Tax-deferred Retirement Accounts: A Gift from the Government

Anybody with a reasonable understanding of math, the US tax code, and the typical earnings cycle of a physician can quickly see that one of the greatest gifts the government has ever given physicians is the ability to use tax-deferred retirement accounts. Despite this, there are many people out there that would try to convince you otherwise.

Sometimes these people have ulterior motives, wanting you to pull money out of your retirement accounts in order to purchase an investing or insurance product that will pay them a big commission. Others, including at least one prominent radio host, advocate that you always use a tax-free (Roth) account preferentially when available. Even well-meaning folks may cause you to worry unnecessarily about large required minimum distributions, investing fees, difficulties accessing money in retirement accounts prior to age 59 ½, and rising taxes. However, the truth is that for most physicians, the very best place to invest their next dollar is inside a tax-deferred retirement account such their employer’s 401(k), 403(b), defined benefit/cash balance plan, or even 457(b), and in the case of a self-employed physician, an individual 401(k) or cash balance plan.

In order to understand why a tax-deferred retirement account is such a great deal, it is critical to understand the typical earnings cycle for a physician. A typical doctor has no significant income until his late 20s when he enters residency. Then, for a period of 3-6 years during training, he has a low income, which rises rapidly over the next 2-5 years to his peak income, usually by his late 30s or early 40s. His income then remains high for 15-25 years before decreasing for a few years as he cuts back on work and then retires completely typically between ages 60 and 70. The vast majority of his retirement savings will come from earnings during the peak earnings years of his late 30s, 40s, and 50s, when he is in the highest tax brackets of his life.

It is also critical to understand the difference between a tax-deferred account, such as a 401(k), and a tax-free account, such as a Roth IRA. When you contribute to a tax-deferred account you contribute pre-tax money, which then grows in tax-protected manner until it is pulled out, at which time you owe taxes on the withdrawal at your ordinary income tax rate. When you contribute to a tax-free account, you contribute post-tax money, which also grows in a tax-protected manner just like a tax-deferred account, but then can be withdrawn completely tax-free in retirement. However, if the marginal tax rate on the contribution and the withdrawal are exactly the same, the two accounts are essentially equivalent. Consider an investor with a 30% marginal tax rate now and a 30% marginal tax rate in retirement. If he earns $5,000 and wants to put it toward his retirement, he may have the choice between a tax-deferred and a tax-free account. He can either put the $5,000 into a tax-deferred account, or he can pay the taxes due and put $3,500 into a tax-free account. After 20 years at 8% growth, the tax-deferred account has grown to $23,305 and the tax-free account has grown to $16,313. However, once you subtract the taxes due on the tax-deferred account ($6,991) you end up with precisely $16,313, the exact same amount as the tax-free account. So despite the fact that you would pay over four times as much in taxes on that tax-deferred money ($6,991 vs the original $1,500), you would end up with the exact same amount of money after-tax.

However, a physician will typically contribute money to his tax-deferred accounts at a much higher tax rate than he will withdraw it at. A physician in his peak earning years is likely to see his marginal tax rate, including the PPACA associated taxes but not state taxes, in the 30-45% range. However, in retirement, particularly an early retirement before starting to collect Social Security, he will likely be able to pull some of that money out at 0%, 10%, 15%, and 25%, filling the brackets as he goes along. Saving taxes at a 40% rate and then paying them later at an average of 15-20% is a winning strategy. Even if the tax brackets climb a bit, the fact that a large percentage of tax-deferred account withdrawals will be used to fill the brackets completely overwhelms the effect of the higher tax rates.

Even aside from the effect of filling the tax brackets, a retiree is likely to have, and need, a much lower income in retirement compared to his peak earnings years, even while maintaining the same lifestyle. As a retiree, he will have lower income taxes, no payroll taxes, no need to save for retirement or college, no child or work-related expenses, and hopefully no mortgage payment. Even if his health care and travel expenses go up, he is likely to find that he needs 50% or less of his pre-retirement income to maintain the same lifestyle. This is a good thing, since most doctors don’t save enough money and don’t invest their savings well enough to replace their entire pre-retirement income anyway. In fact, the less retirement savings you’ll have in retirement, the better deal a tax-deferred retirement account becomes.

Some investors who plan an early retirement invest outside retirement accounts because they are worried about the 10% penalty applied to retirement account withdrawals taken prior to age 59 ½. This fear is dramatically overblown. There is an exception to that penalty for every reasonable issue that could cause you to need to access that money prior to age 59 ½. There are exceptions for large medical expenses, health insurance, disability, higher education expenses, a first home of your own or a family member, and a tax levy. In addition, the substantially equal periodic payment rule allows for an early retirement. It essentially allows you to withdraw from your retirement accounts for any expense without paying that penalty, so long as you take out the same amount each year for five years. A planned early retirement is no reason to pass on the substantial benefits of investing in a retirement account.

Other investors worry that large required minimum distributions (RMD) after age 70 will push them into a higher tax bracket. While this is possible for a supersaver, it is a wonderful problem to have. The IRS mandates you withdraw a reasonable amount of your tax-deferred money each year, starting at less than 4% at age 70 and climbing to about 9% at age 90. For most people, they will need to withdraw this much or more to provide the income they need each year anyway. If you don’t need all of that money to live, it can be reinvested in a taxable account and left to your heirs income-tax-free due to the step-up in basis. For the supersavers, the best solution to this problem IS NOT to avoid contributing to tax-deferred accounts, but to make Roth conversions of some of that money (enough to fill the lower brackets) during late career and early retirement years. Again, a great problem to have. Bear in mind that in order to have an RMD that by itself pushes a married couple into the highest tax bracket will require a tax-deferred account at age 70 of over $13 Million. That simply isn’t an issue for the vast majority of physicians. Even if a doctor contributed $50,000 a year for 30 years and earned an annualized 8% on it over that time period, he would have less than $6 Million and an RMD at age 70 of just $207,000, squarely in the middle of the 28% bracket for a married filer.

This is not to say that there are not times to use a tax-free account. Retirement contributions during low earning years such as residency, fellowship, military service, and sabbaticals are great times to contribute to tax-free accounts. If you cut back on work or go part-time, that may also be a great time to make tax-free contributions or Roth conversions. Serious savers will take advantage of the Backdoor Roth IRA even during their peak earnings years in addition to maxing out their tax-deferred accounts. Of course, Roth conversions near career end and in early retirement can also make a lot of sense. But if you are in your peak earnings years and have not yet maxed out your tax-deferred account contributions, that is clearly where you will see the most bang for your buck.

The tax code may change in the future. Perhaps a flat tax or a value-added tax will replace our income tax system. Perhaps there will be an additional tax placed on Roth IRAs. However, these concerns argue FOR using a tax-deferred account. Get your tax break now while you still can. Take the bird in the hand instead of the two in the bush.

Some investors worry about the poor investment choices and high fees associated with some employer-provided tax-deferred accounts. This problem is rapidly correcting itself as employers are beginning to understand the fiduciary duty they have to their employees. Those who didn’t learn fast enough are now learning this lesson in court. Even if your 401(k) is not ideal, the presence of a potential match and the likely opportunity to transfer it to a better 401(k), an individual 401(k), or even an IRA later still argues strongly to use it for your savings.

Even ignoring the likely difference in marginal tax rates between contribution and withdrawal, the tax-protected growth available in retirement accounts may add as much as 0.5% to your annual returns when compared to investing in a taxable account. Over the course of 50 years (including both earning years and retirement years), that difference can result in you having a 20% larger nest egg (and thus retirement income.)

In addition, in most states retirement accounts receive significant asset protection from your creditors. Even if you end up declaring bankruptcy due to the (admittedly miniscule) possibility of being sued for more than your insurance policy limits, you will probably still get to keep your retirement accounts. Retirement accounts also provide for easy estate planning. Not only can you pass those assets to your heirs immediately outside of probate by designating beneficiaries, but the tax advantages can then be “stretched” for many more decades by the heirs themselves. For many doctors, leaving heirs a tax-deferred account instead of a tax-free account is a savvy tax move because the marginal tax rate for the heirs is lower than for the doctor. Using a tax-deferred account for a charitable contribution at death and leaving the taxable account (with its step-up in basis) or, better yet, a stretchable tax-free account to the heirs can also be a smart move. But none of these options are available if you do not contribute to the tax-deferred account in the first place.

In early career, a physician typically has a high income, a low net worth, a high tax bill, and significant liability concerns. Large contributions to tax-deferred retirement accounts are the perfect solution. Don’t say the government never did anything for you.