Why it’s time to start rethinking how to file your savings.
We all know about employer-sponsored retirement plans such as a 401k and you’ve always heard that maxing out your pretax retirement accounts is a great way to save for retirement. While I agree with that, many emergency medicine physicians will need to save beyond just the 401k to fund an adequate retirement.
One mistake I see physicians — and even financial advisors — make is to think that 401ks and other pretax accounts are the only accounts that should be used to save for retirement. That’s just not true. The concept of pretax accounts is really just a function of the tax code. The right way to think of retirement savings is that the various combinations of accounts comprise your retirement portfolio.
One account many physicians underutilize for retirement is the taxable investment account — sometimes called a brokerage account. The term “taxable” has some negative connotations. After all why would you want to pay tax in an investment account every year?
Well, over the next two months let me walk you through the many advantages of investing in a taxable account:
- No contribution limits
If you’re an employee for a hospital system that has a 401k plan you’re only limited to $19,000 of contributions from your paycheck this year — or $25,000 if above age 50. Traditional IRA and Roth IRA accounts have much lower contribution limits. Unless your employer has a whopping matching contribution or other discretionary contribution or your employer has multiple retirement plans which you can contribute to, that’s just not going to cut it if you want to eventually retire.
Don’t believe me? Let’s do some simple math. Suppose you save $25,000 annually into the 401k plan including any matching contributions and you get a 4% annual return after inflation. Thirty years later your account value is about $1.4 million. Can you live off of that amount for the rest of your life? Well, you could factor in Social Security benefits on top of that, but think of what type of lifestyle you’ll have and if that lifestyle is acceptable to you.
If you’re an independent contractor you can set up your own 401k plan and contribute up to $56,000 (or $62,000 above age 50), but even that might not be enough to meet your specific retirement goals depending on what age you retire, how much you want to spend during retirement and how long you’ll need the money to last.
With a taxable account there are no such limits. You can invest whatever amount you want. This is particularly powerful for physicians who are big savers and who’ve maxed out the pretax retirement account limits. Let’s say you make $400,000 in income and all of that income is employee income from working for a hospital. You contribute $19,000 to the 401k and perhaps the hospital contributes another $16,000 for a total of $35,000. That’s still less than 10% of your gross income and that’s way below what you’ll need to comfortably retire. You could contribute $25,000 to the taxable account, or if you’re a “super saver” you could contribute $65,000 or even more to the taxable account to get your savings rate above 20% or 25%.
- No income restrictions
Traditional IRAs, Roth IRAs and Coverdell Education Savings Accounts have either restrictions on your ability to contribute to the account at all or have restrictions on the ability to receive a tax deduction for the contribution. For example, with a Roth IRA, you can only directly contribute to the Roth IRA if you have compensation such as a salary and if your income is below certain thresholds ($203,000 in 2019 for married couples). While you will not get a tax deduction for contributing to a taxable account, no income limitations exist. You could make $1 million a year and still contribute to the taxable account.
- Ultimate flexibility
Certain accounts such as 529 college savings plans, health savings accounts (HSA), and even 401k accounts are generally earmarked for specific goals such as college funding, current or future health care expenses, or retirement. In certain situations not using funds earmarked for those expenses can lead to penalties. A good example is the 529 college savings plan. Suppose you stuff a bunch of money into the plan and assume that your kid will go to an expensive private college, but decides to go to the much lower cost in state public college and now you’ve got money left over in the plan. If you decide to withdraw money from the account, but not use it for educational purposes you’ll get hit with a 10% penalty on the gains.
With a taxable account you have complete control and flexibility as to how you want to use it. If you’ve maxed out your 401k, the taxable account becomes another account to fund your retirement. Or you can use a taxable account to fund college or grad school for your kids if you don’t like the restrictions in 529 plans. You can also set it aside for other goals (buy a new house in five years) and change the goal of the taxable account over time. You can even use it for emergency purposes if really needed. While there are some ways to access pretax money in 401ks and IRAs in hardship situations, it’s much simpler doing so from the taxable account.
- Better, lower cost and wider investment options
Many 401k plans give you a limited menu of mutual fund choices and often those choices have high expenses or simply lack certain types of investments and asset classes you may want to invest in. What’s worse is that usually you don’t have any say in the matter. With a taxable account, depending on the custodian you can access thousands of mutual funds and access other asset classes not available in your 401k. This can result in a better diversified portfolio than what you can get in the 401k alone. Plus, you can potentially choose funds with lower expense ratios than what may be offered in your 401k. You can also invest in individual stocks and exchange traded funds (ETFs) that are usually not offered in 401k plans. Of course the flip side to this is that you could also blow your hard earned dollars on some highly risky and speculative investments such as some penny stocks that go belly up. Know how much risk you’re taking and be judicious about it.
- Tax diversification
With 401ks and other pretax accounts, when you take distributions (withdrawals) from those accounts, the distributions are usually entirely taxed. Let’s say you contributed $500,000 over the year to your traditional (pretax) 401k and the balance is now $1 million. If you withdraw $50,000 from it during one year when you are retired, that entire $50,000 distribution is reported on your income tax return and effects your taxable income, which is what your tax liability is based on.
Now let’s say you have the exact same scenario, but you invested in a taxable account. When you sell $50,000 in the taxable account, only the gain is reported on your income tax return, not the whole amount. What’s even better is that if it’s a long term gain, then the gain is taxed at the lower capital gains tax rate. Depending on several factors, your long term federal capital gains tax rate could be 0% during retirement or at most 20% with the current tax laws.
Another advantage is that you can claim capital losses on your income tax return when you sell investments for a loss in the taxable account. See 2018 for a great example. In the last few months of 2018 we saw substantial declines in some asset classes. Suppose you invested $10,000 of new cash in October 2018 and that investment is then worth $8,000 in December. You can sell the investment and replace it so you can claim a $2,000 capital loss on your tax return. In pretax accounts you’ve lost that opportunity.
On top of all of these tax benefits, when you’re retired you gain some flexibility in the order of withdrawals from various investment accounts with different tax structures — pretax (401k, 403b and others), tax free (Roth 401k, Roth IRA) and taxable accounts. See? Investing in a taxable account can actually have some tax benefits.
Next month I’ll continue this discussion and share with you more benefits of investing in a taxable account.