Getting Personal: Investing Accounts & Why You Need to Think “Grocery Baskets”
Let’s talk personal finance. Up to this point, my posts have focused on radiology jobs and business finance. With this post, I start to delve into personal finance
Why is this an important topic for radiologists? Personal financial education is a recognized contributor to workplace satisfaction and overall wellness, which in turn may decrease radiologist burnout. However, most radiologists receive little to no formal training in financial literacy or personal finance. It isn’t part of the medical school, residency, or fellowship curricula, and social norms inhibit an open discussion of anything money-related. As a result, radiologists may only obtain financial knowledge through trial and error (which can be very costly) or from peers with little or no financial know-how (which can also be costly).
Considering the subject, it’s only fitting that I also give you a personal account of my adventures in personal finance. I’ll share some of my own experiences and hard-won lessons on my road to enlightenment and maybe save you from making a few blunders that most of us make.
What is an investment account?
A radiologist’s first job out of training usually presents an opportunity to make many personal financial decisions. One of them is whether and how much to invest in retirement accounts. This is a very important decision because choosing to delay investing can significantly alter one’s retirement options (e.g., time of retirement and retirement lifestyle). So I chose my first post on personal finance to be about investing accounts. I use the term “account” to mean a place to put your money, where it will hopefully grow into more money. Think of an account as a grocery basket and all the CDs, mutual funds, stocks, etc. that go in it as groceries. This post will cover the baskets—future posts, the groceries.
There are numerous types of investing accounts and learning about them is the first step to using them to maximum advantage. The first year I started my “real job”, just out of radiology training, and earning the “big bucks,” part of my salary started going into retirement accounts. I never saw that money or missed it because, just like FICA taxes (Social Security and Medicare taxes), it automatically bypassed my greedy fingers to a place that to me seemed like “never never land.” It went to an imaginary and faraway place. Every year I worked, money automatically went into those retirement accounts. Yet, if someone were to ask me to tell them how much money went into each account, how much each account was worth, how each account worked, or really, anything about those accounts, I would have had very little to say. All I knew was that my money was going to a place where my money could grow because someday I would need that money for retirement.
Naive as I was, this strategy worked pretty well. The money did grow– from yearly contributions, income from dividends and interest, and increased fund share prices.
I eventually learned more about investment accounts. I also found out that a lot of trainees and both practicing and retired radiologists were as much in the dark about this as I was. We had a couple things in common – our professional and personal lives kept us very busy, and we weren’t motivated to learn about finances.
F is for finances and fun
It turns out I really like finances. I’ve had some formal education from undergraduate courses and leadership/development courses. I’ve had experience managing finances as a radiology department chair. I’ve managed my own personal finances. I’ve read as many finance as medical textbooks and followed financial blogs and social media. On-the-job training, both professionally and personally, has taught me a lot. About what not to do as much as what to do.
There are certain financial mistakes a large number of radiologists seem to make at some point. One of them is not fully investing in retirement accounts early and throughout one’s working career.
To illustrate how naive I once was, I didn’t understand what people meant when they used the term “retirement” account.
What is a “retirement” account?
To illustrate how naive I once was, I didn’t understand what people meant when they used the term “retirement” account. I was investing in 401(a), 403(b), and 457(b) accounts through work, and outside of work I was investing in an IRA and a personal brokerage account (although I couldn’t have come up with the phrase “personal brokerage account”). I figured I’d be using all of this money when I retired, so to me, all of them were “retirement” accounts. I found this confusing.
Then I learned that when people used the term “retirement” account, they were talking about the special accounts defined by the IRS tax code that offered immediate or future tax benefits.
What is a “taxable” account?
Another term that confused me was “taxable” (versus “nontaxable”) accounts. The way I looked at it, I was eventually paying taxes on all my income. I learned that “nontaxable” refers to, typically, a pre-tax retirement account, where the investor receives a tax deduction in the year dollars are contributed and taxation on the contributions and any investment growth is delayed until money is taken out of the account. In some cases (e.g., with Roth accounts), there is no immediate tax break, but the earnings grow tax free, so it is still considered a nontaxable account. But it’s really not “nontaxable.” You eventually have to pay the taxes when you take the money out of the account. The goal is to pay the taxes at a time when you’re in a lower tax bracket and thus, reduce the amount of taxes you pay.
A “taxable” account is one that allows an investor to deposit funds and buy and sell investments, but as the name suggests, it is not a tax-qualified retirement account. You get no tax deduction on the money that is deposited and earnings do not grow tax free. However, qualified dividends and funds that are sold after being held for over a year are subject to a long-term capital gains tax rate, which is generally lower than a person’s ordinary income tax rate. Although there is no tax incentive available at the time funds are deposited, the purchase price creates a basis that will not be taxed when the funds are distributed or sold.
There are many brokerages and mutual fund companies to choose from when opening a taxable account (e.g., Schwab, Fidelity, Vanguard, TD Ameritrade). Most will offer a broad range of investment options. Non-taxable retirement accounts, depending on how they are set up by the employer, may have limited investment options.
Taxable accounts can be used to save for both long and short-term goals. You can use your taxable account for retirement income, college expenses, vacations, a car or even as a savings account. Many radiologists will invest in a taxable account because they need/want to save more money than they are allowed to contribute to retirement accounts.
Although they offer no up-front tax benefits, taxable accounts offer many flexible features: 1) there are no IRS restrictions or penalties for withdrawal (although the custodian or investment provider may apply fees), 2) there are no required minimum distributions, 3) they may be set up as individual or joint accounts (retirement accounts are individual only), 4) there is no contribution limit, and 5) if you should pass away with money in your taxable account, your heirs will receive the investments with what’s called a step-up in basis. This means when your heirs eventually sell the investments, they will be taxed as if they bought them for what they were valued on the day you died, not at the price you bought them. You didn’t pay capital gains on the growth portion of the portfolio, and now your heirs won’t either as they reap the benefits of a stepped-up basis.
By investing in lower-income generating funds (e.g., low turnover broadly diversified stock index funds and municipal bond funds), taking advantage of tax-loss harvesting opportunities (i.e., offsetting up to $3,000 of ordinary income with $3,000 of investment losses each year on your tax return), and making charitable donations, you can maximize the tax efficiency of a taxable account.
Nontaxable retirement accounts
There are numerous types of “nontaxable” retirement accounts with different eligibility requirements and restrictions as defined by the Internal Revenue Service (IRS). You only need to know about those that are available to you. That will depend on whether you work for an employer, and whether that employer is a tax-exempt entity (aka academic practice) or not (aka many hospitals or corporations), you are a partner in a radiology group (aka private practice), or you are a self-employed independent contractor. A radiologist may work in any of these environments, and sometimes more than one. Although most radiologists work in private practice, more and more are working for corporations due to practice buy-outs.
In general, an employed radiologist will have access to a 401(k) and maybe a 457(f); an academic physician will have access to a 401(a), 403(b), and 457(b); a partner radiologist will have a 401(k)/profit-sharing plan (allowing larger contributions than a typical 401(k)); and an independent contractor can contribute to an individual 401(k). All can contribute to an IRA. Read on to learn what all this alphabet soup means. [Note: this post does not cover retirement options offered by the government (e.g., active military service and civilian employment within the Veterans Affairs (VA) to county, state, and other federal agencies), and if this is applicable to you, you definitely want to research those options.]
Individual Retirement Arrangement (IRA)
Per the IRS, an IRA is an Individual Retirement Arrangement, although many people call an IRA an Individual Retirement “Account”. The IRA is basically a savings vehicle for stashing away cash for retirement. A lot of people mistakenly think an IRA itself is an investment – but it’s just the grocery basket in which you keep stocks, bonds, mutual funds and other assets. The most common types of IRAs are accounts that you open on your own. Others can be opened by small business owners. There are several different types of IRAs, including traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. Each type has eligibility restrictions based on income or employment status. And all have caps on how much you can contribute each year and penalties in most cases for taking out money before the designated retirement age.
A traditional IRA comes in two varieties: deductible and nondeductible. Whether you qualify for a full or partial tax deduction depends mostly on your income and whether you have access to a work-related retirement account like a 401(k). Most radiologists and other practicing physicians earn too much money to qualify for a deductible IRA but can invest in a nondeductible IRA.
How do deductible and non-deductible IRAs differ? A deductible IRA can lower your tax bill by allowing you to deduct your contributions on your tax return – you essentially get a refund on the taxes you paid earlier in the year. You fund a nondeductible IRA with after-tax dollars. You cannot deduct these contributions on your tax return. The funds in both types of accounts grow in a tax-deferred manner. Deferring taxes means all of your dividends, interest payments and capital gains can compound each year without being hindered by taxes – allowing an IRA to grow much faster than a taxable account.
Both the earner and her spouse are eligible to contribute to their own IRA, given the restrictions discussed above. That means that even if a spouse does not have her own earned income, she can contribute to her own IRA based on her spouse’s earned income.
What’s the difference between a traditional and a Roth IRA?
The main difference is when you pay income taxes on the money you put in the plans. With a traditional IRA, you pay some or all of the taxes on the back end – that is, when you withdraw the money in retirement. The tax amount depends on whether it is a deductible or nondeductible IRA. At withdrawal, funds from a deductible IRA are taxed at the ordinary income tax rate, per the prevailing tax brackets. With a nondeductible IRA, taxes are only paid on the growth and not on the contributions (since tax was already paid on the contributions at the time of contribution). With a Roth IRA (named after Senator William Roth), it’s the exact opposite. You pay the taxes on the front end (at the time of contribution), but there are no taxes on the back end (i.e., at the time of withdrawal). In both traditional and Roth IRAs, money grows tax free while it’s in the account.
If you have a traditional IRA, you must take required minimum distributions (RMDs) starting at age 72. Prior to passage of the SECURE Act (Setting Every Community Up for Retirement Enhancement Act, signed into law in December 2019), the requirement to withdraw money from traditional IRAs (and other tax deferred accounts) was age 70½. This law went into effect January 1, 2020. Someone who turned age 70½ in 2019 still needs to take their RMD for 2019 no later than April 1, 2020. Anyone already receiving RMDs (or required to be) must continue taking these RMDs. Only those who turned 70½ (born on or after July 1, 1949) in 2020 or later may wait until age 72 to begin taking required distributions. The amount of the RMD depends on how much you have saved in the account and on your life expectancy, according to tables published by the IRS.
Why is an IRA a good deal?
Because money in the plan grows tax free. That is, the income from interest, dividends and capital gains can compound each year without taxes taking a bite out of it. In addition, you also can escape taxes on either the money you put into the plan initially or on the money you withdraw in retirement, depending upon whether you choose a traditional or Roth IRA. So what’s the catch? The government limits the amount of money you can put into an IRA each year. In 2020 that amount is the lesser of $6,000 ($7,000 if age 50 or older) or total taxable earnings. If you have no earned income, you can’t contribute to a retirement account. Note that income from interest, dividends, capital gains, or pensions is not considered earned income.
Who can put money into an IRA? It depends on what kind of IRA it is. Beginning in the 2020 tax year, there is no age cut off for contributing to an IRA, provided you have earned income. But your contributions are tax deductible only if you meet certain qualifications (as mentioned above, radiologists almost never qualify).
Roth IRA contributions are never tax deductible, and you must meet certain income requirements in order to make contributions directly to a Roth IRA. In 2020, if you are married and filing jointly, and your modified adjusted gross income (AGI) is less than $196,000, you can contribute the full amount allowed. After this level of income the contribution amount phases out. Most radiologists make too much money to contribute to a Roth IRA directly.
|Contributions can be made to a Roth IRA indirectly at any income level by 1) contributing to a traditional nondeductible IRA and 2) immediately converting that money to a Roth IRA.|
Backdoor Roth IRA
It might sound a bit nefarious or dodgy, but don’t worry, it’s perfectly legal! Contributions can be made to a Roth IRA indirectly at any income level by 1) contributing to a traditional nondeductible IRA and 2) immediately converting that money to a Roth IRA. This is called a “backdoor” Roth IRA. A backdoor Roth IRA is a legal way to get around income limits imposed on direct contributions to a Roth IRA. If the contribution to a traditional IRA and conversion to a Roth IRA is performed near simultaneously, no taxes will be owed for the conversion. However, converting money from a traditional IRA that has grown in value will result in taxes being paid on that growth (and on the initial contribution if it was a deductible contribution). All radiologists with earned income are allowed to and probably should contribute to a Roth IRA every year.
When can I access money in my IRA?
You can take money out of an IRA whenever you want, but be warned: if you’re under age 59½, it could cost you a 10% penalty on the amount you withdraw in addition to the regular income tax you’ll owe on the withdrawal. Roth IRAs offer a bit more flexibility. Generally, you may withdraw your contributions to a Roth penalty-free at any time for any reason, as long as you don’t withdraw any earnings on your investments or dollars converted from a traditional IRA before age 59 ½. In that case, you’ll get hit with that same 10% penalty.
Not sure which money is considered a contribution and which is considered earnings? The IRS views withdrawals from a Roth IRA in the following order: your contributions, money converted from traditional IRAs, and then earnings. So if you take out more than you’ve contributed in total, then you’re starting to dip into conversion dollars or earnings, and will be penalized and taxed accordingly. If you’re 59½ or older you can usually make penalty-free withdrawals (known as “qualified distributions”) from any IRA. But you’ll still owe the income tax if it’s a traditional IRA.
To make qualified distributions from a Roth IRA, you must be at least 59½ and it must be at least five years since you first began contributing. And if you converted a regular IRA to a Roth IRA, you can’t take out the money penalty-free until at least five years after the conversion.
But you can escape that 10% tax penalty if you’re withdrawing the money for specific reasons, including but not limited to:
- permissive withdrawals from a plan with auto enrollment features
- after death of the participant/IRA owner
- total and permanent disability of the participant/IRA owner
- qualified higher education expenses (for you, spouse, children, grandchildren)
- qualified first-time homebuyers
- up to $10,000 of unreimbursed medical expenses over a percentage of adjusted gross income (>7.5% AGI age 65 or older; 10% if under age 65)
- certain distributions to qualified military reservists called to active duty
Note: this is a partial list of exceptions and others can be found online at the IRS website.
Also, if you put money into your IRA but then decide you need it back, you can generally “take back” one contribution made to a traditional IRA without paying tax, as long as you do it before the tax filing deadline of that year and do not deduct the contribution from your taxes.
You can also withdraw money from a traditional IRA and avoid paying the 10% penalty if you roll the money over into another qualified retirement account (such as a Roth IRA) within 60 days. But then you wouldn’t actually be able to spend it, unless you’re using the money as a very short-term loan. For example, I know of someone who wanted to use the money from the sale of their house to buy another house, but they needed the money for the new house before the closing on their current home. They took the money out of their IRA to buy the new house, and after receiving the money from the sale of their old house one week later, they deposited the money back into their IRA.
If you’re really desperate for cash, you can take money out of your traditional IRA in what’s called “substantially equal periodic payments.” Here’s how it works: The IRS will determine what amount you can receive each year based on your life expectancy. That’s the amount you must withdraw each year. Once you start substantially equal periodic payments, you can’t stop the withdrawals until you’re 59½ or five years have passed, whichever is longer. So there’s no changing your mind. If you change or stop these withdrawals at any time, you’ll get hit with that 10% penalty – applied retroactively from the time you first began receiving payments, with interest. So it’s generally not a great idea if you’re under 50. Even if you are over 50, you’ll be eating away at your retirement nest egg, rather than building it up.
Should I take money from my IRA to pay off debt?
This is a good question. For several reasons, taking withdrawals from an IRA before you’re retired is something you should do only as a last resort. You might get hit with the 10% tax penalty described above. Plus, the IRA withdrawal would be taxed as regular income, and could possibly propel you into a higher tax bracket, costing you even more. In addition, money you take out of an IRA cannot be replaced, since you would still be restricted to yearly contribution limits for future contributions. So even if you withdraw only a small amount, factor in the years of compounding interest you would be forgoing, and that small withdrawal could end up costing you a small fortune in your golden years.
How can I invest money in an IRA?
The IRS dictates a few ways in which you can’t use the money in your IRA, including lending money to yourself, using it as collateral for a loan and buying real estate for your personal use. Beyond those exceptions, you can invest in just about anything: mutual funds, individual stocks and bonds, annuities and even certain real estate.
You can open an IRA through almost any large financial institution, including banks, mutual fund companies and brokerage firms. Most IRA providers offer a broad variety of investment options, ranging from CDs to money market funds to mutual funds to individual stocks and bonds, so you can put together a diversified retirement portfolio within your IRA no matter which one you choose. The major difference between most institutions is the fee structure, although most of the major brokerage firms now offer accounts with no account fees, no minimum required investment, and no trading fees.
If you are eligible for both a Roth and a traditional IRA, then you’ve got to run some numbers.
In general, a traditional deductible IRA is appropriate if you expect to be in a lower income tax bracket when you retire. By deducting your contributions now, you lower your current tax bill. When you retire and start withdrawing money, you’ll be in a lower tax bracket, giving less money overall to the tax man. This is referred to as “tax arbitrage.” However, as I said above, practicing radiologists usually make too much money to be able to contribute to a deductible IRA.
If you expect to be in the same or higher tax bracket when you retire, you should consider contributing to a Roth IRA, which allows you to pay your taxes now. But it can be difficult, if not impossible, to guess what tax bracket you will be in later in life – particularly if you’ve got a long way to go until you retire. So consider spreading your bets. For example, if you already have a tax-deferred 401(k) plan through your employer, you might want to invest in a Roth IRA if you are eligible.
|Residents, who have lower salaries, usually qualify to contribute to a traditional deductible IRA, although their best option is often to invest in a Roth IRA because they will be in a higher tax bracket when they retire.|
Residents, who have lower salaries, usually qualify to contribute to a traditional deductible IRA, although their best option is often to invest in a Roth IRA because they will be in a higher tax bracket when they retire. Also, having money in a non-Roth IRA could screw up the ability to save in a Roth IRA later on (see pro-rata discussion below). Exceptions may occur when residents are married to an income-earning spouse, or when a resident is trying to minimize their taxable income for purposes of lowering their student loan payment.
IRAs for the self-employed
A Simplified Employee Pension (SEP) IRA is a type of traditional IRA for self-employed individuals or small business owners. Any business owner with one or more employees, or anyone with freelance income, can open a SEP IRA. A SEP does not have the start-up and operating costs of a conventional retirement plan. As an employer, you don’t have to fund contributions every year. But when you do choose to make contributions, you must contribute not only to your own SEP IRA, but the SEP IRA of every eligible employee (if you have employees). If you have a tough year financially, you can choose not to contribute to the plan. If you have a great year, you can fund the plan with a larger contribution than you’d originally intended. Contributions, which are tax-deductible for the business or individual, go into a traditional IRA held in the employee’s name. Employees of the business cannot contribute – only the employer can. Like a traditional IRA, the money in a SEP IRA is not taxable until withdrawal and investments grow tax deferred until you are ready to make withdrawals in retirement.
One of the key advantages of a SEP IRA over a traditional or Roth IRA is the elevated contribution limit. Contributions an employer can make to an employee’s SEP-IRA in 2020 cannot exceed the lesser of 25% of the employee’s compensation, or $57,000, and it can be made in addition to traditional IRA or Roth IRA contributions.
Note: Elective salary deferrals and catch-up contributions are not permitted in SEP plans.
A SIMPLE (Savings Incentive Match PLan for Employees) IRA allows employees and employers to contribute to traditional IRAs set up for employees. It is ideally suited as a start-up retirement savings plan for the self-employed or small employers not currently sponsoring a retirement plan. SIMPLE IRAs have higher contribution limits than traditional and Roth IRAs, and it’s cheaper to set up and run a SIMPLE IRA plan than it is to administer many other workplace retirement plans.
Unlike SEP IRAs, SIMPLE IRAs allow employees to make contributions. There are two sets of contribution limits: one for the employee and one for the employer. The amount an employee can contribute from their salary in 2020 to a SIMPLE IRA cannot exceed $13,500, plus an additional $3,000 catch-up contribution if over age 50. Your employer must make a contribution every year it maintains the plan, even if you choose not to, and all employees must receive the same type of contribution. What makes a SIMPLE IRA unique is that the employer is required to make a contribution on the employee’s behalf regardless of whether the employee contributes to the account.
|If you plan to convert a traditional IRA to a Roth IRA, you should not have any money invested in any other IRA accounts at the end of the year (December 31) or you will wind up paying taxes on some of your conversion.|
Pro-rata rule (warning!)
Now is a good time to warn you about what is called the “pro-rata” rule. This is the formula used to determine how much of a distribution is taxable when the account owner holds both after-tax and pre-tax dollars in their IRA(s). For the purposes of the pro-rata rule, the IRS looks at all your SEP, SIMPLE, and Traditional IRAs as if they were one. So, if you plan to convert a traditional IRA to a Roth IRA, you should not have any money invested in any other IRA accounts at the end of the year (December 31) or you will wind up paying taxes on some of the conversion. This is the reason many people choose not to roll over a 401(k) account to an IRA when they change employment. It screws up the ability to contribute to a backdoor Roth tax-free. Being subject to the pro-rata rule would defeat the purpose of having a Roth IRA, which is to have money in an account that you’ve already paid taxes on and never have to pay taxes on again. Note that the pro-rata rule does not apply to Roth IRA distributions, only conversions.
That was a lot! This is a big topic, so I’ve broken it up into two parts. I’ll leave you to cogitate on this information for now, but make sure you come back for part 2, where I will discuss other common retirement plans, or “baskets.” I’ve also included a handy table in the next post that compares the features of all the different retirement plans discussed. To be continued…