Speaker 1 (00:00.098)
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Speaker 1 (00:08.206)
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Welcome to the Physician Family Financial Advisors podcast, where physician moms and dads like you can turn today's worries about taxes and investing into all the money you need for retirement in college.
Hello physician moms and dads. This is Ben Utley. I'm a certified financial planner and the service team leader at Physician Family.
I'm Nate Rennecke, certified financial planner and primary advisor here at Physician Family. Thanks for joining us. Today's episode is Physician 401k, right or Roth? So Ben, we hear about Roths all the time in many different forms. We have Roth IRA, backdoor Roth IRA, Roth 401k. And when we were preparing for this podcast, we thought, you know, we should
we should look out there and see what people are saying about the Roth, specifically the Roth 401k. and obviously Roth 401k for physicians. And when we read some of the blogs from the big name physician bloggers out there, it wasn't clear about what to do with the Roth 401k. Some people said you should do it. Some people said you shouldn't do it.
Speaker 2 (01:30.07)
And we even looked into a prominent blogger that isn't in the physician world who was really unclear about the answer or maybe even flat out got the answer wrong. We only actually found one person who we follow or keep tabs on who gave what we believe to be the right answer. So we're gonna clear that up today. How's that sound?
Yeah, sounds good to me. In fact, the one guy who got it right didn't specialize in physicians, so I don't know how a doctor would stumble on the right answer to this question. And I think we're going to hear pretty soon that the physicians that I've heard of are stumbling onto the wrong answer.
Right. Okay. Let's start with the basics. Let's start with what does Roth really even mean?
Yeah, like why Roth? Roth was a Senator and came up with this neat new way of contributing and kind of keeping score of taxes. So the essence of Roth is that the money in a Roth, whatever 401k IRA, 403b, whatever it is, that money grows tax deferred. And then
distributions when they're made in the proper fashion are completely free of income taxes.
Speaker 2 (02:52.878)
tax deferred. So, so
Well, it's like Vegas. What happens in Vegas stays in Vegas. What happens in your Roth stays in your Roth. So if you get a dividend, it doesn't get taxed. If you get a capital gain, it doesn't get taxed. If you get interest, it doesn't get taxed. It all stays in the Roth. And then when you make the distributions, you know, you're taking money out for retirement. Uh, then the money comes out tax free, free from federal income tax.
Okay, got it. why, assuming you're you qualify for it and everything, why would anybody choose anything other than a Roth, which we know is traditional contributions? Why would anybody choose the opposite of that? Because that sounds pretty good. No taxes.
Yeah, so what you said is the opposite of Roth is traditional and I think that's probably the best way to put it, the opposite of. With the traditional, everything grows tax-deferred, just like with the Roth, but when the money comes out, you pay taxes on it. You're taxed at ordinary income tax rates for federal taxes. So the things that happen in the traditional account...
interest paid, capital gains accrued and recognized, dividends paid, no matter what that is, they increase the account value and that account is going to be taxed as ordinary income taxes at retirement withdrawal. So that's the difference between Roth and traditional types of accounts. That's easy part.
Speaker 2 (04:29.022)
So in the beginning, traditional, you don't pay taxes. And then at the end, you pay taxes. In Roth, in the beginning, you pay the taxes. And at the end, you don't pay taxes.
That's not exactly it. That's not exactly it. So you talked about at the beginning, you do this and you do that. I totally skipped over that part on purpose because the contribution may give you a deduction or may not give you a tax deduction, depending on whether we're talking about traditional versus Roth IRA versus 401k, because it's different for all of those.
The Roth works in tax deferral and then no taxes paid on withdrawal, traditional works, taxes, tax deferral, and then you pay taxes on withdrawal. So I left off the contribution on purpose just so that we can get the kind of the benefits and the understanding of how the traditional Roth flow once the money's in there.
Right. So it's more complicated than it sounds. And really it's more complicated for high earning individuals than it may seem, which to me is why there's confusion. Because if you're talking to somebody who is an average income earner, it is pretty obvious what to do here, which is why there's confusion because there's different people. What do you know? Everybody's unique.
The advice on this is so glib when you see it on the internet and you hear about it on other podcasts is that they're talking to everyone. They're talking to the masses rather than talking to physicians who, you everyone knows you earn more most other folks do on average. So just working specifically with physicians, we're able to nail it down to just one or two cases at the most.
Speaker 2 (06:21.248)
Right. Okay. So how do you go about choosing between which type of contributions to make?
Okay, so the way that you go about choosing which type of contributions to make is simply to tell your 401k provider, you know, I want to make Roth contributions or I want to make traditional contributions. That's tactically what you do. Strategically, you have to ask yourself, when do I want to pay taxes? Remember Roth, you don't pay taxes when you take the money out. Traditional, you do pay taxes when you take the money out.
But neither one of those is a free ride, right? So when you choose the traditional option, you get in some cases, well, definitely in a 401k case, you get a tax deduction when you make the contribution right now. Okay. Then 20 or 30 years from now, when you take the money out at retirement, that's when you pay your taxes. With the Roth 401k,
You do not get a tax break right now. In fact, you're choosing to have your earnings taxed and then have the money go into the Roth 401k. And when you get down to retirement and you don't pay any taxes. So really you're talking about the timing of when you choose to pay your taxes. So you can choose to pay taxes now or pay taxes at retirement. And when you choose to pay taxes now, you're choosing the Roth.
And when you choose to pay taxes at retirement, you should choose traditional 401k.
Speaker 2 (07:54.942)
Okay, so we kind of are laying this out as if it's a clear-cut answer for physicians. you see that as the case?
I do, I do actually see that as a clear cut case and here's why. So physicians, many physicians will pay taxes somewhere between 24 and 37%. The higher earning physicians are certainly paying taxes at the 37 % federal income tax rate and they're paying some unknown state income tax rate in most states. So.
In retirement, we expect that most physicians will owe taxes in the 22 or 24 % federal income tax rate. So we have to ask ourselves a question, do you want to pay taxes now when my rate is 37 % or do I want to pay taxes in the future when my rate is in the low 20s? And the answer for me is in your low 20s. Right? So when you choose to contribute to your traditional IRA,
You get a tax break at 37 % and then when you take that money out, you're going to pay taxes at 20 or 24%. Right? So you, you save at the high rate, you pay at the low rate and the Roth 401k works exactly the opposite. You pay at your highest rate and you save at your lower rate and that costs you money.
And to be clear, if you're gonna pay at the same rate, which is what most people's situation, if it's pay 22 now and 22 later, that's why there's confusion here because in that situation, it's a different story. But for physicians, they're, I mean, that's the whole thing here. They pay a ton in taxes.
Speaker 1 (09:46.85)
Yeah. And I think many physicians assume that, I'm in the top marginal tax bracket right now. I'm going to be in the top marginal tax bracket for the rest of my life. And that is wrong because when you think about all the things that you pay for right now, and you think about all the things you pay for in retirement, those are very different things. Like right now you're probably paying the mortgage on a seven figure home. Right now you might be paying for a nanny or private childcare, or you might be paying for.
you know, private K-12 or prep school or something related to children, you're going to pay a lot of child related expenses. And a bunch of those things are going to roll off when you got to get out into retirement. In fact, you know, just the cost of airline tickets could go down substantially for a family of four, cost of airline tickets are going to drop in half because you're probably going to be vacationing as a couple rather than as a family of four once you're in retirement.
Yep.
So it doesn't cost as much to live in retirement as it does to live now. And I think that's a, a, a, kind of a thinking trap that a lot of physicians get in. my money's going to grow and I'm going to be in the same rate. Well, the, the brackets creep up as inflation creeps up. So, you know, all things being equal, most physicians are in their highest tax bracket right now than when they are in retirement.
Mm-hmm Do you have I mean you keep saying there's this is a thinking trap how often do you see people kind of get this wrong?
Speaker 1 (11:18.391)
gosh,
I see it quite a bit. Do you want me to tell a story about this or give an example?
Yeah, let's have an example. I think that would make it more real.
Okay, so I was talking to one of our clients who's a neurosurgeon in New York. And I don't have to tell you what New York neurosurgeons make, right? So we're talking bank, definitely in the 37 % tax bracket. And then in whatever the top marginal rate there is in New York, okay, which is one of our highest tax states outside of Oregon. So he writes me and he's like, should I, you know, we have a new 401k plan, I to choose traditional or Roth. What do you think?
And I wrote back and I said, I think traditional is the best way to go. He writes me back and he said, that's interesting because eight of my partners are all doing the Roth. I thought, holy cow. He's like, are you sure? I, I replied and looped his CPA and I said, yes, I'm sure those guys are making a mistake. So that was one case. I talked to an ENT who was in Massachusetts recently and
Speaker 1 (12:31.222)
So you have an idea what ENTs make. This is a high performing group. He said that kind of was the same question. I said, I think you ought to do the traditional 401k. He said, four of my colleagues are doing the Roth 401k. And this time I pushed back a little bit. said, do you know why they're doing that? And he said, I don't know. I'll find out. And he said, you know, basically what they said is they're, they're, they're doing it this way because they figure that, you know, they'll just pay it now. And so I did the math on this.
And I looked at what would happen if you contributed the maximum amount to your 401k and you chose the traditional IRA and you got your tax savings this year and for every year you contribute. And then when you finish, you cash out and you pay taxes at the lower tax rate. And in the meantime, you take those savings, those tax savings, and you invest them at the same rate that you're getting on your 401k. And then you pay your capital gains tax on that when you get out to retirement.
I calculated that over the average physician lifetime, that decision to just pay your taxes now is costing those physicians over $267,000, which is a lot of money, but when you think about it, that's $267,000 after-tax dollars, which is more like $400,000 pre-tax dollars.
And so that's about an extra year's worth of work for a physician for quote unquote just paying it now without thinking about it. And that pains me.
Yeah, the only winner there is Uncle Sam or the state. Yeah Right. So what I'm hearing you say is What what contributes to this decision is one your current income which for most physicians is very high Mm-hmm, right? Two is your current tax rate versus your retirement tax rate, which for almost everybody Most people they spend less in retirement. That's just the nature of life
Speaker 1 (14:12.887)
Yeah, right.
Speaker 2 (14:36.268)
Right. then two would be that you sort of touched on this, which isn't totally obvious, but state taxes now versus later. Yeah. A lot of physicians we know work in New York because that's where they make a lot of money, but they're not going to retire there.
Not many, yeah.
Yeah, it's cold in New York. So they're going to move somewhere else. You know, the classic example would be Florida. Yeah. And they're going to avoid those state taxes completely if they choose the traditional contribution to their 401k versus their Roth.
That's right. I can work out an Oregon example. our, our, uh, state income tax, have compressed brackets. So practically everyone pays at the 10 % rate, whether you're a physician or a mail carrier. Uh, and so about 10%. So if I contribute the, uh, $20,500 to my 401k as I do, uh, then I'm saving $2,000 on my state income tax. Now, if I moved back to Texas where I grew up, not going to happen, but if I did,
They don't have a state income tax there. And so I would withdraw my, my contribution as well as all the earnings on it and pay zero taxes. And that takes that $267,000 figure. And I don't know what it does to it, but it blows it up.
Speaker 2 (15:56.162)
Yeah, I mean, that's like a cherry picked example. The 267 is for everybody. But if you got some sort of state tax arbitrage in there, it's even better or worse, depending on which side of the coin.
And that's not terribly uncommon. mean, Oregon has a high state income tax rate, but Washington has no income tax. So, I mean, just moving 120 miles north means that I've saved, you know, hundreds of thousand dollars worth of taxes.
Yep. Common strategy here.
Yeah, so you asked how often I see it. I see it, I guess I'm seeing this people making this mistake and somewhere between four out of five and nine out of ten situations. And here's the proof positive is like, well, all those doctors can't be wrong. They must really know something. OK, so I'm sure some of our listeners have heard about the mega backdoor Roth IRA.
And if you can get a hold to that, it's a great thing. And basically with that, you're choosing Roth because you have the ability to make a Roth contribution, but you can't deduct it, which is what makes the mega backdoor Roth IRA valuable, right? But if you could deduct it, why would you even bother? Right? So it's the fact that these contributions
Speaker 1 (17:16.724)
are deductible, like you can take a tax break on them this year that makes this strategy work. So we hear Roth Roth Roth Roth and
Right.
Speaker 1 (17:28.704)
It's hard for the human brain to wrap their head around the idea that one word can be good and one word can be bad at the same time. So we talk about Roth IRA all the time and specifically backdoor Roth IRA. backdoor Roth IRA, we've got to get that. That's something great for all physicians, right? So you hear that that's good. And then you go look at your 401k and you're making your election and you see Roth and you're like, Roth is good, but Roth is not good in all situations.
The thing that makes a backdoor Roth a good decision is you already don't get a tax break. That's not available to physicians. Sure, you can contribute to your IRA regardless of how much you make as a physician, but no physicians can deduct that because of how much they make as a physician. So there's not an opportunity there to get a tax break. There's no, it's not deductible like your 401k is. And so with your backdoor Roth, you're making lemonade out of lemons.
Mm-hmm. Right. So all about when you, if you can deduct. If you can deduct, take your break while you 30-some percent taxes. Let's do the best with it, the best thing you can, which is to convert.
Yes, absolutely.
Speaker 1 (18:42.018)
Yes, and I want to hit back on one argument that I hear occasionally, which is, well, tax rates will go higher. Okay. I followed the tax literature, of course, and
what I hear in there from potential tax reformers when they talk about like the way the tax code should be reformed and this is politically neutral, we're not talking Republicans versus Democrats here. They say that the tax code should be reformed such that they widen the base and lower the rate. That means more people pay taxes at a lower rate. That is the way that the neutral parties think that the tax code should be reformed. That's not politically expedient, but that is the way that it should be reformed. So if
rates are going to change, everyone thinks they'll go up, but it is also likely that they could go down, such that I think you can't really call that. You have to look at tax rates as they stand today and understand that, you know, long ago we had very, very high tax rates, almost twice what we have now. So tax rates have actually come down, historically speaking. So, Nate, I guess it really boils down to do you pay me now or do you pay me later? Because either way you go, you're going to pay.
Thank you.
for listening to the Physician Family Financials podcast. Are you getting all the tax breaks you really deserve? To find out, get your copy of the Open Tax Doctor's Retirement Investing Checklist available at physicianfamily.com forward slash go.
Speaker 1 (19:58.353)
advice.
We deserve a copy over to the Resort.
