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, some would try to convince you otherwise.

Sometimes these people have ulterior motives, wanting you to pull money out of your retirement accounts to purchase an investment 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 it's 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.

Will a Doctor Benefit from Tax-Deferred Retirement Accounts?

The truth is, that for most physicians, the very best place to invest their next dollar is inside a tax-deferred retirement account, such as their employer’s 401(k), 403(b), defined benefit/cash balance plan, or 457(b). And, for the self-employed physician, it's an individual 401(k) or cash balance plan.

The Difference Between Tax-Deferred and Tax-Free

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.

Tax-Deferred

When you contribute to a tax-deferred account, you contribute pre-tax money, which then grows in a tax-protected manner until it is pulled out. Then, you'll owe taxes on the withdrawal at your ordinary income tax rate.

Tax-Free

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. However, it's then withdrawn completely tax-free in retirement.

The Physician's Earning Cycle

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 their late 20s when they enter residency. Then, for a period of 3-6 years during training, they have a low income, which rises rapidly over the next 2-5 years to their peak income (usually by their late 30s or early 40s). Their income then remains high for 15-25 years before decreasing for a few years as they cut back on work and then retire completely (typically between ages 60 and 70). The vast majority of their retirement savings will come from earnings during the peak years of their late 30s, 40s, and 50s, when they are in the highest tax brackets of their life.

An Example Using EQUAL Marginal Tax Rates

If the marginal tax rate on the contribution and the withdrawal is exactly the same, the two accounts are essentially equivalent. Consider an investor with a 24% marginal tax rate now and a 24% marginal tax rate in retirement.

If the investor earns $5,000 and wants to put it toward their retirement, they may have the choice between a tax-deferred and a tax-free account. They can either put the $5,000 into a tax-deferred account, or they can pay the taxes due and put $3,800 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 $17,712. However, once you subtract the taxes due on the tax-deferred account ($5,593), you end up with precisely $17,712, the exact same amount as the tax-free account.

Despite the fact that you would pay over four times as much in taxes on that tax-deferred money ($5,593 vs the original $1,200), you would end up with the exact same amount of money after-tax.

An Example Using the Typical Physician with UNEQUAL Marginal Tax Rates

However, a physician will typically contribute money to their tax-deferred retirement accounts at a much higher tax rate than when they will withdraw it. A physician in their peak earning years is likely to see their marginal tax rate, including the PPACA-associated taxes but not state taxes, in the 24%-35% range. In retirement, particularly an early retirement before starting to collect Social Security, they can likely pull some of that money out at 0%, 10%, 12%, and 22%, filling the brackets as they go along.

Saving taxes at a 35% rate and then paying them later at around 12% 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.

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Lower Income Needs in Retirement

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 their peak earnings years, even while maintaining the same lifestyle. As a retiree, this investor 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 their healthcare and travel expenses go up, they are likely to find that they need 50% or less of their 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.

What About the 10% Penalty If I Plan to Retire Early?

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 before 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 before 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 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.

Will RMDs Push Me into a Higher Tax Bracket?

Other investors worry that large Required Minimum Distributions (RMDs) after age 75 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 about 4% at age 75 and climbing to about 9% at age 90.

Most people 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, it'd be a great problem to have.

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But My 401(k) Offers So Few Options

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 have since learned 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 the contribution and the 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).

When Do I Use a Tax-Free Account?

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 earning years while also maxing out their tax-deferred accounts.

Of course, Roth conversions near career end and in early retirement can also make sense. But if you are in your peak earning 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.

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Get Your Tax Break While You Can

In addition, retirement accounts in most states receive significant asset protection from your creditors. Even if you end up declaring bankruptcy due to the (admittedly minuscule) 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 10 years by your 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.

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.

 

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.

What do you think? Do you use tax-deferred retirement accounts? Why or why not? What do you consider the valid reasons to not max them out each year?

[This updated post was originally published in 2016 at MDMag.com.]

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