Most doctors are aware of the importance of diversifying their portfolios. However, too few of us have applied these same principles to the taxation of our assets when it comes time to spend them in retirement.
Most doctors are aware of the importance of diversifying their portfolios among various “asset classes” such as stocks, bonds and real estate (and within those asset classes as well) to spread their money across a large number of individual securities or properties. This move prevents the investor from making the classic mistake of putting too many eggs into one basket, which could lead to financial ruin in the event of a market downturn in a single security or asset class.
However, too few of us have applied these same principles to the taxation of our assets when it comes time to spend them in retirement.
Too many tax breaks now, not enough later
The typical physician is taxed at a very high marginal tax rate during his peak earning years. As such, he naturally looks for tax-deferred retirement accounts that can give him relief from this tax burden, such as 401(k)s, 403(b)s, 457s, profit-sharing plans and defined benefit plans. Each dollar contributed to these accounts is a dollar that isn’t taxed now at high marginal rates. Basically, this income is deferred into retirement when the doctor can withdraw at least some of it at lower marginal rates, reducing the overall tax burden.
Occasionally, a good saver acquires a very large nest egg primarily in tax-deferred retirement accounts and then is surprised when he finds a significant portion of his retirement income falls into the mid- to upper-tax brackets. This problem can be exacerbated when and if his required minimum distributions (RMDs) become larger than the amount he would prefer to withdraw from his tax-deferred retirement accounts or when marginal tax rates are increased.
Roth IRAs and 401(k)s
Roth IRAs were introduced to the retirement landscape in 1997, and a Roth option has been added in recent years to thousands of 401(k)s across the country. Instead of saving taxes now and paying them later, with a Roth retirement account you pay taxes now and you and your heirs avoid paying income taxes on that money ever again, no matter how large it grows.
Similar to tax-deferred retirement accounts, Roth accounts also avoid annual taxation on capital gains and dividends. The obvious benefits to the retiree are no RMDs and the ability to preferentially take some of his retirement money from a tax-free Roth account rather than withdrawing tax-deferred money at high marginal rates.
A taxable account
Many physicians are able to save money above and beyond their retirement accounts, whether in paper assets, like stocks, bonds and mutual funds, or in income-producing assets, such as real estate or small businesses.
This money is also taxed in a different manner than a retirement account. Qualified dividends and long-term capital gains are taxed at lower rates. Real estate and business income can also be taxed in a more favorable manner than regular income thanks to depreciation and other tax breaks.
Although taxable assets provide less asset protection from creditors than retirement accounts, they benefit from a step up in basis upon the death of the investor and can be “tax-loss harvested” in the event of a market downturn. Taxable assets also have fewer restrictions on withdrawals prior to age 59-and-a-half for the early retiree. Combining income from tax-deferred, tax-free and taxable accounts can dramatically reduce the tax burden for a retiree.
The “Backdoor Roth IRA”
A physician who realizes the wonderful tax benefit of taking some of his income from Roth accounts is still left with a dilemma: What is the point of paying a high marginal tax rate during his peak earning years to avoid paying a similar high marginal tax rate later?
Although a doctor can use Roth accounts in the early, lower-paying years or in his last few years as he cuts back to part-time work, it can be hard to save a significant amount of money due to lower total income.
Since 2010, Congress has provided a solution to this dilemma by providing a method I call a “Backdoor Roth IRA.” High-income earners are not allowed to contribute directly to a Roth IRA. For 2013, this phase-out begins at a modified adjusted gross income of $112,000 ($178,000 married). In 2010, this phase-out was eliminated for Roth IRA conversions. So while a typical doctor can’t contribute directly to a Roth IRA, he can convert an otherwise non-deductible traditional IRA to a Roth IRA each year for himself and a spouse, so long as he has no other traditional IRA, SEP-IRA or SIMPLE IRA. (This is due to a required “pro-rata” calculation that must be made for conversions.)
So now a physician could contribute $17,500 of tax-deferred money into his 401(k), plus another $5,500 for himself and $5,500 for his spouse into Backdoor Roth IRAs each year. Assuming an 8% return, after 20 years of making these contributions these retirees would have $865,000 in tax-deferred money and $544,000 in tax-free money, providing tax diversification in retirement.
Another opportunity to increase the size of Roth accounts occurs in years when total income is lower, such as sabbaticals, partial retirement or early retirement prior to taking Social Security payments. A wise retiree may actually choose to pay taxes early at a relatively low rate by converting some of his tax-deferred money to a Roth IRA. Many 401(k)s with a Roth option also offer “in-plan Roth conversions,” simplifying this process.
Building a taxable account
In the last years prior to retirement, especially an early retirement, a doctor may wish to increase the size of his taxable account. Since this money won’t have a lot of time to grow, the basis will be high so the tax burden created by liquidating these assets will be relatively low. This money won’t be subject to the restrictions and penalties that retirement accounts have on withdrawals prior to age 59-and-a-half. It can also provide a ready source of cash to pay the taxes due on any Roth conversions the early retiree may choose to make.
By having all three types of accounts, a retiree can lower his overall tax burden. Consider a married couple that wants $150,000 in retirement income prior to receiving Social Security benefits.
Doctor 1 has a portfolio which is 100% in tax-deferred accounts. Doctor 2 has 60% of his money in tax-deferred accounts, 20% in Roth accounts and 20% in a taxable account with a high basis. The first will have a federal tax bill of about $25,000, or about 17% of his income. Thanks to his tax diversification, Doctor 2 will have a tax bill of only $10,800, or about 7% of his income. That is $14,200 more each year that can be used to take a cruise, spoil grandchildren or support a favorite charity.
Paying attention to your taxes now AND your taxes later will give you the tax diversification and freedom you’ll want during retirement.
James M. Dahle, MD, FACEP, blogs at The White Coat Investor where he tries to give those who wear the white coat a “fair shake” on Wall Street. He is not a licensed attorney, accountant, or financial advisor and you should consult with your advisors prior to acting on any information you read here.