Medical residents: pre-tax (403b) vs taxable

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need403bhelp
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Medical residents: pre-tax (403b) vs taxable

Post by need403bhelp » Wed Sep 13, 2017 8:28 pm

Ok, this isn't directly relevant to me. However, some residents from my former residency program asked me (as the bogleheads/do-it-yourself financial person from our residency program) a question and I am curious about the Bogleheads answer.

The question: let's say you are a medical resident in a low tax bracket. You know that your tax bracket will go up as an attending and likely end up higher (at least if tax rates per income stay the same) in retirement than it was during your residency.

As such, shouldn't you choose a taxable account OVER a pre-tax account when saving for retirement during residency?

The only reason I thought of why you should choose pre-tax OVER taxable in this situation is the opportunity to roll over to a traditional IRA and convert to Roth your first year as an attending (as your salary will generally still be fairly low - you will be a resident until June/July and only have a maximum of half a year's attending salary for that year). Any other thoughts?

Why should a medical resident, presuming they will be in a higher tax bracket in retirement than in residency, defer their (very low) tax now in order to pay a higher tax when withdrawing pre-tax earnings in retirement? I realize there is some "tax drag" for taxable investments, but it seems that, at least in my personal situation (guesstimated retirement tax bracket 25% 30+ years out), it wouldn't really make much of a difference in regard to this investment situation (Bogleheads Wiki recommends adjusting taxable investments in AA by 25% when early in accumulation phase, which would be same as my adjustment for pre-tax retirement accounts).

Thanks!

need403bhelp
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Re: Medical residents: pre-tax (403b) vs taxable

Post by need403bhelp » Wed Sep 13, 2017 9:29 pm

Actually, thinking more, maybe I figured it out.

Let's say a resident is in the 15% tax bracket and will be in 25% bracket in retirement.

Assume no growth in either pre tax or taxable account. Now put $18000 pre tax in each.

Pre tax at withdrawal: $18000 x (1 - 0.25)

Taxable at withdrawal: $18000 x (1 - 0.15) x (1 - 0.25)

Thus, for $18000 pre tax you get a better after tax return in retirement.

Right?

EDIT: Basically, what was confusing me is that if you invest $18,000 in taxable, you are really allocating $18,000 x (1 + 0.15) > $18,000 pre tax dollars. Thus, you have to compare equivalent PRE tax amounts when comparing the two options, which I was not doing.

SkullBaseSurgeon
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Re: Medical residents: pre-tax (403b) vs taxable

Post by SkullBaseSurgeon » Wed Sep 13, 2017 9:34 pm

My 403b was matched by my employer 50 cents to the dollar, so it was a no-brainer. An immediate 50% rate of return can't be beat.

We only got matched up to a certain point, and needless to say I did not go beyond that, exactly for the reason you describe. Any excess went into a Roth.

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Re: Medical residents: pre-tax (403b) vs taxable

Post by grabiner » Wed Sep 13, 2017 9:44 pm

need403bhelp wrote:
Wed Sep 13, 2017 9:29 pm
Actually, thinking more, maybe I figured it out.

Let's say a resident is in the 15% tax bracket and will be in 25% bracket in retirement.

Assume no geowth in either pre tax or taxable account. Now put $18000 pre tax in each.

Pre tax at withdrawal: $18000 x (1 - 0.25)

Taxable at withdrawal: $18000 x (1 - 0.15) x (1 - 0.25)

Thus, for $18000 pre tax you get a better after tax return in retirement.
This slightly understates the advantage of the pre-tax account. As a young investor, you will lose more than 25% of the taxable account to taxes. If you invest in stock, you will pay tax on the dividends every year (0.3% for a 2% qualified dividend yield taxed at 15%, plus state taxes), and then pay tax on the capital gains when you sell (15% plus state taxes, probably on about 3/4 of the value). If you invest in bonds, you will pay 25% tax every year plus state taxes, and you will lose the growth on the amount paid in taxes, so you lose more to compounding. If you invest in municipal bonds (once you move into a higher bracket), you pay no taxes, but you lose a similar amount in lower yields.

You should prefer a tax-free account to either tax-deductible or taxable accounts. Max out your Roth IRA, and use a Roth 403(b) if your institution offers one.
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letsgobobby
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Re: Medical residents: pre-tax (403b) vs taxable

Post by letsgobobby » Wed Sep 13, 2017 10:45 pm

The only reason I thought of why you should choose pre-tax OVER taxable in this situation is the opportunity to roll over to a traditional IRA and convert to Roth your first year as an attending (as your salary will generally still be fairly low - you will be a resident until June/July and only have a maximum of half a year's attending salary for that year). Any other thoughts?
and that is exactly why I did max out my 403b. I figured someday I would have the opportunity to convert at a low rate. In the fall after finishing training I was already above the income threshold for Roth conversions, but starting in 2006 I began to make non-deductible contributions to an IRA, and in 2010 when the income limits went away I converted my old 403b and IRA to a Roth IRA and opened up backdoor Roth IRAs annually thereafter. It was worth the tax that I paid.

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Re: Medical residents: pre-tax (403b) vs taxable

Post by mega317 » Thu Sep 14, 2017 9:32 am

need403bhelp wrote:
Wed Sep 13, 2017 8:28 pm
The only reason I thought of why you should choose pre-tax OVER taxable in this situation is the opportunity to roll over to a traditional IRA and convert to Roth your first year as an attending (as your salary will generally still be fairly low - you will be a resident until June/July and only have a maximum of half a year's attending salary for that year). Any other thoughts?
I would think in the last year of residency, half an attending's salary would likely put you into the 25% bracket. It did for me and I did primary care.

blastoff
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Re: Medical residents: pre-tax (403b) vs taxable

Post by blastoff » Thu Sep 14, 2017 10:24 am

I assume no Roth 403b option?

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Re: Medical residents: pre-tax (403b) vs taxable

Post by neurosphere » Thu Sep 14, 2017 5:38 pm

Remember that any resident who has loans as anticipates public service loan forgiveness will effectively get a 10% match for every dollar contributed to a deductible account. That's because payments are lowered 10%, and every dollar not paid towards loans is eventually forgiven.

So in my financial lectures, I teach these rules of thumb for the typical resident:

-- Expecting PSLF? Maximize pre-tax contributions, then go to Roth IRA if savings allow.
-- Not expecting PSLF? No Roth option in the employer account and no match? Start with Roth accounts (e.g. Roth IRA). If you still have savings, contribute to a deductible plan. The reason is that in the future, it's likely one will have much more money in deductible accounts, and getting some money in Roth earlier is a form of tax diversification.
-- Match? Take the match, always. Then do Roth IRA, then pre-tax contributions.
-- Have Roth option in the employer account? 25% bracket in moderate tax state? Flip a coin between Roth and deductible contributions, or do 50/50. But favor the Roth IRA over an employer plan, because Roth IRA contributions can act as an emergency fund and (usually) better investment choices and lower fees.

Yes, there may be those who will retire early and convert all pre-tax deductions. But how many residents know that might be them? They might just as well be high-earners and high-savers who work into their 70s with giant RMDs on top of high wages. In this case, the Roths are powerful.
-- Real name: Sotirios Keros. If you have to ask "Is a Target Retirement fund right for me?", the answer is yes.

need403bhelp
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Re: Medical residents: pre-tax (403b) vs taxable

Post by need403bhelp » Thu Sep 14, 2017 6:02 pm

Thank you all for your thoughts!

I guess I should have clarified further:
- I told everyone Roth IRA before 403b
- there is NO match for the 403b in my old residency program
- there is NO Roth option for the 403b in my old residency program
- we have no state (income) taxes

Also, for the taxable account estimated adjustments of 25% early in career and 15% late in career, here is my reference (I realize that these are rough estimates):

https://www.bogleheads.org/wiki/Tax-adj ... ginal_rate
You should value your Roth at its full value, and reduce the value of your traditional IRA or 401(k) by your expected tax bracket at retirement (including state taxes if your state taxes these withdrawals, which varies by state). You should also reduce the value of your taxable account by about 25% if you are early in your career, and 15% if you are near or in retirement, plus state taxes; estimated values are necessary because the tax cost depends on how much you will have in capital gains.
Also, thank you for your suggestion re interaction of income with loans. This is the area in which I am least knowledgeable - I went the MD/PhD route and thus, despite being quite a bit older than most of my peers, have no loans.

need403bhelp
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Re: Medical residents: pre-tax (403b) vs taxable

Post by need403bhelp » Thu Sep 14, 2017 6:23 pm

mega317 wrote:
Thu Sep 14, 2017 9:32 am
need403bhelp wrote:
Wed Sep 13, 2017 8:28 pm
The only reason I thought of why you should choose pre-tax OVER taxable in this situation is the opportunity to roll over to a traditional IRA and convert to Roth your first year as an attending (as your salary will generally still be fairly low - you will be a resident until June/July and only have a maximum of half a year's attending salary for that year). Any other thoughts?
I would think in the last year of residency, half an attending's salary would likely put you into the 25% bracket. It did for me and I did primary care.
Yes, 25% is what I guesstimate as well. Again, my personal guesstimate for our retirement bracket is also 25%.

0.75*smaller amount + ~30 years of tax-free growth > 0.75*larger amount kept as pre-tax taken out at withdrawal

So I think you could still convert a reasonable amount (staying within the 25% tax bracket) for that year and come out ahead.

Also, we have boards in July and most people take time off after that. I took ~2 months, I had a friend one year ahead of me who took ?5 months off. So earnings are lower (although I also stayed in academia so someone who is going to one of the "mills" [pardon my term] and starts right after boards may not end up in 25% bracket even for that year).

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Re: Medical residents: pre-tax (403b) vs taxable

Post by ThrustVectoring » Thu Sep 14, 2017 9:01 pm

need403bhelp wrote:
Wed Sep 13, 2017 8:28 pm
The only reason I thought of why you should choose pre-tax OVER taxable in this situation is the opportunity to roll over to a traditional IRA and convert to Roth your first year as an attending (as your salary will generally still be fairly low - you will be a resident until June/July and only have a maximum of half a year's attending salary for that year). Any other thoughts?
This is exactly why you should contribute to your pre-tax account, especially with salary earned in the year you are finishing your residency. Rollover into IRA when you finish your residency, convert to Roth as long as your income remains reasonably low for that year.

need403bhelp
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Re: Medical residents: pre-tax (403b) vs taxable

Post by need403bhelp » Fri Sep 15, 2017 7:23 pm

ThrustVectoring wrote:
Thu Sep 14, 2017 9:01 pm
need403bhelp wrote:
Wed Sep 13, 2017 8:28 pm
The only reason I thought of why you should choose pre-tax OVER taxable in this situation is the opportunity to roll over to a traditional IRA and convert to Roth your first year as an attending (as your salary will generally still be fairly low - you will be a resident until June/July and only have a maximum of half a year's attending salary for that year). Any other thoughts?
This is exactly why you should contribute to your pre-tax account, especially with salary earned in the year you are finishing your residency. Rollover into IRA when you finish your residency, convert to Roth as long as your income remains reasonably low for that year.
Fair enough. I completely agree. However, when I told this argument to the person asking me, I had the impression that their thought was something like "oh my gosh, this sounds so complicated; I thought I was already doing a good thing by contributing to the pre-tax 403b, but it sounds like I have to figure out how to roll it over to an IRA and convert to Roth; aah!." I realize its not that tough, but I think the Bogleheads perspective is unique - most of former residency colleagues have absolutely zero interest in financial matters.

In any case, thanks for sharing your viewpoint!

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