The COVID pandemic has had a significant adverse financial impact on physicians of all specialties despite the widely-held belief that medicine was supposed to be a recession-proof career. As a result, many physicians expect a lower than normal income for 2020.
A year of reduced income presents certain tax-saving opportunities to low spenders looking to minimize long-term tax liabilities.
The Problem
Physicians who respond appropriately to sound financial advice and tax incentives often end up with a significant portion of their net worth in tax-deferred retirement accounts. Such financially savvy docs reduce their taxable income by maximizing contributions to a 401k, defined benefit plan, 457 plan, backdoor Roth IRA and HSA (among others).
This is great news in the short-term, but Uncle Sam gets his cut either now or later. You are playing a game of tax arbitrage by assuming you will be in a lower tax bracket in retirement - usually a safe assumption for high earners in the prime of their careers.
The long-term outcome of maximizing retirement contributions is a lopsided retirement portfolio, with the vast majority of savings in tax-deferred accounts. A recent thumb in the wind accounting suggested that my current net worth (excluding home value) is distributed as follows:
- 20% taxable accounts
- 5% Roth accounts
- 75% tax-deferred accounts
That large tax-deferred component is a ticking tax time bomb. Once my wife and I reach the age of required minimum distributions (RMDs), we are mandated to withdraw funds based on actuarial predictions of our respective life spans. We pay Uncle Sam on his deadline according to his terms, exerting no control over our financial situation.
My wife and I are control-freak ER docs who prefer things be done our way. We get bent out of shape when the roll of toilet paper gets incorrectly installed in the dispenser by some rookie (it should always cascade forward like a waterfall). We'd strongly prefer to control how and when we are taxed on our income during retirement.
You're The Bomb!
Worse still, that time bomb can become a weapon of mass destruction in the common scenario where one spouse predeceases the other.
The romantic in me hopes to live in a physically functional and mentally lucid state until my wife and I pass away in one another's arms / in our sleep / peacefully / in our late 90s. The pragmatist in me realizes that's unlikely to happen.
When one spouse dies, the other can retain Married Filing Jointly (MFJ) status in the year the first spouse passes. There are exceptions that can prolong the MFJ period - when the surviving spouse has a dependent child, Qualifying Widow(er) status enables the benefit of MFJ status for two additional years. After that, the surviving spouse takes on single filer status.
Single filer status takes effect at the worst possible time from a tax perspective. The surviving spouse inherits the decedent's retirement account, likely doubling the amount of tax-deferred funds, which in turn significantly increases the RMDs required by Uncle Sam. At the same time, the tax bracket is functionally halved from MFJ to single. The surviving spouse is required to withdraw much more money, and at a much higher marginal tax rate.
As a male, I'm statistically likelier to pass first. As the spouse who oversees our finances, I'm also the most interested in optimizing these financial details before I depart. The last thing my wife will want to contend with after I'm gone is how to optimize our estate for tax purposes.
Defusing The Bomb
The solution to the tax bomb is to gradually convert a substantial portion of my tax-deferred funds into Roth funds. Doing so creates several advantages:
- By choosing the time of Roth conversion, I retain control over what tax rate I will pay to Uncle Sam. I can preferentially convert in years when I anticipate a lower income and tax rates are expected to be more favorable.
- I gain tax diversification for withdrawals during my retirement years, so that I can maintain my desired level of spending without entering unfavorable marginal tax brackets. By preserving the option to withdraw living expenses from a combination of taxable, tax-deferred and Roth accounts, I can more precisely engineer the tax bracket I plan to be in during retirement to legally reduce my tax liabilities.
Early Roth conversion is not without risk. For one thing, converted assets must remain untouched in the new Roth account for five years before they can be withdrawn, or penalties and taxes are incurred. The money can be withdrawn tax-free and penalty-free if you reach age 59½, become disabled, or make a qualifying first-time home purchase.
Some critics additionally worry that congress could revoke the tax-exempt status of Roth accounts in order to further raise revenue. The counter-argument is that congress is so pleased to receive the added annual tax income from Roth conversions that it is unlikely to forego this stream of additional income by closing off this avenue. Or a a cynic might phrase it, a congressional representative looking for revenue to spend on constituents today (i.e., from Roth conversions) is unlikely to delay that revenue until a later time when she is no longer in office.
A further consideration for high-income professionals is that the Tax Cuts and Jobs Act (TCJA) has multiple provisions set to expire on 12/31/25, meaning tax rates on high earners are very likely to increase after that time, moreso if an election-year change in administration or a swing in political power occurs. Add to this the significant deficit spending undertaken in the past year to combat a pandemic and control a worsening recession, and even a cloudy crystal ball like mine might suggest that in the short-term, I may be better off performing Roth conversions prior to the expiration of the TCJA.
In the next installment, we'll look at some simplified examples of whether and when Roth conversions make sense for both full-time and part-time docs under ordinary and extraordinary (COVID) circumstances.
If you are navigating a personal or professional crossroads and seek assistance, I'd be grateful if you'd consider my burnout coaching service. Thank you.
Comments 1
I’ve considered a new possibility in the Roth argument. Suppose the market doesn’t go up. Dalio is proposing the 3rd lost decade is about to occur. The first was 2000 to 2010. The second 2010 to 2020. He is predicting near zero growth through 2030. The real rate of return on the S&P 500 from Dec 1999 through June 2020, all dividends reinvested is 3.69%. 50M people, (increasing, not decreasing number despite re-opening) remain unemployed. We have spent 3T and are going to spend another 2T before year end to try and prop up the market. This would mean that 3.69% should have an asterisk (3.69% with a 5T stimulus in 2020 and a 1T stimulus in 2008). The studies show once debt/gdp > 0.9, $1 spent on stimulus returns < to < 1 right now meaning shooting money out the fire hose is less and less effective.
So if real returns are only 3.7% over 20 years under extreme FED manipulation what are the prospects going forward? Suppose instead of a real + GDP growth we realize a real – GDP growth. How might this happen? The answer is inflation. $1 today buys what 67 cents bought in 2000. The average inflation has been 2% over 20 years. Suppose we enter stagflation where inflation is > 2% and S&P 500 growth is < 3.7%. Would you rather have the most money left in the pretax account yet to be taxed at RMD, waiting to pay in now over inflated dollars. Or would you rather have already been taxed in 2020 and then have had your resultant slow growing Roth money further depleted by a high rate of inflation? The Congress doesn't have to slip in some tax change on your Roth, to tax your Roth. They merely have to cause inflation. Inflation allows them to pay their debts with cheaper dollars, but that means you will need to own more dollars to buy the same loaf of bread.
Personally I prefer to be free of the government if I can be. You have no idea of future tax policy, inflation or GDP growth except to understand the glory days are likely over and the past will not be prologue to the future. Every fake stimulus has less and less of an effect. It's like giving EPI. The first shot is dramatic, the 5th is more like giving water. If real S&P is <0.5% you can choose to invest in something more lucrative. There's always a bull market somewhere, just as there's always volatility everywhere.