Investing Basics for Professionals With Little Time or Experience

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New visitors to Physician on FIRE may be excited at the prospects of financial independence and the possibility of a reasonably early retirement, but overwhelmed when presented with a lot of technical talk about specific investment accounts and strategies.

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This is totally understandable; we’re not taught the difference between a 401(k) and 457(b) in medical school or residency. If you’re self-employed like I once was, you may have opened a SEP-IRA (as I once did) when an individual 401(k) may have been a better idea.

Even the White Coat Investor wasn’t born with knowledge of expense ratios, the difference between short-term and long-term capital gains, or ordinary versus qualified dividends. Or was he?

No, Dr. Dahle has actually admitted to making more money mistakes than I did, and to be honest, I had only a rudimentary understanding of most of this stuff until about five years ago when I decided to really focus on my finances. For the first five to seven years of my career, I just shoveled money into accounts and made investments that were acceptable, but certainly not optimal.

 

Investing Basics for Beginners

 

Investing Basics for  Professionals With Little Time or Experience

 

I’ve been asked who I’m writing for, and my answer is that I’m writing with someone a lot like me, or a younger version of me, in mind. This is the article for the version of me from a decade or so ago. The newly minted attending and newlywed, starting a family, serving on an ill-fated Board, and working way more than necessary.

That me didn’t have the time or energy to focus on personal finance. He knew enough to steer clear of whole life insurance salesman and to invest mostly in mutual funds. He had term life and disability insurance. He had the bases covered, but if he knew then what he knows now, he would have done some things differently.

If you’re like me back then, you’re not going to read hundreds of blog posts to tease out the information you’re looking for. The only books you have time to read are Little Golden Books. You want to be told what to do or have someone do it for you. It’s no wonder financial advisors are so popular.

I strongly recommend you read a grown-up book or two on personal finance, and if you are dedicated to becoming a do-it-yourself investor, I’ve got a great 20-step guide to doing just that. But if you’re ready to learn the basics, I can get you started down that path.

 

Employer-Based Retirement Plans

 

Nearly all employed attending physicians and some residents will have access to a workplace retirement plan or plans. For the employed physician, the most common names for those are 401(k) and 403(b). There could also be a 401(a) in there, as well, which is often used for matching or profit sharing.

The 401(k) and 403(b) are similar in many ways; the latter is used by governmental institutions such as a University-affiliated academic medical center. These have the same contribution limits ($19,500 in 2020 or $26,000 if you’re 50 or over) and you will often have limited investment options.

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Another account with the same investment limits that many physicians will have available is a 457(b). These come in two flavors: governmental and non-governmental. Perhaps surprisingly, governmental is actually the better tasting.

Why? A governmental 457(b) can be rolled over into an IRA, whereas a non-governmental 457(b) cannot. Also, a governmental 457(b) is backed by governmental solvency, whereas a non-governmental 457(b) is subject to the solvency of the employer.

These are technically deferred compensation plans, and the money’s not truly yours until you take withdrawals from the accounts. These 457(b) plans often have limited withdrawal options. I have always maxed mine out, but be sure to understand the limitations of your particular plan before choosing to do the same.

Finally, some physicians may have access to a non-qualified deferred compensation (NQDC) plan. These act in some ways like a traditional 457(b). The tax is deferred until the time you withdraw the money. There is some danger in that the money still belongs to the employer until it’s withdrawn by you.

A major difference is that there is no limit to how much money can be placed in the NQDC plan, allowing the employee to dial in the tax bracket of choice. A plan like this could be a real boon for an aspiring early retiree. I would not place millions into a plan like this if retirement were 20 years away, though. I don’t have that much faith in any single employer.

 

How do you choose the investment(s) to place in these accounts? Don’t fear the stock market. Understand that investing in a stock-based mutual fund means that you’re buying ownership in a bunch of actual companies that produce some form of product and earn real revenue. Many investors have become wealthy by investing in the stock market and those who sit on the sidelines for too long inevitably regret it.

Also, understand that the stock market’s value can drop a lot in a hurry, but as long as you don’t sell before it bounces back (which typically takes no more than a few years), the drop isn’t going to ruin you, despite how it affects your balance on paper.

With that in mind, assuming you’re young enough to be invested for decades, a stock-heavy portfolio is most likely to give you the best long-term returns. I’d recommend an overall proportion of at least 70% stocks, and 100% stock is not unreasonable if you’ve got nerves of steel. My investor policy statement, which is just a written plan for investing, calls for 10% bonds, with the rest in stock-based mutual funds and real estate funds.

Most people divide their stock allocation into domestic and international portions. Common recommendations for international range from 0% to 50% of stocks. I’ve gone with about 25%. We’ll delve into more detail on asset allocation in Part II.

Should you make traditional or Roth contributions to these plans? I could write an entire blog post on the factors that go into this decision (and I did). Most often, for the high-income professional, I recommend tax-deferred traditional contributions.

 

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Self-employed and Partnership Retirement Plans

 

If you’re self-employed, you may have the option of contributing to either an individual 401(k) or a SEP IRA, each of which can accept up to $57,000 in contributions (or $63,500 in an individual 401(k) for those 50 and over).

I prefer opening an individual 401(k) (also commonly referred to as a “solo 401(k)”) rather than a SEP-IRA to keep open the possibility to fund a personal Roth account via the “Backdoor.” A Simple IRA is not a great choice as the amount you can invest is much lower ($57,000 versus $13,500) and again you’ll be subject to the pro rata rule when attempting the backdoor Roth, just as you would with the SEP IRA.

With the individual 401(k) or SEP IRA, You’ll be able to invest up to $57,000  or $63,500 in tax-deferred dollars, lowering your tax burden by about $15,000 to $25,000 or more depending on your overall household income and state in which you live.

The amount you can invest in an individual 401(k) is limited by your income. Employee contributions are limited to $18,500 and employer contributions are limited to 25% of your W-2 wages (when taxed as an S-corp).  See the IRS documents for the precise details on this number.  It can get complicated quickly.

If you make really big bucks and want to defer a lot more income, it may be worth exploring a defined benefit plan. These carry higher fees and must be invested in a less aggressive manner (100% stocks would not fly), but can potentially be an option if it makes sense for you or your group.

 

 

Milo H. Larson MD
Drs. Larson & Anderson were self-employed

Additional Retirement Plans

 

If your health insurance plan is considered an HDHP (high deductible health plan), you will be able to invest in an HSA. This allows you to defer another $7,100 of income per family or $3,550 in 2020 as you max out an HSA.

The beauty of these accounts is that they are tax-deductible in the year of contribution, but also grow tax-free and are treated like Roth money when withdrawn to be used to cover eligible health care expenses. The only way you pay tax on these contributions is if you withdraw the money for non-healthcare purposes, which you’re allowed to do when you turn 65, but most of us will have health care expenses that meet or exceed the balance of the HSA eventually.

The vast majority of physician households will earn too much money to qualify for either a tax-deductible IRA contribution or a direct Roth IRA contribution. That leaves us with the “backdoor Roth” contribution of $6,000. If you’re married, your spouse can also contribute $6,000 to a spousal IRA regardless of whether he or she has earned income (as long as one spouse has earned income to justify the contributions).

The backdoor Roth steps are pretty simple, but if you’re new to the concept, please read both my step by step guide with Vanguard screenshots and the White Coat Investor’s 17 ways to mess it up. One of the big ones, which I alluded to above, is having money in any form of IRA in your name. You will pay tax on the second step of the backdoor Roth two-step if you do, and it’s best to rollover any IRA money into a 401(k) if that’s an option.

 

Other Investment Accounts

 

If you have filled every tax-advantaged bucket available to you and still have money left to invest, you’re clearly doing something right. This is one point where I see many readers wondering what to do next.

The good news is you have options. If you are debt-averse and have medium-to-high interest debt, this would be a good time to start chipping away at your debt.

Real estate is an avenue that many consider at this point, and there’s a myriad of ways in which to do so. I have only dabbled in crowdfunded real estate and own a Vanguard REIT mutual fund. There are entire sites devoted to real estate, a topic that is beyond the scope of this investment basics series, but I will touch on it in Part II. Look to Passive Income MD for more information on the topic.

This is also a good time to consider investing in stocks and bonds in ways that are not tax-advantaged, or at least not tax-free.

The most common way to do this is to buy more mutual funds or exchange traded funds (ETFs). The two are similar; I have a slight preference for mutual funds, but I have nothing against ETFs.

With mutual funds, you can easily own partial shares (some brokerages do this with ETFs but many do not).

Mutual funds can also easily be exchanged for another fund without you missing a day or two in the market (a benefit when tax loss harvesting). You don’t have to bother with a settlement fund when buying and selling mutual funds.

Mutual funds are purchased at the price of the next market closing time. ETFs, on the other hand, have prices that fluctuate throughout the day, and you’ll pay a small premium to the current asking price (the bid / ask spread) when you purchase them.

ETFs can offer lower expense ratios (Vanguard admiral funds with higher investment minimums have the same expense ratios as the ETFs) and are more portable between brokerages (can be transferred “in kind” without being sold).

Another advantage of many non-Vanguard ETFs is that they’re slightly more tax-efficient when held in a “taxable account.” Vanguard’s mutual funds are structured in a way that makes them similarly tax-efficient.

You don’t have to choose one or the other. Many investors will have both, and it’s not worth losing any sleep over deciding which is best. Both accomplish the same thing — giving you ownership of a basket of stocks and/or bonds.

 

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The Taxable Account

 

When I say “taxable account,” what is that, exactly? It’s just the account in which you buy assets with your post-tax money. These are also referred to as “non-qualified accounts” or “brokerage accounts.”

Don’t be confused by the various terms; they all mean the same thing. It’s just an account that holds mutual funds, ETFs, stocks, or what have you. It doesn’t have the specific tax advantages of some of the retirement accounts, so extra attention needs to be paid to the tax implications of taxable account investing.

However, the taxation on these accounts isn’t nearly as bad as one might assume based on the name. In fact, there are ways in which it can be as good as a Roth IRA or awfully close to it.

How can a taxable account act like a Roth IRA? You could own assets that pay no dividend (Warren Buffett’s Berkshire Hathaway stock being a prime example), let it grow tax-free during your working years, and make your withdrawals tax-free in retirement as long as you have taxable income of $80,000 or less based on 2020 tax code if married filing jointly (half that for singles).

If you’re more comfortable with index funds rather than individual stocks (the only individual stock I own is Berkshire Hathaway, by the way), expect to see a tax drag due to dividends in the range of 0.3% to 0.6% per year depending on how much you earn and where you live.

To put this in perspective, it’s common for many financial advisors to charge 1% or more per year for their services and many actively managed funds also have expense ratios that exceed 0.6%. The tax drag on these funds will be much higher though, as buying and selling by the fund manager creates additional taxable events. If you’re going to consider actively managed mutual funds (as opposed to passive index funds), please do so in a tax-advantaged account.

 

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In terms of dollars, for every $100,000 you have in a taxable account invested in passive index funds, expect to pay $300 to $600 per year in taxes on the dividends (this is assuming 2% qualified dividends, which is about what you’ll currently get from a total stock market or S&P 500 fund). If someone is managing your investments for you with a 1% Assets Under Management (AUM) fee, you will be paying him or her $1,000 per year per $100,000 invested.

The taxation on the withdrawal of funds in a taxable account depends on several factors. If you pay any tax on the withdrawals, tax is only due on the capital gains. Capital gains are the difference between what you paid (the cost basis) and the price at which you sell. Capital gains on assets held less then a year are considered short term gains and are taxed at your marginal income tax rate.

Capital gains on assets held longer than a year, called long-term capital gains, are taxed favorably, and are based on taxable income. Typically in the 2020 tax year, you’ll owe state income tax plus:

 

  • 0% with taxable income of $40,000 or less (filing single) or $80,000 (married filing jointly)
  • 15% with taxable income of $80,001 to $200,000 (filing single) or $250,000 (married filing jointly)
  • 18.8% with taxable income from $200,001 to $441,500 (filing single) or $250,001 to $496,600 (married filing jointly)
  • 23.8% with taxable income of $441,501 or more (filing single) or $496,601 or more (married filing jointly)

 

I’ve highlighted ways to avoid capital gains taxes here. If you can’t avoid them, you can minimize them. Avoid actively managed funds in a taxable account (high turnover) and avoid high-dividend or high-yield (non-municipal bond funds) in a taxable account.

Some investors are enamored with dividends, but in my math-based opinion, the higher your dividend yield, the lower your after-tax returns. I’d rather create my own dividend by selling shares when I need the money, an argument I’ve made with further clarity in a previous post.

 

Which Accounts to Prioritize?

 

Ideally, a physician should be able to maximize every account available, but that isn’t always the case. Residents are often living paycheck to paycheck, and attendings are often focused on paying off debt and saving up for big purchases like a down payment on a home or buying into a practice.

First, be sure to invest enough in a 401(k) or 403(b) to get any matching contribution offered by an employer. Never say “no” to free money.

If you can afford to fully fund the 401(k), go ahead and fill it up to the $18,500 max or $24,500 if 50 or older. This is also a good time to max out the “triple-tax-free” HSA.

Next, I’d do the backdoor Roth. A couple can sneak $11,000 into an account that will grow tax-free and not be subject to tax upon withdrawal, regardless of the filer’s marginal tax bracket at the time of withdrawal.

Then, you’re left with a taxable account and perhaps a 457(b) or defined benefit plan. There are many variables to consider as the latter plans may have lousy investment options or high fees. There is also a benefit to having money readily available (in a taxable account) as opposed to tucked away in an account where the money’s less accessible.

 

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In Part I, I’ve highlighted the various accounts in which an investor can place his or her hard-earned money. This post is continued in Part II in which I discuss choosing investments for those accounts, focusing on asset allocation, asset location (yes, those are two very different things), investment fees, and a little more information on real estate.

I also created a spreadsheet for you to help you keep track of all these accounts and investments. You know how I love spreadsheets.

 

Which of these accounts do you have available? Which do you fully fund to the max? Have you started a taxable account?

 

33 thoughts on “Investing Basics for Professionals With Little Time or Experience”

  1. Very detailed list and incredibly useful for someone who is just beginning investing and can be paralyzed by the amount of choices out there.

    I have maxed out all my tax deferred accounts available (employer 401k, traditional IRA (which this part year was the first time I did a back door roth conversion), and health saving account. In years past I then put the rest in my taxable vanguard brokerage account (this past year have instead put it into syndicated real estate deals)

    I wish I could take advantage of the defined benefit plan or NQDC however when I brought it up to the pension committee (I am on the board) it was shut down because of the cost involved (for safe harbor rules etc with 70 physicians and 500 employees it was financially too expensive since couldn’t design a plan that was weighted in favor of the higher income participants)

    Reply
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. Great overview, POF! I’ll be sure to share this one as it would directly contribute to my target audience. For those of us that know this stuff, I’d say “You can never hear true things enough!”

    Looking forward to the rest of the series and seeing where it goes.

    I am really looking forward to being done with paying off 200K in student loans in 12 months (20 months total). That way I can start diving into my taxable account and (maybe) my 457B plan. Our 457 has index fund options and good withdrawal/distribution options. Not all of them do!

    TPP

    Reply
  4. Great article with very useful information. Wanted to point out that for non working spousal IRA contributions there is a cut off if your adjusted gross income goes over a certain amount and the working spouse is covered under a qualified retirement plan. The limit for 2017 was $196,000 MFJ.

    Reply
    • That’s the limit for making direct Roth contributions, and it applies to both the income earner and the spouse.

      There is no limit on a spousal IRA that I can find, and we’ve been doing backdoor Roth contributions for 6 years now with income that exceeds the direct Roth contribution limit.

      Best,
      -PoF

      Reply
  5. This is great stuff, very thorough overview of the basics. I only wish I had taken the time to learn all of this a couple of years ago when I started out in private practice. I’m now three years worth of contributions into my SEP, and the backdoor Roth route is largely closed to me unless I’m willing to take a massive tax hit (sigh).

    This last year my wife (also a physician) left a job where she had a 457 plan. I know these plans can be different from institution to institution, but I’ll add a couple of points that I was unaware of until we went through the process of looking at our options with her’s:
    1) 457 plans are deferred compensation, meaning that until you actually collect, your institution is still in possession of that money. This means that should they run into financial problems, their creditors can potentially get to that money.
    2) If you leave, you may be faced with the choice of leaving your deferred compensation in the possession of your old institution for however many years are left until you retire, or taking the money as a lump sum and suffering the large tax bill that will come with it.
    -Ray

    Reply
    • Point 1 – That is why I cashed out 457b this year when I moved on from my old employer. Like PoF, I don’t believe in a single employer’s longevity in this era, where hospital systems get sold, bought or bankrupt quite readily.

      Reply
    • Good point, Ray. I wouldn’t invest in a non-governmental 457(b) without knowing my withdrawal options. Fortunately, our particular plan is very flexible.

      When I leave my employer, I can set it up to withdraw either a percentage or dollar amount at the frequency of my choosing. I’ll probably do something like $2,500 a month — that will likely drain the account in 6 to 8 years depending on market performance.

      Cheers!
      -PoF

      Reply
  6. Awesome post and very timely with a new group of interns starting soon. I advise mine one tad different regarding order of investments:
    1) invest in 401k/TSP/403b up to match
    2) pay off credit cards,etc
    3) then do (Roth) IRA
    4) then come back to finish 401k/TSP/403b up to $18.5 total

    I find they are interested in the “emergency savings fund” aspect of the Roth IRA contribution (even though I advise them never to actually use it for a withdrawal) so they can fill that up after getting their employer match locked down.

    Reply
    • Your order makes perfect sense for someone with credit card debt.

      Most (but not all) of my readers have no credit card debt and earn too much to contribute directly to Roth. And unlike in the military, many of us have access to an HSA. I think we agree on how to invest; we’re just speaking to different audiences.

      Cheers!
      -PoF

      Reply
  7. Great review, thank you, awaiting Part II.
    Just wanted to mention that maximum contribution to SEP is 25% of compensation or $55,000 for 2018, regardless of age. Am I wrong?

    Reply
    • Good catch! I’ve updated the post.

      The individual 401(k) allows you to do catch-up contributions up to $61,000 per year for those over 50, but the SEP IRA does not. One more reason to choose the former (along with the ability to do the backdoor Roth without worry of the pro rata rule).

      Cheers!
      -PoF

      Reply
  8. I love this post PoF!

    It’s a must read for anybody who is just getting started with investing. Just like I think your draw down strategy plan is a must read for anybody approaching early retirement.

    Both are classic posts with a different target audience!

    I also like how you explain everything in a way that is clear and easy to understand. I plan to share this with anybody who is intimidated with the idea of investing.

    Reply
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  11. Love this post. Going to read Part II next. A huge thanks to PoF and WCI for your guidance.

    I graduated from residency 3 years ago, but began my retirement contribution this year in January.
    – Planning to max my 403b and 457 contribution of $18,500 each.
    – Wife will max out her 403b contribution of $18,500.
    – We both contributed to backdoor roth of $5,550 in Jan 2018 (for year 2017) and in April 2018 (for year 2018)- thanks again for your guidance with step by step approach.
    – We don’t have HDHP, so no HSA yet.
    – We just opened our first joint taxable account at Vanguard in June 2018: planning/hoping to contribute $5,000/month.
    – Thankfully we are debt free and have total of $40k loans for two cars.

    I have one question regarding my 457b plan. I have access to good vanguard index funds with very low expense ratio in 457b plan: VIIIX and VSMAX. If I decide to leave this job in future and new job either don’t have 457b plan or have not so good options for investment. What happens to this 457b plan then.

    Thanks again.

    Reply
    • You appear to be doing great, Harvi!

      Regarding the 457(b), if it is a governmental 457(b), it can be rolled over into an IRA. From an IRA, it could then be rolled over into other accounts like a different employer’s 401(k) or 403(b).

      If it is non-governmental, you can only rollover into another employer’s non-governmental 457(b), assuming the new plan allows rollovers, or the money can be distributed to you. Different plans have different distribution options, so you’ll want to check with H.R. or your plan administrator to determine what those options are.

      My plan has a lot of flexibility in terms of setting up the distribution plan (but once it’s set, that’s that).

      Best,
      -PoF

      Reply

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