Pre- vs. Post-Tax Retirement Savings: Roth IRA Opportunities for Physicians

There are two major buckets for retirees to withdraw income from at retirement: pre-tax and post-tax buckets. To give you the most options and choices at retirement you should consider stashing your nest egg away in both buckets to some degree.

The big picture thinking on a retirement strategy and the tax issues that surround them is that you want to defer taxes when you are at a higher bracket and pay the taxes at a lower bracket. The issue is that we do not know where tax brackets will be at in five, 10, 20-plus years from now, and we cannot predict exactly how much we will have to pay Uncle Sam out of our nest egg.

Pre-tax vs. post-tax

Pre-tax accounts — 401(k), 403(b), 457 plans, traditional IRAs, etc. — are advantageous because you get a tax break in the year that you contribute to these accounts. You do not have to pay tax on the income you put into these accounts in the year that you contribute it, and the grow is completely tax-deferred, meaning you are not taxed on any growth as it accrues in the accounts. The disadvantage is that you are taxed 100% on all withdrawals past age 59-and-a-half as ordinary income.

Post-tax accounts — Roth IRAs, Roth 403(b)s, Roth 401(k)s — are advantageous because you are not taxed on a single penny that comes out of these accounts when you withdraw from them past age 59-and-a-half … as long as the withdrawal is qualified. For a withdrawal to be qualified the funds must be in the Roth IRA for five years and the account owner must be 59-and-a-half. Roth IRAs also grow on a tax-deferred basis. The disadvantage is that you do not get a tax break in the year that you contribute.

Strategy to use both

Because of the progressive nature of our tax system, we would want to be pulling out money from pre-tax accounts in the lower brackets (currently the 10% and 15% brackets) and then avoid paying a quarter (or more) in taxes on every dollar we pull out by taking out the money needed in retirement above the lower tax bracket thresholds from their Roth vehicles.

The complicated part of this strategy is that there are income phase out ranges and limits that exclude many physicians from putting money directly into a Roth IRA. For instance, if you are married filing jointly then you cannot contribute to these accounts at all when your adjusted gross income is over $183,000 or over $125,000 if you are single — limited to a contribution of $5,000/per person annually). Most physicians’ are over these respective limits.

But on Jan. 1, 2010 income limits on who could convert money into a Roth IRA were lifted. So, almost every physician can do a non-deductible IRA and then convert it to a Roth IRA the next day. You should plan to convert it the next day because that minimized the growth on that account that you would be liable to pay taxes on, as the conversion creates a taxable event on any earnings.

This can be a bit of a paperwork nightmare for some, but there are many financial advisors out there who should be able to help navigate these steps efficiently on your behalf and it may be well worth the hassle when you have tax-favored accounts.

Also, more and more employers (currently about a third) are offering Roth versions of their 401(k) and 403(b) options, so you can put post-tax contributions away under the current limits of $17,000 per year as well.

A rough guideline — which can vary immensely from family to family depending on their specific savings patterns, goals, etc. — is to put roughly two-thirds of your money into a pre-tax account and one-third of your intended retirement money into a post-tax vehicle.

If you do not have access to a Roth account through your employer and you want to supplement your retirement assets another option to consider could potentially be a cash value of life insurance policy. These types of vehicles are very complicated and should be carefully contemplated. Talk with your advisor. However, keep in mind that the primary reason to purchase a life insurance product is the death benefit.

Disclosure:

This should not be considered as tax or legal advice. Please consult a tax or legal professional for information regarding your specific situation.

For a Roth IRA, earnings withdrawn prior to reaching age 59-and-a-half and/or not meeting the five-year holding period may be subject to a 10% penalty in addition to income tax. After-tax contribution amounts are generally returned income tax free; however, for Roth conversions, if converted amounts are not held for the five-year period, distributions may be subject to a 10% penalty.

Investors' anticipated tax bracket in retirement will determine whether or not a Roth IRA versus a traditional will provide more money in retirement. Generally, investors who are in a higher tax bracket at retirement relative to their current tax bracket while making contributions to a Roth IRA benefit more than an investor who is in a lower tax bracket at retirement.

Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender charges.

Policy loans and withdrawals may create an adverse tax result in the event of a lapse or policy surrender, and will reduce both the cash value and death benefit.

Jon C. Ylinen is a Financial Advisor with North Star Resource Group and offers securities and investment advisory services through CRI Securities, LLC. and Securian Financial Services, Inc., members FINRA/SIPC. CRI Securities, LLC. is affiliated with Securian Financial Services, Inc. and North Star Resource Group. North Star Resource group is not affiliated with Securian Financial Services, Inc. The answers provided are general in nature and are not intended to be specific recommendations. Please consult a financial professional for specific advice in relation to your individual circumstances. This should not be considered as tax or legal advice. Please consult a tax or legal professional for information regarding your specific situation. 509349/ DOFU 5-2012