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

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Topic Author
need403bhelp
Posts: 1636
Joined: Thu May 28, 2015 6:25 pm

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

Post by need403bhelp »

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!
Topic Author
need403bhelp
Posts: 1636
Joined: Thu May 28, 2015 6:25 pm

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

Post by need403bhelp »

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
Posts: 6
Joined: Wed Mar 09, 2016 3:37 pm
Location: Nashville, TN

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

Post by SkullBaseSurgeon »

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.
User avatar
grabiner
Advisory Board
Posts: 35307
Joined: Tue Feb 20, 2007 10:58 pm
Location: Columbia, MD

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

Post by grabiner »

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.
Wiki David Grabiner
letsgobobby
Posts: 12073
Joined: Fri Sep 18, 2009 1:10 am

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

Post by letsgobobby »

Deleted
Last edited by letsgobobby on Thu Oct 03, 2019 1:29 am, edited 1 time in total.
mega317
Posts: 5705
Joined: Tue Apr 19, 2016 10:55 am

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

Post by mega317 »

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
Posts: 402
Joined: Thu Jan 19, 2012 11:04 am

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

Post by blastoff »

I assume no Roth 403b option?
User avatar
neurosphere
Posts: 5205
Joined: Sun Jan 17, 2010 12:55 pm

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

Post by neurosphere »

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.
If you have to ask "Is a Target Date fund right for me?", the answer is "Yes" (even in taxable accounts).
Topic Author
need403bhelp
Posts: 1636
Joined: Thu May 28, 2015 6:25 pm

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

Post by need403bhelp »

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.
Topic Author
need403bhelp
Posts: 1636
Joined: Thu May 28, 2015 6:25 pm

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

Post by need403bhelp »

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).
ThrustVectoring
Posts: 771
Joined: Wed Jul 12, 2017 2:51 pm

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

Post by ThrustVectoring »

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.
Current portfolio: 60% VTI / 40% VXUS
Topic Author
need403bhelp
Posts: 1636
Joined: Thu May 28, 2015 6:25 pm

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

Post by need403bhelp »

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!
Post Reply