Wiens: Because of the lengthy period of training, doctors begin their first “real” jobs 8–10 years after many of their friends from college. And, depending on specialty, burnout may cause a physician to retire a few years earlier than the average American. Both these factors lead to a compressed retirement saving timeline.
TCPR: How much money should we be saving for retirement?
Wiens: First, determine what sort of lifestyle you’d like in retirement. Then quantify your living expenses, based on your retirement activities and lifestyle goals. Generally, physicians aim to replace 40%–60% of their pre-retirement income once in retirement. For example, if you earned $250,000 per year before taxes in your clinical practice, you may want to build enough in Social Security, retirement accounts, passive income, etc, to provide $100,000–$150,000 of after-tax income in the future. In my experience, once the goals are set and quantified, the average physician needs to save 20%–30% of gross annual income for retirement, beginning at completion of residency or fellowship and continuing until the physician’s late 50s or early 60s.
TCPR: Let’s address growing what we save. What’s the difference among the savings vehicles: IRAs, SEP IRAs, Roth IRAs, 401(k)s, etc?
Wiens: All of the items you mentioned are different types of retirement accounts. To help differentiate among them, I often think about the way they are taxed. First, let’s categorize the different types of accounts:
• Tax-deferred: often referred to as “tax-sheltered,” these are the retirement accounts we traditionally think of, including 401(k), 403(b), SEP IRA, traditional IRA, pension plan, and 457(b)
• Taxable savings: savings accounts, brokerage accounts, and other “trading” accounts
• Tax-advantaged: Roth IRA, Roth 401(k), Roth 403(b), 529 plans when used for qualified college expenses.
Also, see the diagram below.
TCPR: How do the tax-deferred accounts save money?
Wiens: Let’s assume that you have $18,000 that you’d like to put toward retirement and you’re in the 33% tax bracket.
• If you contributed the $18,000 to a 401(k), which is tax-deferred, you wouldn’t pay income taxes on the $18,000 (saving you $5,940).
• Then let’s assume your investment returned a 5% dividend ($900 in income). If you held this in a taxable account, you’d have to pay dividend tax on it. But since it’s in the 401(k), you won’t pay any taxes until you take the money out in retirement, when you may be in a lower tax bracket than you are today. If the $900 was taxed as ordinary dividends, the 401(k) would save you an additional $297 in income tax today. Since you don’t pay tax on that income, you have more principal to grow next year—this compounds growth faster than in a taxable investment account.
TCPR: How much can you contribute to a 401(k)?
Wiens: An employee can contribute $18,000 per year, plus a $6,000 catch-up amount for those 50 and older. But in addition to that, companies can match your 401(k) contribution. The amount of the match varies and is determined by the employer. The neat thing about running your own practice is that you are your own employer and you can set your own match. Many of my self-employed physician clients are able to contribute a total of $54,000 (the 2017 IRS limit) between the employee and employer, plus an additional $6,000 catch-up for those 50 and older.
TCPR: What are the advantages of a 401(k) over a SEP IRA?
Wiens: I see three advantages for self-employed doctors to use a 401(k) over a SEP IRA:
• Depending on income and what legal/tax entity the practice is (eg, LLC, sole proprietorship, S corporation, etc), a doctor may be able to contribute more to a 401(k) than a SEP IRA. For example, a 52-year-old self-employed psychiatrist with no employees netting $200,000 a year can put about $38,000 into a SEP IRA. Using a 401(k), that same doctor could contribute $60,000. You can run your own numbers using Vanguard’s online contribution calculator (https://personal.vanguard.com/us/SbsCalculatorController).
• Secondly, you can borrow from a 401(k) should you ever need a low-interest loan. The interest you pay on the loan goes back into your own 401(k). Please note a 401(k) loan should typically only be used for short-term needs, and I recommend paying these loans back promptly.
• Lastly, a 401(k) enables you to use a tool we call the “backdoor Roth IRA” that can’t be used with a SEP IRA.
TCPR: What’s a “backdoor Roth IRA?” I thought most doctors made too much to use a Roth IRA.
Wiens: That’s right—in 2017, if a married physician files taxes jointly and has an income of more than $196,000, that physician can’t contribute to a Roth IRA directly. That’s unfortunate, because Roth IRAs can be powerful tools—the contributions are funded after-tax, but when you withdraw funds in retirement, you pay no taxes on the distributions. The strategy for high-income individuals to fund a Roth IRA is often referred to as the “backdoor Roth IRA” (see https://www.bogleheads.org/wiki/Backdoor_Roth_IRA).
Here are the steps:
1. An individual contributes to a non-deductible IRA, as there are no income limitations on these contributions.
2. The individual then converts the non-deductible IRA into a Roth IRA. Voila, Roth IRA funded through a backdoor. There are some things that could cause hiccups (an existing balance in a pre-tax IRA or SEP IRA, for example), so I recommend that physicians seek the advice of a qualified accountant to ensure they are implementing the strategy appropriately. However, if used properly, the tax savings can be significant.