As a high-earning physician, you must start preparing for financial independence retirement early in your career. The more time you give yourself to save, the less stress your transition becomes, especially if you want to maintain your current or similar lifestyle in your next step.
You have numerous options for building your retirement savings. If your hospital system offers a 401(k) or 403(b), they may also allow you to utilize a Roth option.
Here’s a breakdown of what exactly a Roth 401(k) is, plus a few pros and cons to keep in mind when deciding if this vehicle is right for you.
What Is a Roth 401(k)?
It’s likely your hospital system offers you a defined contribution plan, like a 401(k) or 403(b). With a traditional account, you elect to remove money from your paycheck via payroll deferrals before taxes and contribute those funds directly into the account.
So, you can deduct contributions to a traditional 401(k) from your taxable income, and lowering your taxable income could open you up to additional tax credits and deductions.
The money grows tax-free, and when it’s time to make withdrawals, the distributions are taxable as ordinary income.
A Roth 401(k) works in the opposite direction.
You contribute after-tax money to a Roth 401(k), meaning your contributions won’t lower your taxable income for the year. Again, the money in the account grows tax-free. But the big difference is that the distributions you take in retirement are tax-free because the money was already taxed at the onset.
2022 Roth 401(k) Contribution Limits
For the 2022 tax year, the contribution limit for a Roth 401(k) is $20,500. If you are 50 or older, you can make an additional $6,500 in catch-up contributions.
Roth 401(k)s are a significant savings opportunity for high-earning physicians, but how does it stack up against other vehicles like a Roth IRA?
Roth IRAs are excellent, but the annual contribution limits are much lower, $6,000 a year with $1,000 in catch-ups when you turn 50. Plus, Roth IRAs have income restrictions for contributing, and that’s not the case with a Roth 401(k). You can contribute to a Roth 401(k) no matter your income and take advantage of the tax-free growth and distributions down the line.
But income restrictions can’t always bar high-earners from contributing to Roth IRAs. You can look into a backdoor Roth IRA, which enables you to fund a traditional IRA and convert all or a portion of it into a Roth IRA. Keep in mind that there are some tax consequences to consider, and this strategy isn’t going to be the best fit for everyone. Plus, there’s a possibility that new tax legislation would remove this strategic action.
It’s important to note that unlike a Roth IRA, a Roth 401(k) has required minimum distributions (RMDs), meaning you have to start taking withdrawals when you turn 72. Seeing as these are tax-free distributions, it’s not as significant of a tax event as it would be with RMDs from a traditional 401(k), which the IRS taxes as ordinary income.
Speaking of distributions, keep in mind that there are some rules for making a “qualified” one.
- You’ve had your Roth 401(k) for at least five years.
- You start taking withdrawals at 59 ½.
There are, as always, some exceptions to these rules that your tax professional can help you review.
Pros of a Roth 401(k) for Physicians
Here are a few specific reasons why a Roth 401(k) can appeal to doctors and medical specialists.
#1: Tax-Free Withdrawals
As we mentioned above, one of the most appealing draws of a Roth 401(k) is the tax-free distributions in retirement. This benefit gives physicians more flexibility to spend in their golden years, as it creates some much-appreciated wiggle room within their retirement income plan.
#2: No Income Restriction
Roth IRAs come with income restrictions. For the 2022 tax year, the limits are as follows:
- Married filing jointly: You can contribute a reduced amount if you earn between $204,000 and $214,000.
- Married filing jointly: If you earn above $214,000, you can not contribute at all.
- Single, head of householding, filing separately: You can contribute a reduced amount if you earn between $129,000 and $144,000.
- Single, head of householding, filing separately: If you earn above $144,000, you can not contribute at all.
For most physicians, especially specialized doctors, their income will exceed these limits. A Roth 401(k) does not have income limits, making it an appealing alternative for those looking to take the tax advantages in retirement.
#3: Your Expected Tax Rate Is The Same or Higher
If you expect your tax rate to be the same or higher in retirement than your current tax rate, then a Roth 401(k) may be advantageous.
The general idea is to minimize your tax obligation on this retirement income. The higher your expected income, the higher your tax rate will be.
What does that mean for your tax liability in retirement?
If you’re an early-career physician, it’s possible (even likely) you’re earning less now than you will be when you enter retirement. So, contributing to a Roth account could be a benefit in the long run. Even though you’ll pay taxes now, it will be at a lower rate than you anticipate paying in the future.
But if you’re a physician in your peak earning years, you could earn less (hence be in a lower tax bracket) come retirement. If this is the case, a traditional 401(k) could make more sense.
#4 Beneficiaries Can Receive Proceeds Tax-Free
Roth accounts can make an excellent addition to your estate plan. Based on current law, your heirs won’t have to pay income tax on any distributions from the account.
The IRS allows heirs to transfer the money from a Roth 401(k) directly into an Inherited Roth IRA. While they will need to take RMDs from this account, they should be tax-free distributions, so they won’t negatively impact your beneficiary’s tax situation.
Cons of a Roth 401(k) for Physicians
Every retirement savings account has its considerations; here are a few things to consider regarding Roth 401(k) accounts.
#1: Expected Tax Rate Increase
Remember, your expected tax rate today versus in retirement should play a significant role in your decision to use a Roth or traditional savings account.
If you expect that your effective tax rate will remain the same or decrease in the future, a traditional 401(k) account may be a better move. Contributions to a traditional account will lower your taxable income for the year you make them. This process can have a domino effect on other areas of your financial life, such as capital gains tax rates, net investment income tax, and availability of certain tax credits or deductions.
If you’re retired already, lowering your taxable income for the year can play an essential part in your Medicare premiums and Social Security taxes.
#2: Less Access to Money Early
It can be tough to access your 401(k) before retirement, and doing so can incur severe penalties, which reduce your retirement savings. If you believe you’ll need the money from these accounts before you turn 59 ½, investing in a Roth IRA may provide more flexibility.
If you are under 59 ½, there are certain circumstances in which you can access the money in your Roth IRA account without incurring taxes. These include:1
- Purchasing your first house (up to $ 10,000-lifetime maximum)
- Covering qualified education expenses
- Paying for expenses related to birth or adoption
- Becoming disabled or dying
- Paying for unreimbursed medical expenses or health insurance (if unemployed)
It’s important to note that if you make a qualifying withdrawal for any of these reasons, you may still incur a penalty if the Roth IRA is less than five years old.
#3: Fewer Investment Choices
While it may not matter to everyone, a 401(k) tends to offer fewer investment choices because you’re typically restricted by what your employer offers. If individualizing your investment options is important to you, an IRA will offer much more flexibility.
Deciding What Works for You
As you weigh your savings options to reach financial freedom, try to stick with the tenets of a strong investment strategy: create a diverse portfolio, keep your risk tolerance top of mind, consider your time horizon, and put your goals at the forefront of your investment strategy.
We recommend working with a team like Partners in Financial Planning, as we specialize in helping physicians prepare for a fulfilling retirement at any stage in their career.
Feel free to give us a call today and see how we can help develop a personalized strategy for you.
Partners in Financial Planning provides tax-focused, comprehensive, fee-only financial planning and investment management services. With locations in Salem, Virginia and Charleston, South Carolina, our team is well-equipped to serve clients both locally and nationally with over 100 years of combined experience and knowledge in financial services.
To learn more, visit https://partnersinfinancialplanning.com