurance for retirees is also available through STRS. The ability to purchase STRS health insurance can result in saving a considerable amount of money after retirement.
- How do you value other benefits? In addition to health insurance, participants in STRS have access to other benefits. If you become disabled, then you may be eligible for a monthly disability benefit. There are also options for monthly benefits for surviving beneficiaries (spouse or children). My father died when I was in college and his STRS plan helped support me while I was in medical school and 42 years after his death, my mother still receives a monthly STRS benefit.
- Your confidence in STRS. There is a reason that most corporations have eliminated pensions – they are expensive and have the potential to run out of money. Although most teacher retirement systems are supported by their state governments, they are not immune to financial crisis. For example, the Illinois Teachers’ Retirement System is in danger of running out of money and not being able to pay its retirees. Each state’s system varies in terms of financial stability. My own opinion is that it is very unlikely that any state government will allow a teacher’s retirement system to default – if they do, that state will not be able to find new teachers willing to work there and the public education system would collapse. However, you should look at participation in an STRS plan as a type of investment and all investments have risk. For most states, that risk is equal or less than the risk of investing in bonds.
- You won’t have Social Security. At most public universities, physicians do not contribute to Social Security. The idea is that STRS substitutes for Social Security but even of you elect the alternative retirement plan (ARP) instead of STRS, you still do not contribute to Social Security. Therefore, when you are retired, you will not receive Social Security benefits. Even if you have contributions to Social Security from years that you worked for other employers or from outside consulting that you did while working at a university, your monthly Social Security payments in retirement will be considerably reduced. Therefore, if you elect the ARP instead of STRS, you will need to have a higher percentage of your retirement savings in stable investments such as bonds, annuities, or certificates of deposit since you will not have the safety that a fixed income source brings to a diversified retirement portfolio.
- How old will you (and your spouse) live to be? Pension benefits are determined by actuaries who estimate how long the beneficiaries will live. If beneficiaries live a long time after retiring, then the monthly pension amounts have to be lower to be sure that the pension does not run out of money. On the other hand, if retirees die shortly after retiring, then the pension can afford to have higher monthly pension payments. Currently, a man who retires at age 65 can expect to live to age 83.2 years; a women retiring at age 65 can expect to live to age 85.8 years. If you anticipate dying younger than these ages, then the ARP may be better for you. If you anticipate living beyond these ages, then STRS becomes a better option. Factors to consider in estimating your longevity include any chronic diseases (diabetes, hypertension, etc.), personal or family history of cancer, age of death of your parents, your smoking history, whether you get regular vaccinations, your body mass index, etc.
- Your risk tolerance. Remember, a pension should be considered as the defined benefit component of a diversified retirement portfolio. As such, it is a low-risk component. Each person has a different risk tolerance. Those who have a higher risk tolerance will generally have a higher percentage of their retirement portfolio in higher risk stocks and real estate. Those with a lower risk tolerance will generally want to increase the percentage of their portfolio in low-risk bonds and fixed income. If you choose STRS, then the percentage of your overall retirement savings portfolio derived from your STRS pension should match your risk tolerance. If you find that contributing to STRS would make your overall portfolio diversification too conservative, then the ARP may be preferable.
What about the 403(b), 457, and Roth IRA?
The base retirement 401(a) plan will not be enough to fund your entire retirement portfolio. For most academic physicians, the largest component of their portfolio will be in their 403(b, 457, and 415(m) plans. As mentioned above, the 403(b) and 457 plans are very similar but the 457 plan’s lack of early withdrawal penalties gives it a slight advantage over the 403(b). For that reason, it is preferable to maximize annual contributions to a 457 plan before starting to contribute to a 403(b) plan. If you can afford it, ideally, you should be contributing to both.
Most universities will have options of directing contributions to different investment brokerages and to different mutual funds within each brokerage. It is within the 403(b) and 457 accounts that most people can create the proper risk diversification for their overall retirement portfolio by selecting funds that compliment fixed income sources such as STRS.
A Roth IRA is an essential component of a balanced and diversified retirement portfolio and everyone should have one. Ideally, one should contribute to all three options: a 403(b), a 457, and a Roth IRA. Maximizing annual contributions to all of these would add up to $47,000 per year and if you did that every year with an average annual rate of return of 8%, then after 35 years, you would have $8.7 million in retirement savings. However, $47,000 per year is beyond the reach of most people so I recommend doing an annual partial contribution to both a Roth IRA and a 457 initially. Once you reach the contribution limit of the 457, then increase your Roth IRA contribution to the IRS limit. Next, steadily increase your 403(b) contributions until you reach the IRS limit.
Academic physicians can save more
Physicians in private practice usually have access to a 401(k) or 403(b) plan… and that is about it. Physicians employed by public universities usually have access to a 401(a), 403(b), 457, and 415(m) plan. Moreover, most of the 401(a) plans include sizable employer matching contributions. Physicians in private practice will generally have a higher annual income than academic physicians. However, academic physicians can generally save more for retirement in deferred income plans with the tax advantages that come with those plans. For many academic physicians, these increased retirement savings can offset the lower annual income with the result that the decision between private practice versus academics can be based more on workplace preference and lifestyle rather than on economics.
May 12, 2022