WCI #11: Should You Make Roth or Traditional 401K Contributions?

This is the White Coat Investor Podcast where we help those who wear the white coat get a fair shake on Wall Street.

We've been helping doctors and other high income professionals stop doing dumb things with.

Their money since 2011.

Here's your host, Dr. Jim Dahli. Welcome to episode number 11 of the White Coat Investor Podcast.

At some point in our financial lives, it will be time to buy a home. A physician mortgage can be a good vehicle for a young doctor who's just.

Out of school and has a more.

Effective place to use their money than.

On a big down payment.

These loans allow doctors to secure a mortgage with fewer restrictions and a lower down payment than a conventional mortgage. But if you're further advanced in your career or deeper into your journey to financial freedom, buying a home with a conventional mortgage and then later on potentially refinancing that loan to a better rate with a shorter timeframe could be a great move. Wherever you are in your financial journey, make sure you use the mortgage that will be most financially beneficial for you. Hop over to our recommended tab to learn more about all of your mortgage and refinancing options@whitecoatinvestor.com mortgage. You can do this and the White Coat Investor can help.

Thank you for what you do. The work you do matters. You're likely on your way into work or on your way home from work and maybe a little bit tired, maybe a little bit burned out, maybe feeling you're not making a difference. Well, I assure you, you are. The little things you do each day have dramatic importance in the lives of your patients and those you serve. Today's episode is going to be all about the Roth versus traditional 401k decision. What we're not going to be talking about today are backdoor Roth IRAs, Roth conversions after tax contributions to a 401, or the mega backdoor Roth IRA. Those are all separate concepts, and it is important to keep them separate in your mind as you discuss this, because once you start confusing these concepts one with another, it can become really difficult to figure out exactly what's going on. Before you need to even worry about a Roth 401, you need to determine whether your particular 401k actually offers this option. Although it is becoming more and more common, there are still plenty of 401 s out there where the only contributions you can make are to the tax deferred option. You can also do this with a 403, which is generally what's offered at an academic medical center or even with a 457. They often have Roth options as well. Remember that a traditional or tax deferred 401k is basically a big tax break. When you put the money in and then it grows in a tax protected manner and when you take the money out, you pay taxes at your then marginal tax rate. With a Roth 401 contribution, you put after tax money in and then it grows in a tax protected manner and when it comes out, it comes out completely tax free. So both types of accounts are excellent and they're great ways to save for retirement. However, there are slight differences and that can make it tricky to decide which one you should be using when you have the option. Remember always that the employer portion of the contribution was or the match is always tax deferred. The only portion that can be a Roth contribution is your employee portion, which if you're under 50 is $18,000 per year. If you're 50 or over, you can do a catch up contribution of another $6,000 per year. The basic idea behind having some money in a Roth account and some money in a tax deferred account when you get to retirement is that you want to have tax diversification or what that allows you to do is to actually set your own tax rate in retirement. You basically take out of a tax deferred account up to the top of the next tax bracket and if you want to have more income from your retirement accounts, you take it out of the Roth account after that and that allows your overall tax burden throughout your lifetime to be as low as possible. Remember also that this isn't the only way to get money into a Roth account. You can also do a backdoor Roth IRA each year, which is essentially a no brainer for most high income professionals. Later in your career, particularly if you go part time or if you retire early, you should also consider doing some Roth conversions which will also increase the amount of tax free money you have saved for retirement. The basic concept is that you want to compare your marginal tax rate at contribution to to your marginal tax rate at withdrawal. If you're in a high tax bracket now and expect to be in a lower tax bracket later, you want to use a tax deferred account. If you're in a low tax bracket now and expect to be in a high tax bracket later, you want to use a Roth or tax free account. However, you have to keep in mind this concept of filling the buckets. Remember, if you have no other income and you're taking money out of a tax deferred account in retirement, and this is your only taxable income, just the money coming out of that account. Well, if you're married, your first $20,000 a year comes out tax free. So if you got a 33% or a 39.6% tax break when you put that money in and then you're pulling out $20,000 a year tax free, that's a heck of a great deal. Your next $18,000 comes out at 10%. Your next $50,000 coming out of that account each year comes out at 15%. Your next $75,000 a year comes out at 25%. So all of that is dramatically better than the 33 or 40% you put that money in at. In fact, it works out that your first $50,000 that you'd pull out of the account, assuming no other taxable income, comes out at about 7%. So if it goes in at 33 and comes out at 7, that's a winning strategy. Your first hundred thousand comes out at about 12%. Your first 150,000 comes out at 16%. So you have to have really quite a large tax deferred account before your effective tax rate is equal to what you saved with the marginal tax rate when you put the money in. This is the main reason why residents, part timers, people in sabbatical years, or if you're in the military should do Roth, and attendings in their peak earnings years should do traditional. And that is the basic general rule for who should be using which of these types of accounts. However, there are a lot of other factors that go into it. For example, there are political and economic considerations. If you are convinced that taxes are going to go up and go up dramatically in the future, well, you should use a Roth account because that allows you to pay the taxes. Now. If you're concerned that the government is going to change the rules and double tax the money that's in a Roth account by taxing it when you made it and then also taxing it when it comes out. Well, you'd want to use the traditional tax deferred side of your 401 because that would allow you to get the tax break even if the rules change later. At least you got yours. If you believe the government's going to implode at some point during your investment career. Well, you probably also want to get your tax break now. So that would favor using a tax deferred account. If you will have a lot of other retirement taxable retirement income from Social Security, from a pension, from rental properties, perhaps from a younger spouse that continues to work. That would Argue to have less money in a tax deferred account and more in a Roth account, because then more of your money will come out at a higher tax bracket in retirement. There are also estate planning considerations. A Roth IRA is a wonderful thing to inherit because as the heir, you can stretch it out over decades and essentially pay no tax on that income for decades. However, it's also not a terrible thing to inherit a traditional ira. Although you will have to pay tax on that money, it sure beats getting nothing from the deceased. Also bear in mind that estate tax, should it apply to you, is applied to all the dollars in the state in the estate, which includes those that will be going to the government. So if the goal is to keep your estate size underneath the limit, you may very well want to consider doing more Roth contributions because a Roth dollar is essentially worth more than a tax deferred dollar. If your heirs will be in a lower tax bracket than you are in in retirement, that's a no brainer. To leave them a heir tax deferred account, let them pay the taxes in their low bracket rather than you paying them in your high bracket. If you'll be leaving the money to charity, then use a traditional IRA because the charity won't be paying taxes on that money they inherit anyway. Also bear in mind when making estate tax decisions that stretch IRAs may be going away or may be severely limited in the future. There's some talk under the new administration that the total amount that heirs can stretch may be only $450,000. So if you're planning on leaving millions of dollars behind your heirs, that could really change your plans if that law actually goes through. Another factor to consider when deciding between roth and traditional 401 contributions is any possible future opportunities you may have to convert the tax deferred money to tax free money. You don't really know what the future holds, so it's a good idea to have some money in a tax deferred account just in case you happen to have a few low income years that you weren't expecting, that gives you an opportunity to do some Roth conversions at a very low tax rate. Another factor is what state you will be in when you retire. For example, if you are in a high tax state now and you plan to move to a low state tax state later, you may want to use a tax deferred account preferentially because that will allow you to pay those taxes in the lower tax state. The vice versa also applies if you are living in a tax free state right now and you plan to retire in a high tax state such as California or New York, well, you may want to favor Roth contributions more than you otherwise would. Also Be aware of phase outs. Phase outs are little items in the tax code that can change your marginal tax rate in ways that you didn't really predict. There are many phase outs that can apply to physicians. Luckily, once you get into the 200,000 range, you're mostly phased out of all of those that are going to phase out. But if you are a little bit below that, those phase outs can really have a dramatic change on your decision between going tax deferred and Roth. So be sure to run the numbers through the some tax software before making that final decision to make sure there's not something that you're missing. Also bear in mind that your Roth vs traditional 401k decision can have some effects on college aid. Remember that the expected family contribution is an important factor in determining what grants and loans your college student is eligible for. The calculation basically uses your after tax income plus any retirement contributions. So the same amount of after tax money contributed to a Roth 401 instead of a traditional 401 lowers your expected family contribution. Also remember that any Roth conversions done during the college years will also increase your expected family contribution. If you are lucky enough or savvy enough to have a very high income, you may also want to consider doing more Roth than you otherwise would. And the reason why is because you are likely going to end up with a very large tax deferred account anyway. And once your tax deferred account is very large, the Roth becomes just about as attractive. Whereas if you have a very small tax deferred account, that tax deferred account is very attractive. Great savers should also consider doing more Roth 401 contributions for the same reason you're likely to end up with a huge tax deferred account. While that isn't a problem for the vast majority of Americans and the vast majority of doctors, it can be a problem if you really are a super saver. Also bear in mind that you can actually put more money in a Roth 401 than you can in a tax deferred 401. And the reason why is that a Roth dollar is worth more than a tax deferred dollar. That tax deferred dollar is partially owned by the government. So if all things are equal tax rate wise, meaning you're putting the money in at 33% and you're taking the money out at 33%, well, you should lean a little bit more toward Roth for that slight advantage. Basically, the way to think about it is that if you're saving $18,000 in a Roth account, that's kind of the equivalent of putting $12,000 in a tax deferred account and saving another $6,000 in a taxable account. You're better off having it all inside a tax protected account, which is a Roth account. Okay, let's move on to a couple of questions that I've gotten by email. What are your thoughts on investing in inflation protected securities such as TIPS or I bonds through a 529? Most 529s seem to offer funds that address this in some capacity, while very few, from what I can tell, offer the investor direct purchase of said bonds. Okay, now let's go to some questions I've gotten by email. What are your thoughts on investing in inflation protected securities such as TIPS or I bonds through a 529? Most 529s seem to offer funds that address this in some capacity, while very few, from what I can tell, offer the investor direct purchase of said bonds. I'm about to start my first child's 529 and will likely use the Vanguard Nevada 529 as no state income taxes in Tennessee. Being 32 years old, I have a growth portfolio allocation and am comfortable with risk and market downturns. I know target dated funds heavy on equities and growth when the child is young is often recommended when it comes to my child's future education costs. However, I'm interested in something that I can start, fund early, forget and guarantee a return plus principal. Such things help me sleep at night a bit like overpaying my mortgage. Well, there's a lot of issues wrapped up in this question. I prefer to take a lot of risk with my 529s for various reasons. First, it's not my money, so I don't feel bad when some of it disappears. So I can have a very higher, very much higher risk tolerance for 529 money that I'm investing for my children than I can with my own retirement money. Another reason why I can take more risk is because the consequences of shortfall are not nearly as serious. If you end up running out of money in retirement, you're kind of hosed. If you end up running out of money for college, that's not as big of a deal. You can go to a lower cost college, you can work a little bit more during college, you can even take out some student loans, but nobody's going to give you a loan for your retirement. Finally, bear in mind that the gains on a 529 are tax free. So you want to have, in order to maximize the tax advantages, as much in gains as possible. Having only a little bit of gains is not a particularly useful way to use a 529. You want to invest it aggressively for that reason. Plus, a lot of people are worried, well, what if there's a market downturn right before my kid enrolls in college? But the truth is you're going to be using this money over several years, at least four to minimum, and that gives some time for a market recovery. And so I don't think it's the end of the world if you've got to use some of the other resources for that freshman year because the market's down, and then use more of the 529 contributions in the junior or senior year after the market has recovered. All of that adds up to my recommendation to take significant risk in your 529. But if you really want to be conservative, most 529s do have bond options, or at least some sort of less aggressive option. Bear in mind, however, that in the past educational inflation rates have been higher than the general inflation rates. So the idea of protecting this money using I bonds or TIPS doesn't really function in the way that you might hope it would where it's guaranteed to keep up with inflation. There are, of course, some guaranteed models of 529s where you're basically prepaying your tuition, which really would have the effect of keeping up with education rates of tuition. But you really have to read the details on those plans. The devil's in the details, and many of them have significant penalties if what you're planning for, for example, your child attending a state university doesn't actually happen. Keep in mind your referral to I bonds is a little bit problematic. I don't know of any 529 where you can buy I bonds. That's okay though. You can buy I bonds in a taxable account, and if used for education, the gains are essentially tax free. So if you want a conservative investment for college, I bonds are a great choice. But you don't need to put them inside of 529. If you're using the Nevada or Vanguard 529, you can just buy the tips fund inside of that. I don't know of a single 529 that allows for the purchase of individual TIPS securities. One more question. I was paid a bonus by my new employer as 1099 income. I would like to open a solo 401k to deposit the money into. I'm a little confused about how much of the bonus I can put into the solo 401k. Can I put in the entire amount since it is below the yearly limit? Or is the amount a percentage of the total? Well, a couple of factors that go into this. First of all, if you've already used your $18,000 a year employee contribution, then you can't use that again in the Solo 401. But if you're getting paid with a 1099 that means you're getting self employed income and that you'll have to pay payroll taxes on it. That is money that can be used as earned income to go into an individual or solo 401k. The rules are basically you only get one $18,000 a year employee contribution no matter how many 401ks you have. So if you used it at your employer's 401k, you can't use it in your individual 401. The other rule is that you can put 54,000 total into any given 401k as long as the employers are unrelated. And so what this doc can probably put in there, assuming this is earned income, all 1099 income is not earned income. But assuming this is earned income, it can go 20% of the net income net of business expenses including the employee errs. Half of payroll taxes can go into the solo 401k. So if he was getting paid a bonus of say $40,000, he could put in $8,000 into the individual 401k.

At some point in our financial lives, it will be time to buy a home. A physician mortgage can be a good vehicle for a young doctor who's just.

Out of school and has a more.

Effective place to use their money than on a big down payment. These loans allow doctors to secure a mortgage with fewer restrictions and a lower down payment than a conventional mortgage. But if you're further advanced in your career or deeper into your journey to financial freedom, buying a home with a conventional mortgage and then later on potentially refinancing that loan to a better rate with a shorter timeframe could be a great move. Wherever you are in your financial journey, make sure you use the mortgage that will be most financially beneficial for you. Hop over to our recommended tab to learn more about all of your mortgage and refinancing options@whitecoatinvestor.com mortgage. You can do this and the white coat investor can help.

Head up. Shoulders back. Remember that the work you do matters. Thank you for doing it. See you next time.