If you live a reasonably balanced lifestyle, you will, at some point in your lives, find yourselves debt free, 529s funded and accumulating cash. As physicians, particularly in dual-doctor households, you can accomplish this 10 years or so out of training if you focus on making good financial decisions and limit your extravagances.
Until you reach this point, you are most likely doing everything possible to lower your tax bill and throw everything left at loans and future education. When you reach this milestone, however, I think it’s a good idea to step back and ask if it’s a good idea to retire with a $3M pre-tax 401k and only a few hundred thousand dollars in other types of accounts, such as Roth’s and brokerage (or, taxable) accounts.
When we first began focusing our business on financial planning solely for physician households, those first few “Initial Foundation Plans” (IFPs) we completed were eye-opening. Our first couple was a dual physician household with no children. Their IFP showed lifetime savings of over $100M at death. Surely, we thought, there was an error. But as subsequent plans and a careful examination of our calculations has shown, these projections are not unusual.
This led to an uh-oh experience: RMD (Required Minimum Distribution) calculations. Conventional wisdom has long held that most people will be in lower tax brackets in retirement than they will during their careers. However, we were projecting that physicians with normal career spans (~25 – 30 years) who were optimal savers and took advantage of all work retirement options were going to owe significant income taxes on IRA distributions in retirement. This was due to their high savings rates along with the long-term compound growth of their retirement accounts.
As a result, we developed a strategy for high-income professionals to allocate savings in such a way as to focus not simply on current tax savings, but also on tax reduction in retirement. At retirement, we began recommending a targeted savings allocation by tax streams. We set a goal of dividing total savings equally among pre-tax, Roth, and brokerage accounts.
- Pre-tax accounts include tax deductible employer retirement accounts, IRAs, and pensions.
- Roth accounts include the Roth portion of employer retirement accounts, Roth IRAs, and Health Savings Accounts (HSA’s)
- Brokerage accounts include all taxable investments, real estate, shares of partnerships and corporations, and cash.
I’ll freely admit that we did not arrive at the 3-way division by scientific determination, but because I believe having control over tax brackets is preferential to being held hostage to high fully taxable RMDs.
When we initially discuss our recommended allocation with clients, the first question is always, “How do we build up the Roth allocation in our portfolios?” This typically takes long-term planning coupled with an eye for watching for Roth conversion opportunities. I’ll cover ways to maximize Roth opportunities in my next DD.