To Roth or Not to Roth
How Doctors’ Roth Choices Today Can Impact Their Financial Security in Retirement
By Katherine Vessenes, JD, CFP®, RFC, Josh Lantz, CRPC®, and Mike Urch
Our doctors frequently ask whether they should invest in their Roth 401k/403bs or use the pre-tax option instead.
Doctors under the age of 50 can contribute up to $18,500/year into their 401k/403b. Those over the age of 50 can contribute up to $24,500 this year. Note, this article only deals with Roth 401ks/403bs. A Roth IRA, another great tax-free saving option, is a topic for a future article.
There are a number of factors that savvy doctors should consider when deciding whether or not to Roth at work.
Let’s start with a few basics about the differences, the advantages and the disadvantages between pre-tax 401ks/403bs and their Roth counterparts:
1. Contributing to either a pre-tax or Roth plan will help you accumulate more funds for retirement due to tax deferrals.
2. In general, both plans have penalties if you withdraw the funds before age 59 ½.
3. If your employer has a policy of “matching” your contribution, their match will always go into the pre-tax option. There is no need to worry about filling up the pre-tax account, as most employers will do this for you.
4. The pre-tax option will allow you to save on taxes today. The reason is your taxable income is reduced by the amount you contribute. If you are making $300,000 this year, and maximize your pre-tax option, you will only pay tax on $281,500 ($300,000- $18,500). Depending on your state, and your spouse’s income, this could roughly save you anywhere from $5,500 to as much as $9,000 in a high tax state like California, Minnesota or New York.
5. Unfortunately, using the pre-tax option today could cost you more tax dollars in retirement. This is due to the fact that once you reach 70 ½, the IRS requires you to make withdrawals from these accounts and pay tax on them, whether you need the funds to live on or not! These are called “Required Minimum Distributions” or RMDs, for short. This means you could be paying a much larger tax bill in the future.
Take this example: Jim and Joanna are a doc couple, both 35 years old and together make $500,000 annually. If they both put the maximum into the pre-tax 401k or 403b, they will save roughly $14,000 in taxes this year! ($18,500 x 2 x 40%). Enough for a very nice trip. However, we have to consider the future growth of that money and taxes owed in the future.
Using the rule of 72, we know that if you divide the initial investment by an interest rate, it will show you the number of years it takes for the investment to double. To keep the math simple, let’s assume we can, after fees, get 7.2% on Jim and Joanna’s money every year. That means their initial investment of $37,000 ($18,500 x 2), will grow to $1,184,000 by the time they start using it at age 85! And this is just one year’s contributions.
Even if Jim and Joanna’s tax bill is only 30% in retirement (possibly an overly-optimistic assumption!), they will owe $355,200 in taxes on just that one year’s contribution! ($1,184,000 x 30%). The problem is compounded if you consider they will be maximizing their contributions every year of their working lives. You can see how additional contributions every year add to the joy of having more money now, but the pain of paying more tax during retirement.
Jim and Joanna face a dilemma that is common to most doctors: Should they pay tax on the smaller amount of $37,000 today, or defer the tax payment into the future, when the account has grown, and so has the tax bill?
6. You can only use a Roth option if your employer offers it. This is becoming more common, so if your employer doesn’t offer a Roth option, it is worth asking your HR department to consider it.
7. Contributing to a Roth 401k or 403b requires that you pay the taxes today. Let’s return to Jim and Joanna: if they decided to maximize the Roth options at work, then they would owe an extra $14,000 in taxes this year.
8. The advantage of the Roth accounts is that once you pay the taxes, and assuming you do it correctly, you never have to pay taxes again! Jim and Joanna, using the Roth option, will have $1,184,000 tax free in retirement, or $355,200 more by using the Roth option.
9. Contributing to a Roth Retirement plan (especially when maximizing contributions) could allow doctors to effectively save more towards their retirement goals than contributing to a traditional/pre-tax plan. The reasons is by pre-paying the tax bill today you’re effectively putting away more tax advantaged savings.
What’s best for you?
The answer can vary from doctor to doctor. Here are a few factors for you to consider:
1. Your other investments, savings, debts, and emergency fund. If you are a young doctor, just starting out, and have high student loans, you may want to just contribute the minimum to either the pre-tax or Roth option. By minimum, we mean enough to get your employer’s match. This is free money—so you don’t want to pass on getting these funds, if you can afford to make the contributions today. We would only advise a minimum contribution in this instance, because it is important to build up savings and emergency funds, as well. For the first few years of your career, this should probably take priority over saving for retirement. You may not want to maximize your retirement accounts at work to give you more liquidity in the short term.
2. Your Tax Rates. For doctors who are in a higher tax bracket, or who live in a state that has high state income taxes, you will probably want to put more money into the pre-tax portion. Saving taxes today is likely to be a higher priority for you than saving taxes later.
3. Changes to Tax Rules. This might be the year to go Roth. Due to the new tax rates, most of our doctors will be paying less in taxes this year than last. As a result, this might be a good time to switch to Roth contributions. You are less likely to feel the pain of paying for the Roth now because it will feel more like last year’s tax payments. Take advantage of this year’s low taxes to trick yourself into feeling like it doesn’t “cost” you anything to pay the taxes now.
4. A 50/50 approach. Some clients like to hedge their bets. If this is you, consider putting in ½, or $9,250 into the pre-tax funds and the other half into the Roth. You will get some tax deductions and some funds into tax-free retirement savings.
5. Max your Roths, if you can. In short, during this lower tax environment, we encourage clients to put as much as they can into their Roths. The advantages in retirement will be huge. The more funds you have in Roth, the longer your money will last and the less taxes you will owe later.
Whatever your choice: Roth or traditional/pre-tax—make those changes as soon as possible. That way you’ll have a more tax efficient retirement income plan later.
Katherine Vessenes, JD, CFP®, RFC is founder of MD Financial, a concierge financial planning firm for physicians and dentists across the country. She currently works with over 300 doctors from coast to coast. Josh Lantz is a Chief Investment Officer (CIO), CRPC® and advisor at MD Financial.