In this week's episode, we are taking listener questions regarding retirement accounts. We talk about 403(a), 403(b), and 457(b) accounts and what the maximum contributions for those are. We cover defined benefit plans vs. a Mega Backdoor Roth and when to pick which or both options. We answer questions about taxable accounts and catch-up contributions, as well as differences in employer contributions and solo 401(k) accounts and when you can make contributions for a spouse. If you have questions about retirement accounts, you will find some answers here.
In This Show:
- Traditional 403(b) or Roth 403(b)?
- Recommended Reading:
- Taxable Accounts
- Recommended Reading:
- 401(a), 403(b) and 457(b) Contributions
- Catch-up Contributions
- Employer Contributions to Solo 401(k)
- Defined Benefit Plan vs Mega Backdoor Roth
- Active Bond Fund vs Index Funds
- Recommended Reading:
- Sponsor
- Milestones to Millionaire Podcast
- Conferences
- Quote of the Day
- Full Transcription
Traditional 403(b) or Roth 403(b)?
Our first question comes from Gordon.
“Hi, Dr. Dahle. Thanks for everything that you do. We just had a question about my situation. I just sold my house and moved to start my fellowship. I was lucky enough to walk away from the house with about $30,000 worth of profit. I've already maxed out my Roth IRA for this year, and I have some more money from that profit from selling my house and also some money that I made during moonlighting my last year of residency.
I would like to invest some more of this money after making sure I have enough in my emergency fund. So, I figured out I would either start contributing to the traditional 403(b) or the Roth 403(b) at work, but I'm not sure which one would be best. That's my first question.
My second question is that I have a little bit of money in a traditional 403(b) from residency. And I was trying to decide if I should roll this over into my existing Roth IRA or the new traditional or Roth 403(b) that I will start contributing to. Any advice would be very much appreciated. Thank you.”
Well, Gordon, I don't really have enough information to give you good advice on this, but I can give you the general rules of thumb. As a general rule, when you're in medical school, residency fellowship, the year you get out of training, the year you're doing a sabbatical, or the years that for some other reason you have lower income than your peak earnings years, those are generally good years to do Roth conversions of any pretax money you may have and to do Roth contributions to 401(k)s IRAs, 403(b)s, and 457(b)s.
In general, what I would do in your situation, assuming there's no other reason why you should be favoring a tax-deferred account, I would convert that 403(b) from residency to a Roth IRA, and I would use the Roth 403(b) available to you in fellowship, in addition to the Roth IRA.
The main caveat is that someone who is going for public service loan forgiveness, or possibly going for forgiveness through one of the IDR programs, would not want to do that. If you think you're going to try to get your loans forgiven, you might want to run the numbers because in those situations it can often make sense even during residency or fellowship to be using a tax-deferred account instead of a Roth account.
But the general rule for most people is that Roth is for residents and Roth is for fellows. Roth is for any year in which you're not at your peak earnings. So, that's probably where you ought to be investing your money at this point.
Recommended Reading:
Should You Make Roth or Traditional 401(k) Contributions?
Taxable Accounts
The next question is about understanding taxes in a taxable account. It's exactly what you're trying to get away from if you're investing in a tax-protected account.
Now, remember the word “tax-protected” or “tax advantage” is just an umbrella term that includes traditional or tax-deferred accounts and Roth or tax-free accounts. The opposite of that, of course, is a taxable account.
“Hello, Jim. My employer 401(k) plan through Fidelity does not allow for a diversified portfolio and offers funds with high expense ratios except for a target date fund. I exchanged my 401(k) into a Fidelity brokerage link, where it can be invested in many more options. Have you heard of any issues with this?
Secondly, a few years ago, I started investing in my taxable brokerage account and did not know about the tax ramifications of REITs, small value funds, bonds, etc. at that time. Since then, I no longer contribute monthly to these assets and my taxable accounts. The gains are probably a few thousand total. The tax drag is around 0.4%. Should I sell these and take a capital gains hit or keep them in the account?
Also, if my gains overall each year are greater than the tax drag, then why wouldn't it still be worth it to keep investing in these in my taxable account as long as they're earning a good return? Thank you. And thank you for everything that you've done through your podcast.”
The Fidelity brokerage link is fine to use. Schwab has something similar called the PCRA—Personal Choice Retirement Account. Basically, you get to opt out of the mutual funds that your employer has selected for you, and you can invest in anything available at the brokerage. That includes all kinds of stuff most of the time, just about any ETF that's available out there that's publicly traded, any publicly traded stock or bond, etc.
Usually, you have to sign some sort of waiver disclaimer saying you know what you're doing and you have taken on all the risk. Normally those sorts of assets aren't necessarily allowed in a 401(k), because your employer has a fiduciary duty to you to provide you good investments.
Your second question is an asset location question. And the point of asset location is to eke out a little bit of extra return by being smart about where you put your various assets—which ones go into tax-protected accounts, which ones go into a taxable account.
And so, in general, you want assets with a really high return and assets that are very tax-inefficient in tax-protected accounts, because you want those accounts to grow so you can benefit from the tax protection on even more money in the future. And of course, the less tax-efficient it is, the better off it is in those tax-protected accounts because you get to keep the entire return.
REITs are notorious for being tax-inefficient. They do benefit now from the 199A deduction, which helps a little bit, but they're still pretty tax-inefficient because they have relatively high returns and most of that return comes from a distribution that is taxable at ordinary income tax rates.
Bonds, particularly in times of high-interest rates, also tend to be pretty tax-inefficient. So, they often go into tax-protected accounts as well. It sounds like you've learned this somewhere and are thinking about making corrections in your portfolio, which is appropriate. If it doesn't cost you much, why not make the correction?
But when we're talking about stuff you have in your taxable account that you don't really want there, the term we use for this is legacy assets or legacy investments. And sometimes it's some actively managed mutual fund. Sometimes it's just a mutual fund you want, and you just don't want it to be taxable. And so, you've got to weigh your options there. Sometimes it makes sense to just leave those there and build around them. Obviously, you don't want to be reinvesting dividends or distributed capital gains, but you can build around those things if you don't want to take the capital gains hit.
If you give money to charity, these are great assets to donate to charity instead of cash. You can put them into your DAF or you can come directly to the charity. As we talked about last week, you can use them in a CRT or private foundation or whatever you prefer to use.
You can also just hold them until you die and your heirs get a step-up in basis on those. But if it's just a few thousand dollars in capital gains, you may want to pay the taxes on that, just to simplify your portfolio and be done with it. It really depends on how badly you want a simplified portfolio. In the next down market, you could do some tax-loss harvesting which could leave you with enough losses that you could offset the gains when you sell those legacy assets.
Remember asset allocation first, then tax location.
Recommended Reading:
The Taxable Investment Account
401(a), 403(b) and 457(b) Contributions
The next question comes from someone with multiple retirement accounts.
“I work for a nonprofit organization, and my employer offers 401(a), 403(b) and 457(b). Will I be able to make max contributions for all of them, which are $58,000 for 401(k), $19,500 for 403(b), and $19,500 for 457(b)? Or is there a max contribution limit that should not exceed it, but spread across all of these accounts?”
A 403(b) is most easily thought of as a 401(k). Your 403(b) however, and your 401(a) share the same limit so you cannot put $58,000 into both of them. That is a limit they call the 415(c) limit.
When you have this setup, you can typically put money into the 403(b). Some employers will also put a small match in there as well. In 2021, you can put $19,500 if you're under 50 in there. And maybe the employer gives you another $5,000 or $10,000. So, that's about $30,000 you've used up.
Then the employer oftentimes will allow you to have money put in the 401(a) instead, and that might be another $20,000 or $25,000. The 401(a) contribution is typically not negotiable. The employer tells you how much of your pay goes into the 401(a) every year and maybe it's 10%. So, if they're counting, your pay is $290,000, they'll put $29,000 in there and then they allow you to put your $20,000 into your 403(b) and they give you a little match on top of it. And that gets you somewhere close to $58,000 if you're under 50.
The 457(b) limit is totally separate. Remember those other accounts are your money. A 457(b) is your employer's money. It's deferred compensation. It's money that's coming to you that they haven't paid you yet. It's really good for asset protection from your creditors. It's really bad for asset protection from their creditors. So, before you use a 457(b), you want to make sure that you're not likely to have your employer go under. Now that's usually not the case at a big state academic institution, but keep that in mind.
If it's got reasonable fees, reasonable investment options, and most importantly, reasonable distribution options, not just one big lump sum in the year you leave the employer, then go ahead and use the 457(b), as well. The limit on that is $19,500 for 2021. It should be $20,500 for 2022. And that's basically the way it works. But that's a totally separate limit from the $58,000 limit for your 401(a) or 403(b).
So, if you look at it all together, chances are you're going to be able to get something close to $75,000-$78,000 into these three accounts. Anything above and beyond that, you'll need to invest into a personal or spousal backdoor Roth IRA and/or a taxable account and/or an HSA. Or if you've got a side gig somewhere else that you're getting 1099 income, you can open an individual 401(k).
Catch-up Contributions
Our next question is,
“I’d love a catch up on retirement contributions post. One question. If I turn 50 in February 2022, can I make an IRA catch-up contribution in 2022? Or do I have to be 50 for a full year?”
Well, good news. If you turn 50 in 2022—if you turn 50 on Dec. 31, 2022, or on Jan. 1, 2022—you can make your IRA catch-up contribution. You can’t do it for prior years, but you can do it for 2022. You don't have to wait until you turn 50 to make that contribution. You don't have to be 50 for a full year before it happens. You don't have to be over 50. You just have to be 50. That includes your 401(k) and your IRA. Remember the catch-up contributions for your HSA starts at 55, not 50.
Employer Contributions to Solo 401(k)
Our next question comes from Radesh, regarding employer contributions into a solo 401(k).
“Hi, Jim. Thank you for everything that you do. I have a question about solo 401(k)s. I am a W-2 employee. I max out my 401(k) through my institution, and I maxed out all my other retirement accounts. I've started doing some consulting this year. And for sake of argument, I anticipate having a total profit of $10,000 this year.
Since I max out my employee contribution in my W-2 401(k), I'm assuming that I cannot make an employee contribution to my solo 401(k). As the employer, am I correct in understanding that I could contribute 25% of my total profits? So, in this case, $2,500 to my solo 401(k)?
The second question I have is what about my spouse? I've heard that the one exception to the no-other employee rule for the solo 401(k) is having a spouse and contributing on their behalf. Under this whole setup, how would the spousal contribution work? My spouse works at home and home schools our children. So, she does not have a 401(k) that she makes an employee contribution to.
So, with the 401(k) that I may set up with my consulting side gig income, how much can I contribute on my wife's behalf to that solo 401(k)? Again, my purpose for a solo 401(k) is not to roll over any money. It's just to provide more tax advantage growth. I hope this question was clear. Thank you so much.”
First of all, let's talk about your contribution. You already used your employee contribution, so you're correct that you cannot use it in this other 401(k). That total is $19,500 per person per year. No matter how many 401(k)s you have, no matter how many unrelated employers you have, it's $19,500.
You can make an employer contribution. And this is a little bit confusing until you work through the IRS forms and run the numbers. But the way it works out is not 25% of what you make consulting. It's only 20%. And it's only 20% of your net income from that. Net of what? Net of all your expenses and net of the employer half of social security and Medicare taxes.
Now, if you are incorporated and this is an S-corp, it’s 25% of your salary. So, you can't even use your distributions toward that number. It's only what you pay yourself as salary. And of course, the amount, the contribution again, is separate from that. And so, it works out to be about the same if you pay yourself the entire $10,000 as salary. Again, it's only 20%, not 25%. I hope that is clear, but you're not going to like that answer very much, because it's going to mean that you can't even put in there as much as you thought you would.
A lot of people look at that and go, “I can only put $2,000 in there? Well, that's not worth the hassle to me.” Maybe you just use $10,000. You're really making $100,000 in which case maybe $20,000 is worth it to you. I don't know. But I'll have to leave that up to you. If it's worth the hassle of having a solo 401(k) to save a few bucks, then go ahead and do it. There's no minimum amount of profit you have to have to open a solo 401(k). If you only made $200 in profit, you could open a solo 401(k), and you can put $40 into it. But that's the way the system works.
Now, as far as a spousal contribution, a lot of people get confused because, with a spousal IRA, you can make a full IRA contribution no matter what your spouse does. They can sit on the couch, eat bonbons all day, and watch TV, and you can make a full spousal contribution for them.
But despite the fact that your wife is at home, homeschooling your kids, and working hard, that does not give you the right to make a spousal 401(k) contribution for her. She actually has to work in the business, and the business has to pay her. She has to be on the payroll, or she has to be an owner of the company.
Now, if you are putting her as the owner of the company, and she doesn't actually do anything for the company, that's going to look kind of bad to the IRS. So, in this sort of a situation where you're consulting and you're making $10,000, you really are not going to be making any sort of spousal solo 401(k) contribution.
You are correct that you can use a solo 401(k) when the only employees of the business are you and your spouse. You don't have to get a real 401(k) until you have a non-spouse employee. And this is what Katie and I used for several years with the White Coat Investor, because all of our employees were independent contractors. Now that they're all employees, we had to get a real 401(k). But we were using a solo 401(k) for several years there.
However, Katie was actually doing work in the business. She was doing stuff. She was getting paid a salary. And that's what we calculated her 401(k) contributions off of. And so, if you want to figure out a way to have your spouse actually be working in the business and you pay her a reasonable salary for that, then she can make pretty significant contributions. Because most of the time, unless you're paying her more than $19,500, she basically can contribute everything she makes into the 401(k) as an employee contribution.
And so, that's an option, but again, she's got to actually do something for the business. You can't just homeschool your kids and say she's working in the business. That's not legit.
Defined Benefit Plan vs Mega Backdoor Roth
Next, we have a question from Alfred.
“Hi Jim. This is Alfred from New York. I have a question regarding defined benefit plans vs. Mega Backdoor Roth in preparation for withdrawing $120,000 per year when we retire.
I'm 37. I'm a hospitalist making approximately $250,000 of W-2 income. We max out our 401(k), HSAs, 529s, Backdoor Roth IRAs. We paid off all of our loans and we follow your advice. My wife is 39. She became an equity partner in our firm for three years now. She makes anywhere from $1.4 million to $2.5 million of W-2 income annually.
We save 75% of our gross income. She does consulting on the side and makes $175,000 in 1099 income per year. Our advisor recommended we set up a defined benefit for her, and we contribute $100,000 into this. And we've been doing that for three years. This is obviously pre-tax, and we get a tax break for this, because we pay close to 50% tax living in New York City.
My questions are when I run the numbers, we have a very large defined benefit for her in 20 years. We're getting a tax break now, but with likely higher taxes in the future, I don't know if it's worth going through all this trouble if we're not going to withdraw it at a lower rate when we retire.
Do you recommend that we just set up a Mega Backdoor Roth IRA and contribute to it post tax and let it grow given our large income now? What tax strategies would you employ at this time to make this most tax efficient when we retire? What would you and Katie do in this situation? I recognize I'm the luckiest guy in the world, and these are first-world problems. I'm very blessed. I appreciate you and everything you do. I'll buy you a Peter Luger steak when you come to New York City next. Thanks a lot.”
What would Katie and I do in this situation? We do them both. We'd totally do the Mega Backdoor Roth IRA. And we'd totally do the defined benefit cash balance plan. I mean, why not? You guys are clearly good savers. You are maxing out everything. So why wouldn't you use everything pre-tax that you could possibly use? It sounds like she's got something going on the side, too. You can open a solo 401(k) for her and put some employer contributions into that, as well.
Yes, chances are, if you guys work a full career making a couple million bucks a year, you're going to have substantial accounts by the time you retire, which is why I think it's kind of funny that you're talking about only having $120,000 in retirement income. Chances are you might be in the top bracket if you really work for years and years and save all this money, while making $2 million a year.
I think chances are reasonable you may leave New York City at some point, as well. So, pre-tax stuff now, where you're saving not only the top federal income tax bracket rates, but also the top New York City and New York state income tax rates. And then you move to Florida or Nevada or something like that, or Texas, and all of a sudden, you're really going to have a huge arbitrage just on the state taxes alone.
Active Bond Fund vs Index Funds
Our next question comes from Marie.
“Hello, Dr. Dahle. Thank you very much for taking another question of mine. This is Marie. At historic low to negative yields in bonds, assuming these are in tax protected accounts, would it be better to go with an active bond fund rather than a passive one?
The reason I asked this question is because my 401(k) offers two very similar intermediate core bond funds. These are the non-TIPS ones. They actually have a good TIPS index fund that I put half my bond in, but one is an active bond and one is an index bond fund.
And comparing the two from year-to-date yields to 10-year yields, the active bond fund was surpassing performance by more than 1% at various intervals. I have to say that the gross expense ratio of the active bond fund is 0.15%. And the index bond is 0.025%. Am I overthinking this? Thank you so much for your input. I appreciate it.”
As a general rule, I like index funds. Everybody knows that. I like eliminating that manager risk. It works in bonds just as well as it works in stocks. In fact, at lower yields, all of a sudden, those expenses start mattering more since they're eating up a larger percentage of the yield. But in this situation, you're not talking about a significant price difference. And when active funds beat index funds, they're usually very inexpensive active funds. And at 0.15% expense ratio, it would be a very inexpensive active fund. In fact, I would double-check all that, double-check that it's actually active.
So, I would not necessarily rule it out just because it's actively managed. I would not necessarily rule it out because the expense ratio is a little bit higher than what you can get in your index bond fund in your 401(k). What I would do is look under the hood. The reason the yield is higher is because it's investing in something different than the index fund is. It’s probably investing in longer-term bonds. It’s probably investing in riskier bonds. And that's the reason why the yield is higher.
So, the question you have to ask yourself is which bonds do you want? Do you want the shorter-term, less risky ones in the index fund? Or do you want the longer-term or riskier bonds in this particular actively managed fund? And once you make that decision, it should be an easy choice.
Now, if you told me the expense ratio on this bond fund was 1.5%, instead of 0.15%, I'd say, just use the index fund. Or if you told me that you've looked under the hood and it was just full of junk bonds, well, I'd use the index fund. But assuming that it's reasonable investment quality bonds under there and you're confident in the management team and its long-term track record, I would look at it and actually consider it.
Recommended Reading:
10 Reasons I Invest in Index Funds
Sponsor
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Conferences
Registration is now open for The Physician Wellness and Financial Literacy Conference. The conference is in Phoenix on Feb. 9-12, 2022. In the past, the tickets have sold out quickly so don’t wait to get yours. If you cannot attend the in-person event, we are also offering a virtual component. Get your tickets today!
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Quote of the Day
Our quote of the day comes from James Lang, a keynote speaker at WCICon this year. He says,
“All things being equal, following the adage, don't pay taxes now, pay taxes later by using retirement accounts can be worth almost $2 million over your lifetime.”
Full Transcription
Transcription – WCI – 229
Intro:
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 Dahle.
Dr. Jim Dahle:
This is White Coat Investor podcast number 229 – Q&A on retirement accounts.
Dr. Jim Dahle:
If you are finding our podcasts informative and helpful we would encourage you to sign up for our monthly newsletter! It is totally free and includes useful, actionable information NOT AVAILABLE on the regular blog posts. It's almost like being in a secret club – the kind of club that can boost your knowledge and enhance your wealth at the same time – with no strings attached. Sign up today at whitecoatinvestor.com/newsletter.You can do this and The White Coat Investor can help.
Dr. Jim Dahle:
All right, welcome back to the podcast and thanks for what you do, especially those of you on the front lines of our ongoing COVID pandemic, which never seems to end these days.
Dr. Jim Dahle:
I saw a statistic the other day that said 75% of Americans have had at least one vaccination, but it's amazing how rampant this pandemic can be in just a quarter of the population.
Dr. Jim Dahle:
For those of you feeling burned out this too shall pass, it will get better. People have kind of made a decision at this point either to get a vaccine or get the disease, but eventually they will have all had it. And hopefully we don't just keep getting it over and over and over again with all the different variants.
Dr. Jim Dahle:
So, hang in there, we appreciate what you do, even though you're not getting quite as many donuts sent into the hospitals as you were a year and a half ago. There's still a lot of people out there thinking about you and are grateful for your sacrifices. Any of you in the high-income earning profession have made significant sacrifices to do your job. And if no one has told you thanks for that today, let me be the first.
Dr. Jim Dahle:
Our quote of the day today comes from James Lang, who is actually going to be one of the keynote speakers at WCI con this year. He's a CPA and a JD and well known for paying taxes later, Roth conversions, those sorts of things. He says, “All things being equal. following the adage, don't pay taxes now, pay taxes later by using retirement accounts can be worth almost $2 million over your lifetime”.
Dr. Jim Dahle:
We're going to talk more about that today, as we get into listeners' questions. Before we do that, I want you to know about two things we're promoting right now. The first one is WCI con 22. This is going to be an awesome conference. This is the Physician Wellness and Financial Literacy conference in Phoenix, February 9th through 12th, 2022.
Dr. Jim Dahle:
This is a hybrid conference. There will be an in-person component if you're lucky enough to be one of the first thousand people to sign up for it. It will be a virtual conference for all of the other people who either just want to stay home for whatever reason, whether it's COVID related or not, or couldn't get into the in-person version because it's sold out.
Dr. Jim Dahle:
Now, I'm actually recording this podcast on September 8th and registration opens on September 14th. By the time you are listening to this, it's been open for over a week. So maybe the in-person is all sold out and all that's going to be available is the virtual. But the virtual is going to be awesome anyway. You're going to get all the content and you're not going to be able to come up and talk to people face to face. You won't be able to do some of the wellness activities that are there, but you're going to get all of the content, all the presentations there. And so, you can still have a pretty awesome experience.
Dr. Jim Dahle:
You can sign up for that at whitecoatinvestor.com/wcicon22. And make sure you sign up in time so you can get the swag bag. If you wait too long, you won't be able to get the swag bag. Even the virtual people are going to get the swag bag if they sign up in time, we're just going to mail it to you. But it's going to be an awesome swag bag with books from all the keynote speakers. It's going to be great.
Dr. Jim Dahle:
Also keep in mind if you've been waiting to enter Peter Kim's or Passive Income MDs Passive Real Estate Academy. It's open again. You can sign up from now until the 26th of September for three payments of $747 or a one-time payment of $1,997, the course starts 9/29.
Dr. Jim Dahle:
This course is for those who are interested in passive real estate. We're talking syndications, we're talking private real estate funds. If this is something you feel like you want to get into, but you don't know enough to evaluate what's a good deal, what's a bad deal, you don't have any contacts. This is the course for you. So go ahead and sign up for that. You can do that at whitecoatinvestor.com/prea for Passive Real Estate Academy.
Dr. Jim Dahle:
All right, our first question comes in from Gordon. Let's take a listen.
Gordon:
Hi, Dr. Dahle. Thanks for everything that you do. We just had a question about my situation. I just sold my house and moved to start my fellowship. I was lucky enough to walk away from the house with about $30,000 worth of profit. I've already maxed out my Roth IRA for this year, and I have some more money from that profit from selling my house and also some money that I made during moonlighting my last year of residency.
Gordon:
I would like to invest some more of this money after making sure I have enough in my emergency fund. So, I figured out I would either start contributing to the traditional 403(b) or the Roth 403(b) at work, but I'm not sure which one would be best. That's my first question.
Gordon:
My second question is that I have a little bit of money in a traditional 403(b) from residency. And I was trying to decide if I should roll this over into my existing Roth IRA or the new traditional or Roth 403(b) that I will start contributing to. Any advice would be very much appreciated. Thank you.
Dr. Jim Dahle:
Well, Gordon, I don't really have enough information to give you good advice on this, but I can give you the general rules of thumb. As a general rule, when you're in medical school, residency fellowship, the year you get out of training a year you're doing a sabbatical or for some of the reasons to have lower income than your peak earnings years. Those are generally good years to do Roth conversions of any pretax money you may have, and to do Roth contributions to 401(k)s IRAs, 403(b)s, 457(b)s, whatever.
Dr. Jim Dahle:
That's the general rule. Now you're telling me you're going from residency into fellowship. You've got a little bit of extra money. You've got some pre-tax stuff and you've got the option to do a Roth 403(b) in addition to a personal Roth IRA. It sounds like you can probably contribute to that directly.
Dr. Jim Dahle:
You probably don't even have to go through the backdoor, but make sure you look at your income and see. If you're worried you might be close to that, just go through the backdoor. It works fine. If you get married, then of course, you can also do a spousal Roth IRA either directly or indirectly through the backdoor Roth IRA process.
Dr. Jim Dahle:
In general, what I would do in your situation, assuming there's no other reason why you should be favoring a tax deferred account, I would convert that for 403(b) from residency to a Roth IRA, and I would use the Roth 403(b) available to you in fellowship, in addition to the Roth IRA. And that's right, invest that money. If you've decided you're going to use that money for retirement, that's what I'd use it for.
Dr. Jim Dahle:
Now, there's lots of other things you could use it for. You could use it to pay off student loans, pay off credit card debt to save up for a house down payment after fellowship, to boost your emergency fund, pay off your car, whatever. I don't know. But if you're going to invest this for retirement, then I think doing it in a Roth account is a pretty good way to go at this stage of your career.
Dr. Jim Dahle:
The main caveat, the main person who doesn't want to do this is someone who's going for public service loan forgiveness, or possibly going for forgiveness through one of the IDR programs. So, if you think you're going to try to get your loans forgiven, you might want to run the numbers because in those situations, it can often make sense even during residency or fellowship to be using a tax deferred account instead of a Roth account.
Dr. Jim Dahle:
But the general rule for most people, Roth is for residents. Roth is for fellows. Roth is for any year in which you're not at your peak earnings. So, that's probably where you ought to be investing your money at this point.
Dr. Jim Dahle:
All right, let's take our next question here. And this one is about understanding taxes in a taxable account. Exactly what you're trying to get away from if you're investing in a tax protected account.
Dr. Jim Dahle:
Now, remember this word “tax protected” or “tax advantage” is just an umbrella term that includes traditional or tax deferred accounts and Roth or tax-free accounts. The overarching umbrella term is tax protected or tax advantage. The opposite of that of course is a taxable account. So, let's listen to this question about a taxable account.
Speaker:
Hello, Jim. My employer 401(k) plan through Fidelity does not allow for a diversified portfolio and offers funds with high expense ratios except for a target date fund. I exchanged my 401(k) into a Fidelity brokerage link, where it can be invested in many more options. Have you heard of any issues with this?
Speaker:
Secondly, a few years ago, I started investing in my taxable brokerage account and did not know about the tax ramifications of REITs, small value funds, bonds, et cetera at this time. Since that I no longer contribute monthly to these assets and my taxable accounts. The gains are probably a few thousand total. The tax drag is around 0.4%. Should I sell these and take capital gains hit or keep them in the account?
Speaker:
Also, if my gains overall each year are greater than the tax drag then why wouldn't it still be worth it to keep investing in these in my taxable account as long as they're earning a good return? Thank you. And thank you for everything that you've done through your podcast.
Dr. Jim Dahle:
Okay. Yes. The Fidelity brokerage link is fine to use. Schwab has something similar called the PCRA – Personal Choice Retirement Account. I think this is what it stands for. But basically, you get an opt out of the mutual funds that your employer has selected for you, and you can invest in anything available at the brokerage. That includes all kinds of stuff most of the time, just about any ETF that's available out there that's publicly traded, any publicly traded stock or bond, et cetera.
Dr. Jim Dahle:
Usually, you have to sign some sort of waiver disclaimer saying you know what you're doing to do this and you have taken all the risk because normally those sorts of assets aren't necessarily allowed in a 401(k) because your employer has a fiduciary duty to you to provide you good investments.
Dr. Jim Dahle:
Incidentally, if all they've given you is a crummy list of expensive actively managed mutual funds in your 401(k), you might want to remind them of fiduciary duty that some employee you might come along sometime and sue them for not taking that duty seriously.
Dr. Jim Dahle:
But in the meantime, you can just use the brokerage thing. No big deal. I've done the same thing in my partnership 401(k). We have PCRA options via Schwab. And so, I've used that for years and years and years. It's no big deal.
Dr. Jim Dahle:
The main reason I did it wasn't actually because of the investments in the 401(k) sucked, ours were fine but the fees were slightly lower to roll my own investments by going through that PCRA. And so, that's fine to use.
Dr. Jim Dahle:
Your second question is an asset location question. And the point of asset location is to eke out a little bit of extra return by being smart about where you put your various assets. Which ones go into tax protected accounts, which ones go in a taxable account.
Dr. Jim Dahle:
And so, in general, you want assets with a really high return and assets that are very tax inefficient in tax protected accounts, because you want those accounts to grow so you can benefit from the tax protection on even more money in the future. And of course, the less tax efficient it is, the better off it is in those tax protected accounts because you get to keep the entire return.
Dr. Jim Dahle:
REITs are notorious for being tax inefficient. They do benefit now from the 199A deduction, which helps a little bit, but they're still pretty tax inefficient because they have relatively high returns and most of that return comes from a distribution that is taxable ordinary income tax rates.
Dr. Jim Dahle:
Bonds, particularly in times of high interest rates, also tend to be pretty tax inefficient. So, they often go into tax protected accounts as well. It sounds like you've learned this somewhere and are thinking about making corrections in your portfolio, which is appropriate. If it doesn't cost you much, why not make the correction?
Dr. Jim Dahle:
But when we're talking about stuff you have in your taxable account that you don't really want there, the term we use for this is legacy assets or legacy investments. And sometimes it's some actively managed mutual fund. Sometimes it's just a mutual fund you want, you just don't want to be taxable. And so, you've got to weigh your options there. Sometimes it makes sense to just leave those there and build around them. Obviously, you don't want to be reinvesting dividends or distributed capital gains, but you can build around those things if you don't want to take the capital gains hit.
Dr. Jim Dahle:
If you give money to charity, these are great assets to donate to charity instead of cash. you can put them into your DAF or you can come directly to the charity. As we talked about last week, you can use them in a CRT or private foundation or whatever. But that's a great way to get rid of them.
Dr. Jim Dahle:
You can also just hold them until you die and your heirs get a step up in basis on those.
But if it's just a few thousand dollars in capital gains, you may want to pay it, pay the taxes on that, just to simplify your portfolio and be done with it. It really depends on how badly you want a simplified portfolio.
Dr. Jim Dahle:
Other things you can do. In the next down market, maybe you can do some tax loss harvesting and then you'll have enough losses that you can now offset the gains when you sell those legacy assets. That's another option you can use or if you already have a bunch of tax losses, you can use those up to get rid of those and move them into whatever tax protected account you would rather have them in.
Dr. Jim Dahle:
But don't beat yourself up too badly. The way this goes for a lot of people that are really good savers, especially if you have a decent income is your taxable account keeps getting bigger and bigger and bigger over the years and becomes a bigger portion of your portfolio.
Dr. Jim Dahle:
And so, at this point I've moved most of my asset classes into my taxable account. My US stocks are there. My international stocks are there. My small international stocks are there. An increasing percentage of my small value stocks are there. A fair amount of my real estate is there. The vast majority of it actually. I don't have my publicly traded REITs there yet, but someday they may be in taxable as well. And I've got a big chunk of my bonds there now in a Muni bond fund.
Dr. Jim Dahle:
So don't beat yourself up too badly, realize that there's a lot of people that ended up doing that just because they have to, because the ratio of tax bill, the tax protected accounts is just too high in order to have very much in that tax protected account at all.
Dr. Jim Dahle:
Remember asset allocation first, then tax location. Don't let your tax tail wag your investment dog but do try to be smart about where you put your assets and you can eke out a little bit more return by doing that.
Dr. Jim Dahle:
All right, here comes another question on the Speak Pipe from somebody with multiple retirement accounts. Let's take a listen.
Speaker 2:
I work for a non-profit organization and my employer offers 401(a), 403(b) and 457(b). Will I be able to make max contributions for all of them, which are $58,000 for 401(k), $19,500 for 403(b) and $19,500 for 457(b)? Or is there a max contribution limit that should not exceed it, but spread across all of these accounts?
Dr. Jim Dahle:
All right. This is a common setup for academic docs. You get a 401(a), you get a 403(b) and you get a 457(b). This is what they have up at the University of Utah close to me and I'm sure at many places all over the country. So, let's talk about each of these three accounts.
Dr. Jim Dahle:
A 403(b) is most easily thought of as a 401(k). There are a few minor differences, particularly with the catch-up contributions. It can be a little bit different that way, but I'm not going to get into that today. Think of that as your 401(k). Your 403(b) however, and your 401(a) share the same limit. That's a limit they call the 415(c) limit. In 2021 it's $58,000. It's probably going to be about $61,000 for 2022. They share the same limit. So, you can't put $58,000 into both of them.
Dr. Jim Dahle:
And when you have this setup, the way it typically works is you can put money into 403(b). Maybe the employer puts a little match in there. So, you can put your $19,500 if you're under 50 in 2021 in there. And maybe the employer gives you another $5,000 or $10,000. So, that's about $30,000 you've used up.
Dr. Jim Dahle:
And then the employer oftentimes will allow you to have money put in the 401(a) instead and that might be another $20,000 or $25,000 or something like that. Now the 401(k) contribution is typically not negotiable. It's basically going in there. They're telling you we're going to put this much of your pay into the 401(a) every year and maybe it's 10%. So, if they're counting, your pay is $290,000, they'll put $29,000 in there and then they allow you to put your $20,000 into your 403(b) and they give you a little match on top of it. And that gets you somewhere close to $58,000. Maybe you're in the $40,000s, $50,000s, somewhere in there, but it should be less than $58,000 if you're under 50.
Dr. Jim Dahle:
The 457(b) limit is totally separate. Remember those other accounts are your money. A 457(b) is your employer's money. It's deferred compensation, it's money that's coming to you that they haven't paid you yet. It's really good for asset protection from your creditors. It's really bad for asset protection from their creditors. So, before you use a 457(b) you want to make sure that you're not likely to have your employer go under. Now that's usually not the case at a big state academic institution, but keep that in mind.
Dr. Jim Dahle:
If it's got reasonable fees, reasonable investment options, and most importantly, reasonable distribution options, not just one big lump sum in the year you leave the employer, then go ahead and use the 457(b) as well. The limit on that $19,500 for 2021. It should be $20,500 for 2022. And that's basically the way it works. But that's a totally separate limit from the $58,000 limit for your 401(a) or 403(b).
Dr. Jim Dahle:
So, if you look at it all together, chances are you're going to be able to get something close to $75,000 – $78,000 into these three accounts. Anything above and beyond that you'll need to invest into a personal or spousal backdoor Roth IRA and or a taxable account and or an HSA, or if you've got a side gig somewhere else that you're getting 1099 income, you can open an individual 401(k), but that's about it.
Dr. Jim Dahle:
It's a pretty common setup. Get the plan documents, read them, understand how they work. Make sure you get your entire match if any, and make sure you got the investments set up the way you want them to be. I hope that's helpful.
Dr. Jim Dahle:
Our next question comes off email. It says “I’d love to catch up on retirement contributions post. One question. If I turn 50 in February, 2022, can I make an IRA catch-up contribution in 2022? Or do I have to be 50 for a full year?”
Dr. Jim Dahle:
Well, good news. If you turn 50 in 2022, even if you turn 50 on December 31st, 2022 on January 1st, 2022, you can make your IRA catch-up contribution. You can’t do it for prior years, but you can do it for 2022. And so, that's what the limit is for the year in which you turn 50.
Dr. Jim Dahle:
You don't have to wait until you turn 50 to make that contribution. You don't have to be 50 for a full year before it happens. You don't have to be over 50. You just have to be 50. If you turned 50 that year, you can use a catch-up contribution. That includes for your 401(k). That includes your IRA. Remember the catch-up contributions for your HSA starts at 55, not 50.
Dr. Jim Dahle:
All right. Our next question comes from Radesh. I think we had him on last week. He's from Phoenix, as I recall. He's got a question about employer contributions into a solo 401(k).
Radesh:
Hi, Jim. Thank you for everything that you do. I have a question about solo 401(k)s. I am a W2 employee and I max out my 401(k) through my institution and I maxed out all my other retirement accounts. I've started doing some consulting this year. And for sake of argument, I anticipate having a total profit of $10,000 this year.
Radesh:
Since I max out my employee contribution and my W2 401(k), I'm assuming that I cannot make an employee contribution to my solo 401(k). As the employer, am I correct in understanding that I could contribute 25% of my total profits? So, in this case, $2,500 to my solo 401(k)?
Radesh:
The second question I have is what about my spouse? I've heard that the one exception to the no other employee rule for the solo 401(k) is having a spouse and contributing on their behalf.
Radesh:
Under this whole setup, how would the spousal contribution work? My spouse works at home and home schools our children. So, she does not have a 401(k) that she performs an employee contribution to.
Radesh:
So, with the 401(k) that I may set up with my consulting side gig income, how much can I contribute on my wife's behalf to that solo 401(k)? Again, my purpose for a solo 401(k) is not to roll over any money. It's just to provide more tax advantage growth. I hope this question was clear. Thank you so much.
Dr. Jim Dahle:
All right, Radesh. Good question. It's a common question, but it's a good one. You're not going to like the answer. First of all, let's talk about your contribution. You already used your employee contribution, so you're correct that you cannot use it in this other 401(k). That total is $19,500 per person per year. No matter how many 401(k)s you have, no matter how many unrelated employers you have, it's $19,500. You already used it. You can't put any of that into your solo 401(k).
Dr. Jim Dahle:
You can make an employer contribution. And this is a little bit confusing until you work through the IRS forms and run the numbers. But the way it works out is not 25% of what you make consulting. It's only 20%. And it's only 20% of your net income from that. Net of what? Net of all your expenses and net of the employer half of social security and Medicare tax. 20% of that.
Dr. Jim Dahle:
Now, why does it say 25%? Well, 25% is what it is if you don't count the contribution. So, you make $10,000, you put in $2,000, right? And you pay yourself $8,000. Well, that $2,000 is 25% of $8,000. It's not 25% of $10,000 though. It's only 20% of $10,000. So, if you include the contribution amount, it's 20%. If you don't include it, it is 25%.
Dr. Jim Dahle:
Now, if you are incorporated that this is a S-corp, it’s 25% of your salary. So, you can't even use your distributions toward that number. It's only what you pay yourself as salary. And of course, the amount, the contribution again, is separate from that. And so, it works out to be about the same if you pay yourself the entire $10,000 as salary, while again, it's only 20%, it’s not 25%. I hope that is clear, but you're not going to like that answer very much, because it's going to mean that you can't even put in there as much as you thought you would.
Dr. Jim Dahle:
A lot of people look at that and go, “I can only put $2,000 in there? Well, that's not worth the hassle to me”. Maybe you just use $10,000. You're really making $100.000 in which case maybe $20,000 is worth it to you. I don't know. But I'll have to leave that up to you. If it's worth the hassle of having a solo 401(k) to save a few bucks, then go ahead and do it. There's no minimum amount of profit you have to have to open a solo 401(k). If you only made $200 in profit, you could open a solo 401(k), and you can put $40 into it. But that's the way the system works.
Dr. Jim Dahle:
Now, as far as a spousal contribution, a lot of people get confused because with a spousal IRA, you can make a full IRA contribution no matter what your spouse does. They can sit on the couch, eat bonbons all day and watch TV and you can make a full spousal contribution for them.
Dr. Jim Dahle:
But despite the fact that your wife is at home, homeschooling your kids, working hard, that does not give you the right to make a spousal 401(k) contribution for her. She actually has to work in the business and the business has to pay her. She has to be on the payroll, or she has to be an owner of the company.
Dr. Jim Dahle:
Now, if you are putting her as the owner of the company, and she doesn't actually do anything for the company, that's going to look kind of bad to the IRS. So, in this sort of a situation where you're consulting and you're making $10,000, you really are not going to be making any sort of spousal solo 401(k) contribution.
Dr. Jim Dahle:
You are correct that you can use a solo 401(k) when the only employees of the business are you and your spouse. You can still use a solo 401(k). You don't have to get a real 401(k) until you have a non-spouse employee. And this is what Katie and I used for several years with the White Coat Investor, because all of our employees were independent contractors. Now that they're all employees we had to get a real 401(k). But we were using a solo 401(k) for several years there.
Dr. Jim Dahle:
However, Katie was actually doing work in the business. She was doing stuff. She was getting paid a salary. And that's what we calculated her 401(k) contributions off of. And so, if you want to figure out a way to have your spouse actually be working in the business and you pay her a reasonable salary for that, then she can make pretty significant contributions. Because most of the time, unless you're paying her more than $19,500, she basically can contribute everything she makes into the 401(k) as an employee contribution.
Dr. Jim Dahle:
And so, that's an option, but again, she's got to actually do something for the business. You can't just homeschool your kids and say she's working in the business. That's not legit.
Dr. Jim Dahle:
All right, the next question comes from Alfred from New York City. Let's take a listen.
Alfred:
Hi Jim. This is Alfred from New York. I have a question regarding defined benefit plans versus mega backdoor Roth in preparation for withdrawing $120,000 per year when we retire.
Alfred:
I'm 37, I'm a hospitalist making approximately $250,000 of W2 income. We max out our 401(k) HSAs, 529s, backdoor Roth IRAs. We paid off all of our loans and we follow your advice. My wife is 39. She became an equity partner in our firm for three years now. She makes anywhere from $1.4 million to $2.5 million of W2 income annually.
Alfred:
We saved 75% of our gross income. She does consulting on the side and makes $175,000 in 1099 income per year. Our advisor recommended we set up a defined benefit for her and we contribute $100,000 into this. And we've been doing that for three years. This is obviously pre-taxed and we get a tax break for this because we pay close to 50% tax living in New York City.
Alfred:
My questions are when I run the numbers, we have a very large defined benefit for her in 20 years. We're getting a tax break now, but with likely higher taxes in the future, I don't know if it's worth going through all this trouble if we're not going to withdraw it at a lower rate, when we retire.
Alfred:
Do you recommend that we just set up a backdoor Roth IRA and contribute to it post tax and let it grow given our large income now? What tax strategies would you employ at this time to make this most tax efficient when we retire? What would you and Katie do in this situation? I recognize I'm the luckiest guy in the world, and these are first world problems. I'm very blessed. I appreciate you and everything you do. I'll buy you a Peter Luger steak when you come to New York City next. Thanks a lot.
Dr. Jim Dahle:
I'm afraid I'm going to have to reveal my ignorance here. I don't know what a Peter Luger steak is, but I like steak and it sounds like a really expensive tasty steak. So, I'm going to take you up on that. I like New York. I like it for about three days. After that, I feel like I'm stuck in a slot canyon walking around in the city. But it's a really cool place. I just don't think I could live there long-term.
Dr. Jim Dahle:
Anyway, I'm glad you do. They certainly need docs and I'm not sure exactly what your spouse does, an attorney or something it sounds like. I'm glad you're there and people do need your services there. So, thanks for what you do out there. You're right. It's a first world problem. That's okay. That's all we talk about here at the White Coat Investors – First world problems.
Dr. Jim Dahle:
What would Katie and I do in this situation? We do them both. We'd totally do the mega backdoor Roth IRA. And we'd totally do the defined benefit cash balance plan. I mean, why not? You guys are clearly good savers. You are maxing out everything. She's making, I don't remember what it was, $1.7 million or something, and you're making $275,000 or something like that. I mean, you're making $2 million a year and you're getting the snot tax out of you in New York.
Dr. Jim Dahle:
So why wouldn't you use everything pre-tax that you could possibly use? Yeah, I would totally do that. It sounds like she's got something going on the side too. You can open a solo 401(k) for her and put some employer contributions into that as well. So, I look into that. Why not? You get some additional asset protection. State planning gets easier with it. You get the tax breaks.
Dr. Jim Dahle:
Yes, chances are, if you guys work a full career making a couple million bucks a year, you're going to have substantial accounts by the time you retire, which is why I think it's kind of funny that you're talking about only having $120,000 in retirement income. Chances are you might be in the top bracket if you really work for years and years and save all this money, while making $2 million a year.
Dr. Jim Dahle:
I think chances are reasonable you may leave New York City at some point as well. So, pre-tax stuff now where you're saving not only the top federal income tax bracket rates, but top New York City and New York state income tax rates. And then you moved to Florida or Nevada or something like that, or Texas, and all of a sudden, you're really going to have a huge arbitrage just on the state taxes alone.
Dr. Jim Dahle:
I think in your situation, I would definitely go with all of those tax advantaged accounts. And chances are, you're going to have a significant taxable account above and beyond all that anyway.
Dr. Jim Dahle:
So, good question. I'd try to do it all. And I know it's expensive to live in New York City, but you can probably handle it even if you eat a lot of steaks on $2 million worth of income. So, thanks again for what you do. Congratulations on your success. I agree. It sounds like you are a lucky man. But you know what? In some ways, all of us are at least a little bit lucky.
Dr. Jim Dahle:
All right, let's take the next question. This one comes in from Marie.
Marie:
Hello, Dr. Dahle. Thank you very much for taking another question of mine. This is Marie. At historic low to negative yields in bonds, assuming these are in tax protected accounts, would it be better to go with an active bond fund rather than a passive one?
Marie:
The reason I asked this question is because my 401(k) offers two very similar intermediate core bond funds. These are the non-TIPS ones. They actually have a good TIPS index fund that I put half my bond in, but one is an active bond and one is an index bond fund.
Marie:
And comparing the two from year-to-date yields to 10-year yields, the active bond fund was surpassing performance by more than 1% at various intervals. I have to say that the gross expense ratio of the active bond fund is 0.15%. And the index bond is 0.025%. Am I overthinking this? Thank you so much for your input. I appreciate it.
Dr. Jim Dahle:
Okay. As a general rule, I like index funds. Everybody knows that. I like eliminating that manager risk. It works in bonds just as well as it works in stocks. In fact, at lower yields, all of a sudden, those expenses start mattering more since they're eating up a larger percentage of the yield.
Dr. Jim Dahle:
But in this situation, you're not talking about a significant price difference. And when active funds beat index funds, they're usually very inexpensive, active funds. And at 0.15% expense ratio, it would be a very inexpensive active fund. In fact, I would double-check all that, double check that it's actually active. Double-check that it’s actually the expense ratio, because that would be a very inexpensive actively managed bond fund.
Dr. Jim Dahle:
So, I would not necessarily rule it out just because it's actively managed. I would not necessarily rule it out because the expense ratio is a little bit higher than what you can get in your index bond fund in your 401(k).
Dr. Jim Dahle:
What I would do is look under the hood. The reason the yield is higher is not because it's actively managed. The reason the yield is higher is not because the expense ratio is a little higher. The reason the yield is higher is because it's investing in something different than the index fund is. It’s probably investing in longer term bonds. It’s probably investing in riskier bonds. And that's the reason why the yield is higher.
Dr. Jim Dahle:
So, the question you have to ask yourself is which bonds do you want? Do you want the shorter term, less risky ones in the index fund? Or do you want the longer term or riskier bonds in this particular actively managed fund? And once you make that decision, it should be an easy choice, but that's what I would make this particular decision off of.
Dr. Jim Dahle:
Now, if you told me the expense ratio on this bond fund was 1.5%, instead of 0.15%, I'd say, just use the index fund. Or if you told me that you've looked under the hood and it was just full of junk bonds, well, I'd use the index fund. But assuming that it's reasonable investment quality bonds under there, and you're confident in the management team, their long-term track record, I would look at it and actually consider it.
Dr. Jim Dahle:
But for the most part, I prefer avoiding manager risk. I just invest in index funds. So, my bond funds are either index or index like funds. But keep in mind, even at Vanguard, when you go to Vanguard in recent years, they've added more bond index funds there, but a lot of their longest-term bond funds that are very low expense funds are not technically index funds. They're actually actively managed funds.
Dr. Jim Dahle:
Now they're very index-like and very passively managed or managed by a team. There isn't much manager risk there, but they're not technically index funds if you look at them carefully. And so, I'm not totally against using an actively managed bond fund, but you got to look at the whole picture there and make a decision while looking at all of that.
Dr. Jim Dahle:
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Dr. Jim Dahle:
All right, don't forget to sign up for WCI con 22. Whitecoatinvestor.com/wcicon22 is the link you will need for that. The virtual would still be open by the time you hear this, the in-person option might not be open. But if it is, go ahead and sign up for that as well. I'd love to meet you personally.
Dr. Jim Dahle:
Thanks for those of you who are leaving us a five-star review and telling your friends about the podcast. Our latest one comes in from Nycmarilyn, who said, “Jim Dahle has a way of explaining things that make it very understandable and relatable. I look forward to my morning commute on Mondays and Thursdays when the new episodes come out. I do wish he had more guests on Milestones to Millionaire in the $5 mil and over range. Highly recommended”.
Dr. Jim Dahle:
All right, you heard it. If you've got more than $5 million, Marilyn wants to hear from you. So, go ahead and sign up for the Milestones to Millionaire podcasts. That's whitecoatinvestor.com/milestones. We'll get you on there and celebrate your success and use it to inspire more people like Marylin.
Dr. Jim Dahle:
Until then keep your head up, shoulders back. You've got this and we can help. We'll see you next time on the White Coat Investor podcast.
Disclaimer:
My dad, your host, Dr. Dahle, is a practicing emergency physician, blogger, author, and podcaster. He’s not a licensed accountant, attorney or financial advisor. So, this podcast is for your entertainment and information only and should not be considered official personalized financial advice.
