A tax-diversified portfolio should be made up of tax-deferred, Roth, and taxable accounts.
In this post from the White Coat Investor, learn about the importance and various methods for thinking of tax now and in the future as you make investment and withdrawal decisions.
Paying attention to your taxes now AND your taxes later will give you the tax diversification and freedom you’ll want during retirement. A tax-diversified portfolio should be made up of tax-deferred, Roth, and taxable accounts.
Most doctors are aware of the importance of diversifying their portfolios among various “asset classes” such as stocks, bonds, and real estate (and within those asset classes as well) to spread their money across a large number of individual securities or properties. This move prevents the investor from making the classic mistake of putting too many eggs into one basket, which could lead to financial ruin in the event of a market downturn in a single security or asset class.
However, too few of us have applied these same principles to the taxation of our assets when it comes time to spend them.
How Are Retirement Accounts Taxed?
The typical physician is taxed at a high marginal tax rate during their peak earning years. As such, we naturally look for tax-deferred retirement accounts that can give us relief from this tax burden, such as 401(k)s, 403(b)s, 457s, profit-sharing plans, and defined benefit plans. Each dollar contributed to these accounts is a dollar that isn’t taxed now at high marginal rates. Basically, this income is deferred into retirement when we can withdraw at least some of it at lower marginal rates, reducing our overall tax burden.
Occasionally, a good saver acquires a very large nest egg primarily in tax-deferred retirement accounts, and then that saver is surprised when they find a significant portion of their retirement income falls into the mid-to upper-tax brackets. This problem can be exacerbated when and if their required minimum distributions (RMDs) become larger than the amount they would prefer to withdraw from their tax-deferred retirement accounts or when marginal tax rates are increased.
Utilizing Roth IRAs and 401(k)s to Reduce Taxable Income
Roth IRAs were introduced to the retirement landscape in 1997, and a Roth option is commonly found in 401(k)s across the country. Instead of saving taxes now and paying them later, with a Roth retirement account, you pay taxes now and you and your heirs avoid paying income taxes on that money ever again, no matter how large it grows.
Similar to tax-deferred retirement accounts, Roth accounts also avoid annual taxation on capital gains and dividends. The obvious benefits to the retiree are no RMDs (on Roth IRAs; Roth 401(k)s still have RMDs unless you’re still working and own less than 5% of the company) and the ability to preferentially take some of their retirement money from a tax-free Roth account rather than withdrawing tax-deferred money at high marginal rates.
The Taxable Investment Account
Many physicians can save money above and beyond their retirement accounts—whether in paper assets, like stocks, bonds, and mutual funds, or in income-producing assets like real estate or small businesses.
This investment account is also taxed in a different manner than a retirement account. Qualified dividends and long-term capital gains are taxed at lower rates. Real estate and business income can also be taxed in a more favorable manner than regular income thanks to depreciation and other tax breaks.
Although taxable assets provide less asset protection from creditors than retirement accounts, they benefit from a step-up in basis upon the death of the investor and can be tax-loss harvested in the event of a market downturn. Taxable assets also have fewer restrictions on withdrawals prior to age 59 1/2 for the early retiree.
Combining income from tax-deferred, tax-free, and taxable accounts can dramatically reduce the tax burden for a retiree.
Using a Backdoor Roth IRA
A physician who realizes the wonderful tax benefit of taking some of their income from Roth accounts is still left with a dilemma: what is the point of paying a high marginal tax rate during their peak earning years to avoid paying a similar high marginal tax rate later?
Although a doctor can use Roth accounts in the early, lower-paying years or in their last few years as they cut back to part-time work, it can be hard to save a significant amount of money due to lower total income.
Since 2010, Congress has provided a solution to this dilemma by providing a method called a Backdoor Roth IRA. High-income earners are not allowed to contribute directly to a Roth IRA. For 2022, this phase-out begins at a modified adjusted gross income of $129,000 ($204,000 married).
In 2010, this phase-out was eliminated for Roth IRA conversions. So while most full-time, attending-level doctors can’t contribute directly to a Roth IRA, they can convert an otherwise non-deductible traditional IRA to a Roth IRA each year for themselves and a spouse. They might not want to do it if they have money in a traditional IRA, SEP IRA, or SIMPLE IRA, though, due to a required “pro-rata” calculation that must be made for Roth conversions.
So now in 2022, a physician can contribute $20,500 ($27,000 if age 50+) of tax-deferred money into their 401(k), plus another $6,000 for themselves and $6,000 for their spouse into Backdoor Roth IRAs each year. Assuming an 8% return, after 20 years of making these contributions, these retirees would have about $1 million in tax-deferred money and about $600,000 in tax-free money, providing tax diversification in retirement.
Another opportunity to increase the size of Roth accounts occurs in years when total income is lower, such as sabbaticals, partial retirement, or early retirement prior to taking Social Security payments. A wise retiree may actually choose to pay taxes early at a relatively low rate by converting some of their tax-deferred money to a Roth IRA. Many 401(k)s with a Roth option also offer “in-plan Roth conversions,” simplifying this process.
Building a Taxable Investment Account
In the last years prior to retirement, especially if taking an early retirement, a doctor may wish to increase the size of their taxable account. Since this money won’t have a lot of time to grow, the basis will be high so the tax burden created by liquidating these assets will be relatively low.
It can be even higher if you continually flush capital gains out of your account by donating appreciated shares instead of cash to charity. This money won’t be subject to the restrictions and penalties that retirement accounts have on withdrawals prior to age 59 1/2. It can also provide a ready source of cash to pay the taxes due on any Roth conversions the early retiree may choose to make.
An Example of a Tax-Diversified Portfolio
By having all three types of accounts, retirees can lower their overall tax burden. Consider these two 2021 portfolio scenarios for a married couple taking the standard deduction that wants $150,000 in retirement income prior to receiving Social Security benefits and (to keep things simple) withdrawing from each available account equally.
- 100% in tax-deferred accounts
- 60% in tax-deferred accounts
- 20% in Roth accounts
- 20% in a taxable account with a high basis
Portfolio #1 will have a federal tax bill of about $18,975, or about 12.6% of their income. Thanks to tax diversification, Portfolio #2 will have a tax bill of only $7,390, or about 4.9% of their income. That is $11,585 more each year that can be used to take a cruise, spoil grandchildren, or support a favorite charity.
Paying attention to your taxes now AND your taxes later will give you the tax diversification and freedom you’ll want during retirement.
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What did you think? What do you do to get tax diversification? Comment below!