In the past, I mainly advised new physicians in our department about retirement investment options at our university. More recently, my children have asked advice about their retirement planning. After you have made the decision about how much money you can invest in your retirement accounts, how do you go about deciding on what kind of investments to direct that money into? A few years ago, one of the wisest physicians at our university had recently retired and lamented to me that every year he had dutifully contributed the maximum he was allowed to his 403b plan but that he had allocated all of it to a very low interest money market fund and consequently, the value of his 403b was not enough to cover his expenses in retirement. Successful retirement planning means getting the right investment allocation in your retirement accounts and that allocation will vary depending on the type of account and your age.
The 4 Types of Retirement Accounts
There are many different types of retirement plans and all of the various plan numbers and names can be overwhelming at times. The plans you have access to will depend on your employer. For example, if you work for a for-profit company, you may have access to a 401k. For a non-profit company, it may be a 403b. And for a government agency, it may be a 457. Your employer may or may not provide a pension plan. However, all of the retirement investments can be divided up into four general categories:
- Roth accounts (including the Roth IRA, Roth 401k, and Roth 403b). These are investment accounts that you purchase after paying income taxes. They grow tax-free and when you take money out of them in retirement, you do not have to pay tax on the withdrawals.
- Deferred compensation accounts (including the traditional IRA, SEP IRA, 401k, 403b, and 457). These are investments that you direct pre-tax income into. The investments grow tax-free but when you take the money out in retirement, you pay regular income taxes on the withdrawals, based on whatever your income tax bracket is the year you withdraw the money.
- Post-tax accounts. These are investments that you purchase with money that you have already paid income tax on and are not subject to withdrawal rules in retirement. These can be broken down into financial investments (such as savings accounts or shares of stocks) and non-financial investments (such as artwork or real estate properties). For the purposes of this post, I am only going to consider the financial investments. The tax you pay on these investments depends on the type of investment: interest is taxed as regular income, dividends are usually taxed as capital gains but some types of dividends are taxed as regular income, and investment appreciation is taxed as capital gains.
- Defined benefit plans. These include pensions and social security. They generally give you a fixed income every month for as long as you live and you pay regular income tax on the monthly payments. Nearly every American has some form of a defined benefit plan since most Americans are eligible for Social Security. However the amount that each person gets from their defined benefit plans can vary widely – Social Security will pay out a relatively small amount where as a pension may pay out a very large amount each year. An annuity works similarly, with a portion of the fixed monthly payments being subject to regular income tax. The specific investments in most defined benefit pension plans and annuities are chosen by the company or institution that administers the pension or annuity so the individual investor does not have a choice of how the funds in the pension or annuity are invested.
Roth Account Allocations
Not all Roth accounts are the same. For example, the Roth IRA is not subject to required minimum distributions at age 72 (the IRS requires you to take a certain amount out of a regular IRA, 401k, 403b, or 457 each year after age 72). However, the Roth 401k and Roth 403b do have required minimum distributions after age 72. You can get around this by rolling your Roth 401k or Roth 403b over into a Roth IRA. Because the Roth IRA is not subject to required minimum distributions, many people will not start taking withdrawals from their Roth IRAs until well after age 72. For this reason, the investment horizon for your Roth IRA should be further in the future than the investment horizon for your deferred compensation accounts. The result is that your investment allocation will be different for your Roth IRA than for your other accounts. Strategies for your Roth IRA include:
- A higher percentage of equities. Because your investment horizon is longer for the Roth account, you can and should invest in more higher risk stocks rather than lower risk bonds compared to the investment mix in your other retirement accounts.
- No tax-free investments. Certain types of investments grow tax free, mainly municipal bonds. These generally pay lower interest rates than other bonds but the interest is not taxed. Since you do not have to pay income tax on Roth account withdrawals anyway, there is no advantage to investing in tax-free bonds, only the disadvantage of getting lower interest rates.
- No cash investments. Cash investments include money in your checking account, savings account, or money market account. Although not exactly cash, I would also lump short-term certificates of deposit into this category. The main cash investment that most people will have access to in a Roth account is a money market fund. Because money market funds pay very low interest rates, you really lose the tax advantages of the Roth account by putting Roth money into a money market.
- Use your Roth account to re-balance. Periodically, you should re-balance your retirement investments to be sure that you are maintaining a desired percentage of stock and bonds. You do not incur capital gains tax when you sell shares of mutual funds within your Roth account in order to exchange those shares for a different mutual fund. However, when re-balancing, remember that your Roth account should be more heavily weighted to stocks than your deferred compensation accounts. Also, be aware that you may be charged administrative fees every time you sell or exchange shares of mutual funds so do not get carried away and be exchanging shares too frequently.
Deferred Compensation Account Allocations
For many people, the majority of their retirement investments will be in a deferred compensation fund: 401k, 403b, 457, or traditional IRA. You do not pay any tax on these accounts until you withdraw money in retirement. Then, you pay regular income tax on the withdrawals. At age 72, the required minimum distribution rules come into play, meaning that the IRS requires you to withdraw a certain percentage from your deferred compensation accounts every year.
- Get the right mix of stock and bonds. The first issue to be addressed is what ratio of stocks to bonds should you have. There is not a one-size-fits all answer to that question and the ratio will depend on your age, how long you plan to work, and how much in defined benefits you can expect. As a starting point, the percentage of stocks in your account should be 120 minus your age. Next adjust that percentage upward if you plan on a later retirement age or downward if you plan to retire early. Then adjust the percentage upward if you have relatively more defined benefit income in retirement, for example, a large pension. I am 62 years old, so using the equation, I should have 58% of my retirement investments in stocks; however, I will have a pension from our State Teacher’s Retirement System so I have adjusted that percentage upward to 66% in my deferred compensation accounts.
- Be more conservative than you are in your Roth account. Because of the required minimum distributions starting at age 72, most people will start to withdraw from their defined benefit account several years before withdrawing from their Roth account. By spending down your deferred compensation amount, you can avoid being pushed into a higher tax bracket at age 72 when you may be required to take more out of your deferred compensation account than you actually need to meet your annual expenses. Because of this shorter withdrawal horizon, you should have a lower percentage of stocks in your deferred compensation account than you do in your Roth account.
- No tax-free investments. Similar to a Roth account, you should avoid tax-free municipal bonds in your deferred compensation plan since you will not realize any tax advance from the interest in a deferred compensation account and you will get a lower return on your investment.
- No cash investments. Similar to a Roth account, you should avoid cash investments such as money markets in your deferred compensation accounts, at least until you reach retirement.
- Use your deferred compensation account to re-balance. Similar to a Roth account, you will not pay capital gains tax every time you exchange one mutual fund for another within your deferred compensation account. But again, be aware of administrative fees charged when you sell or exchange shares of mutual funds within your deferred compensation account.
- Chose funds with low expense ratios. Small differences in the expense ratio for different mutual funds can translate to big differences in total costs. Let’s take a mutual fund with an expense ratio of 0.75% – it seems like such a small number on the surface – less that one percent. But if you have $500,000 in your deferred compensation fund, you will pay $3,750 each year in expense fees. On the other hand, the same amount of money in a mutual fund with an expense ratio of 0.05% will result in only $250 annual expenses. In other words, you would be spending $3,500 more each year to be invested in the mutual fund with the higher expense ratio. As a general rule, index funds will have lower expense ratios than actively managed funds.
- Are balanced mutual funds right for you? The default investment in many deferred compensation accounts will be an age-adjusted balanced fund such as a “Retire in 2035” fund. These will have a mix of stock and bonds, both domestic and foreign, with the mix pre-determined by the investment company based on one’s age. As you get older, the investment company automatically re-balances the components with thin these funds based on what is appropriate for your age. For investment novices, these are a great choice (which is why they are often the default investment) but they tend to be 2-3 times more expensive than their component index funds if you were to select the individual index funds yourself. Also, the balance of stocks and bonds in these funds may not be optimal for you if you have additional retirement investments in Roth accounts and post-tax accounts. And if you have a sizable pension, the balanced funds may be inappropriately conservative for your overall portfolio.
Post-Tax Account Allocations
The amount that you can save each year in a 401k, 403b, or 457 plan is limited. For most people, and especially for physicians with relatively high incomes, those deferred compensation accounts will not be enough to fund retirement. Anyone can supplement these by contributing to a post-tax traditional IRA (and then promptly converting it to a Roth IRA) and some people can contribute to both a 403b and a 457 each year (for example, employees of state-supported universities). However, when you maximize your annual contributions to these investments, you will probably still need to add more money into your retirement investments. This usually comes from the income that you have already paid regular income tax on, which I will call post-tax accounts. These accounts are not subject to the same IRS regulations that deferred compensation accounts and Roth accounts are but they have very different tax implications that can affect your asset allocations within them.
- Here is where you should keep your cash investments. The whole purpose of having cash in your retirement portfolio is to be able to weather downturns in the stock market. In addition, you need to have 3-6 months of cash in an emergency fund in case you lose your job. In both situations, you want to have immediate access to money without withdrawal penalties. This is the where you should have your money market account.
- This is the place for tax-free investments. Tax-free municipal bonds are not for everyone. The interest is considerably lower than for non-tax-free bonds and the tax advantages are primarily for the very wealthy. But for some people, having a portion of their retirement investments in tax-free bonds can be an important part of a balanced investment portfolio that will allow the retiree to strategically withdraw money from different funds in order to optimize their tax bracket. If you do chose to invest in tax-free bonds, they should be in your post-tax accounts where you can take advantage of the tax-free interest benefits.
- Minimize re-balancing. Whenever you sell a stock, bond, or mutual fund, you will have to pay capital gains tax on the appreciated value of that investment. If you purchase $1,000 worth of a mutual fund and then sell it a year later for $1,120, then you have to pay capital gains tax on the $120 of appreciated value. The capital gains tax rate varies, depending on your annual taxable income. For married couples filing jointly, their capital gains tax rate is: 0% if making < $78,750; 15% if making $78,751 – $488,850; or 20% if making > $488,850/year. Therefore, if your joint taxable income is < $78,750, you do not pay any capital gains tax so you can sell or exchange your mutual funds all you want and you do not have to pay tax on the appreciated value. On the other hand, if your joint taxable income if > $488,850, then you will be paying the higher capital gains tax rate of 20% and you are better off holding on that investment until you are in retirement and may have a lower taxable income. One caveat to this is during periods when the stock market declines, such as the 2009 recession or the March 2020 COVID-19 market crash, re-balancing post-tax accounts will incur less capital gains tax since there will be relatively little appreciated value of the funds at that time.
My personal philosophy is that everyone should have retirement investments in each of these 4 types of accounts in order to reap the rewards of a fully diversified investment portfolio. Because each of these accounts has different tax implications, the ideal mix of investments in each type of account is going to be different. Begin planning those allocations as soon as you start to save for retirement.
October 12, 2020
