In my last Doctor Dilemma, How Should You Allocate Savings?, I discussed a different kind of investment strategy: taxation of withdrawals. Because we recommend allocating ~1/3 of investable assets to Roth accounts, we are regularly asked how that is possible for a high-income professional. As with other successful strategies, you must plan carefully, be flexible, and monitor your progress.
Here are some ideas to help you build Roth account balances to help get to 1/3 of your savings:
- Every couple should be contributing the maximum ($6,000 as of yr 2020) to backdoor Roth IRAs annually.
- Even if you have significant pre-tax IRAs and nowhere to move them, I think you should go ahead and pay the pro-rata taxes. Remember, you are only pre-paying taxes you’ll have to pay later, while increasing the length of time for tax-free Roth growth.
- Consider dividing contributions between Roth and pre-tax when your employer accounts allow. This can be 1/3 to 1/2 in your Roth and the rest in pre-tax. Your CPA can help you plan to contribute enough pre-tax to stay out of the top tax bracket (if possible).
- When you change jobs, roll part of your employer account into a Roth IRA. Again, tax planning with your CPA will be very useful.
- During bear markets (sustained drops in the market of at least 20%) and corrections (drops of 10% – 20% over relatively short periods), convert as much as possible to a Roth IRA and change your work allocation to 100% Roth.
- Finally, don’t forget to make Roth conversions between your retirement date and starting RMD’s.
Having a reasonable allocation to these three areas during retirement will allow you to draw from a combination of accounts and control your income tax bracket post-employment. Keeping track of your progress toward the division during the years leading up to retirement will help you make decisions about allocating extra savings and will help you move toward the Roth when opportunities arise.
At least annually, we compare the balances in each of these tax pails so clients can track progress. They may never reach a 3-way division, but they at least will are of their tax diversification when approaching retirement. Having this goal will motivate you to think twice about the standard advice of allocating all money possible to pre-tax accounts before moving on to Roth and brokerage.
After retirement (and even before), take aggressive advantage of market drops with Roth conversions. This will help reduce your RMDs at age 70.5 and increase the balance of tax-free assets you can pass along to your heirs at death. Because Roth IRAs are not subject to RMDs during the lifetime of the owner, you’ll have the advantage of withdrawing funds only when necessary, leaving the balance to continue to grow tax-free during your lifetime. In addition, while your heirs will be required to distribute inherited Roth IRAs over their lifetimes, the accounts will remain untaxed until they are emptied.
Roth Conversions: When and How to Convert
Fiscal Fitness News 
If you are at a significant tax bracket while working (I’ve always been in the top bracket as a single physician radiologist), would you still recommend dividing your 401k money into a roth401k and traditional 401k? (my plan offers both).
I hesitated to do this because I always feel like there will likely be a tax arbitrage in my favor (going from higher to lower tax bracket in retirement, plus I plan on retiring early so have almost 2 decades anticipated where I can do Roth conversions at that point.
LikeLike
Unfortunately, I cannot give a specific answer. If the market is down significantly, I will probably recommend a conversion or turning on the Roth contribution “faucet” even at a high income level. The blog post When and How to Convert explains in more detail: https://blog.foxwealthmgmt.com/2016/09/23/1266/ . Of course, you need to have liquidity to pay the taxes, also – I would not recommend paying taxes from a pre-tax IRA. In your early retirement situation, you should have plenty of low income years to plan for Roth conversions, too.
LikeLike
Could you please broadly explain the mathematical reason you recommend 1/3 of your 401k to be Roth rather than pre-tax? Are you assuming government is increasing the tax rate? The general comparison I hear is “are you at your highest earning potential now or when you retire?” and most millennial physicians do not plan to be working at that age so many physicians would say their current tax rate is higher than when they have to take their RMDs. But at a certain nest egg 4-5MM?, their RMDs will push them into the current highest tax bracket as to make additional pre-tax 401k contributions moot. Ultimately my question is, what is the cut-off for pre-tax 401k contributions being worth it and when should we invest in roth? thanks!
LikeLike
Hi, Jason, Thanks for asking. This is simply a rule of thumb; a general goal and a starting point intended to motivate you to consider a plan for allocating savings. Every individual’s situation is different. I’m not saying that 1/3 of 401k contributions should be allocated to Roth’s, though. I believe investors should consider strategic conversions when the market is down, when they have a low income year, or when other opportunities arise. The blog post When and How to Convert may be helpful: https://blog.foxwealthmgmt.com/2016/09/23/1266/ . As you can see, the answer on when to move from pre-tax to Roth contributions is more nuanced and depends on the facts and circumstances, along with market movements.
LikeLike