Jeff Witz, CFP

Many physicians wonder if they should be making pre-tax or Roth contributions to their retirement plans. Both have potential advantages but often require looking into a crystal ball and envisioning your financial circumstances at the time you retire. Will you still be earning a significant income in retirement from business interests or investments or will your income be minimal aside from Social Security and retirement plan distributions? Choosing between Roth or pre-tax contributions can be overwhelming—no one wants to make a mistake. There are some key differences you will want to consider when making your decision.

Let’s start by understanding the basic concepts of pre-tax and Roth accounts. To compare, let’s break each account type down into 3 phases: the contribution phase, the growth phase, and the distribution phase.

. Money is deposited into the account pre-tax. For employer-provided plans such as 401(k)s and 403(b)s, this means the money is contributed to the account before any federal or state taxes are withheld. If it is a traditional individual retirement account (IRA), you contribute post-tax money but then take a deduction when you file your tax return, which makes the contribution pre-tax. (Note: The ability to take a tax deduction from contributing to a traditional IRAs is phased out at certain income levels if you are a participant in an employer-sponsored retirement plan.) Pre-tax contributions reduce the taxable income that gets reported to the Internal Revenue Service (IRS).

 Money is invested and grows tax deferred. This means you can buy and sell and accumulate investment gains without owing tax on those gains. This tax-advantaged feature allows more money to stay in the account and accumulate gains.

 The IRS is patient, not generous. When you take a distribution from the pre-tax retirement account, you must include the full distribution in your reportable income and pay tax on it.

. A deduction to claim on your tax return, investments grow tax deferred, and distributions are taxed at your ordinary income tax rate.

 No tax benefit is received the year the money is contributed. You are depositing money that has already had federal and state taxes withheld or paid on it. (Note: The ability to contribute to a Roth IRA is phased out at certain income levels regardless of your participation in an employer-sponsored retirement plan.)

 As in the pre-tax account, the money is invested. However, instead of growing tax deferred, investments in Roth accounts grow tax free. You can buy and sell and accumulate investment gains without owing tax on those gains. Like pre-tax accounts, this feature allows more money to stay in the account and accumulate gains.

 Since you paid the tax on the front end, distributions from Roth accounts are tax free. You do not have to include them in your reportable ordinary income or pay tax on them, including the investment gain.

. No tax benefits the year the contributions are made, tax-free investment growth, and tax-free distributions.

So which type of contribution may be best for you? If you know or suspect you will be in a lower tax bracket in retirement than you are now, contributing to a pre-tax account may make sense. You will report less income now while in a higher tax bracket and then take taxable distributions at a lower tax rate when you’re retired.

Alternatively, if you know or suspect you may still be in a high tax bracket during retirement, contributing to a Roth account may make sense. This is frequently the case if there are business interests or investments that still provide a high level of income. If there is no clear tax savings benefit by contributing pre-tax, then tax-free distributions from a Roth account may produce a greater tax benefit. Additionally, if you are earning a significant amount in retirement, tax-free distributions from your Roth account may help you stay in a lower tax bracket because they are not counted as part of your income.

Finally, there can often be a benefit to having both types of accounts. It is not uncommon for physicians to have pre-tax money in a 401(k) or 403(b) and have a Roth IRA (using the backdoor IRA process) as well. Having both types of accounts provides options in retirement. Maybe there will be a year when you have a significant amount of income and are in a higher tax bracket. You would not want to take a distribution from a pre-tax account and pay tax at a higher rate. That would be a year to take a tax-free distribution from your Roth account. In another year, you may have very little income and could be in a lower tax bracket. That would be a year to take a distribution from the pre-tax account and pay the tax.

To determine which types of accounts are best for your individual circumstances, we recommend that you speak with your financial professional or certified public accountant.

Effective June 21, 2005, newly issued Internal Revenue Service regulations require that certain types of written advice include a disclaimer. To the extent the preceding message contains written advice relating to a Federal tax issue, the written advice is not intended or written to be used, and it cannot be used by the recipient or any other taxpayer, for the purposes of avoiding Federal tax penalties, and was not written to support the promotion or marketing of the transaction or matters discussed herein.

The information contained in this report is for informational purposes only. Any calculations have been made using techniques we consider reliable but are not guaranteed. Please contact your tax advisor to review this information and to consult with them regarding any questions you may have with respect to this communication.

MEDIQUS Asset Advisors, Inc. does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.

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Your projected retirement tax bracket may help guide selection.

What to consider when weighing pre-tax, Roth IRAs

Earlier this month, the Federal Reserve (Fed) announced they will start taking actions to raise interest rates and end their quantitative easing policy to halt rising inflation. With inflation currently around 7.00%, businesses and consumers are feeling the pinch of higher prices. The Fed’s actions are designed to reduce the inflation rate to a more comfortable 2.00%-3.00%. To accomplish this, the Fed will raise its Federal Funds rate. The Federal Funds rate is the rate at which banks can borrow and lend from each other so they can continue to provide loans to businesses and individuals. They will also end their policy of quantitative easing. Quantitative easing is a monetary policy that allows the Central Bank to purchase long-term securities from the open market. The policy increases the amount of money in the money supply, encourages lending and investment, and lowers interest rates. By raising interest rates and ending quantitative easing, the Fed hopes to reduce the amount of the money in the money supply and bring inflation rates down to more comfortable levels.

What could be the impact of rising interest rates on your investments? Bond prices typically move in the opposite direction of interest rates, meaning rising interest rates generally cause formerly issued bond prices to fall. This is commonly known as interest rate risk. When the yield on newly issued bonds is higher than the yield on older bonds, the newly issued bonds have more value. If you own an older bond, you must sell that bond at a discount to entice someone to buy it, otherwise they would just purchase a new bond. Thus, the value of old bonds decreases when interest rates increase. Additionally, with higher yields available with new bonds, many investors tend to sell their current bonds to purchase the higher-paying ones. Heavy selling causes the prices of old bonds to fall even more.

The best way to manage interest rate risk is with a diversified portfolio, including international and domestic bonds with short to intermediate maturities, as they may be less affected by rate hikes. The sooner a bond matures, the sooner you can use the proceeds to buy bonds that offer higher coupons. The trade-off is that bonds with shorter maturities tend to pay lower coupons than long-term bonds. A mix of short-term, intermediate-term, and high-yield bonds is worth considering. Each offers value in different ways, so not all your bond holdings will be as exposed to rising interest rates.

If you do not want the hassle of buying and selling your own bonds, bond mutual funds and exchange-traded funds (ETFs) are good options. The fund managers are consistently replacing maturing bonds with newly issued bonds to adapt their portfolio to changing rates. This can often reduce the negative impact of rising interest rates on the value of your bond holdings.

Although less predictable, stocks also tend to move in a negative direction when the Fed increases interest rates. The reason for this is that businesses, including large corporations, now must borrow money at a higher rate. This means more money must be allocated to paying back the loan(s), so profits tend to shrink. Additionally, consumers are also borrowing at higher rates. Thus they too must allocate more toward paying back their loans and have less discretionary income to spend. Less spending means less revenue and profits for businesses.

If companies are seen as cutting back on their growth due to less borrowing or are less profitable because of higher debt expenses or less revenue, their stock price will often drop. If many companies experience these declines, the whole market, or key indexes such as the S&P 500, the Dow Jones Industrial Average, Nasdaq, and the Russell 2000, will go down.

Just like with bonds, the best way to manage interest rate risk is by being diversified. The Fed raising interest rates is primarily a US-focused event. Although other countries could follow suit, it is unlikely to be matched globally. Therefore, owning a mix of US-based stocks, mutual funds, and ETFs, along with international and emerging market holdings, is the best way to reduce the impact that raising rates has on your stock positions.

What is the overall takeaway? Diversification is key. The more diversified your stock and bond holdings, the less affected you are likely to be by rising interest rates. To take that one step further, the more diversified you are, the less affected you are likely to be by any event that negatively affects one specific type of investment.

The material has been prepared or distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Investing involves risk, including risk of loss. Before investing, you should consider the investment objectives, risks, charges, and expenses associated investment products. Investment decisions should be based on an individual’s own goals, time horizon and tolerance for risk. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. Consult your financial professional before making any investments.

Diversification is key to mitigate impact of rising rates.

Rising interest rates could affect your investments

If you have a mortgage or children, there is a good chance that life insurance is a necessary piece of your overall financial plan. If you were to die prematurely, would your family still be able to afford your mortgage on a single income? Would your spouse have to change jobs or return to work to pay the bills and attempt to maintain the family’s standard of living? With potentially only 1 parent, would someone need to be brought in to help raise your children? How would that be paid for? Would your children’s college educations still be paid for? Life insurance can help ensure your family’s goals and lifestyle do not have to change, even if you are not there to provide.

Depending on your goals and what you are trying to pay for with life insurance, there are different types of policies that may be a good fit. Let’s look at some of the more common types of life insurance and their advantages and disadvantages.

Often, the goals you are trying to protect with life insurance are temporary. If covering the balance of a mortgage, protection is only needed for the duration of the loan, which is typically 15, 20, or 30 years. If covering a child’s college education, coverage is only needed until the child has completed that education. Term insurance has no cash value or savings component attached to it. If you do not use it, you will not get any of your premiums back. However, because of this and the shorter coverage period, these policies tend to be significantly less expensive than whole life or variable products. You pay your premium, and if you die during that policy year, the death benefit is paid to your beneficiary.

Just as it sounds, whole life insurance is intended to cover you for your entire life. This type of coverage is commonly used to give an inheritance, make a charitable donation, or pay estate taxes.Unlike term insurance, whole life insurance has an internal cash value account. When each premium payment is made, a portion of that premium goes into a savings account within the policy. This cash value account is guaranteed a modest return, so the money continues to grow. The money in the cash value account can be withdrawn, you can take a loan against it, or you can eventually use it to pay your premiums. Any portion of the money you contributed to the cash value account comes out tax free, but any investment growth must be included in your income for tax purposes. Because of the dual nature of the premium payments, where a portion pays for the life insurance and the remainder goes into the cash value account, the cost of a whole life policy is often significantly higher than a term life insurance policy.

This type of coverage works similarly to whole life insurance except it provides some added flexibility. Universal life allows you to adjust your premiums or death benefit if needed. If the cash value of your account can cover the costs, you may have the ability to lower or stop paying your premiums on a universal life policy for a certain amount of time. However, there can be negative consequences. Your coverage may end if you use up the account’s cash value to pay for premiums. Indexed universal life policies also allow you to invest the money in the cash value account; however, there are often caps on how much you can earn in those investments. The death benefit can also be adjusted up or down to fit your evolving needs.

This type of coverage has a much greater investment focus. In a variable policy, you can choose much more specific investments like an S&P 500 fund, an emerging markets fund, or domestic bond fund. These options typically allow you to tailor the investment strategy so it aligns with other elements of your financial plan, like your retirement account. The investment growth is also tax deferred.

The downside to variable policies is often the cost. The individual investments carry their own expense ratios, and the policy itself tends to have some higher fees than other types of life insurance. This type of coverage is typically used once all other tax-deferred retirement vehicles have been maxed out. However, the costs compared to investing in taxable accounts should be examined.

Depending on your goals and what you would like to cover, there are different options available. Careful consideration should be given to the type of policy suitable for each goal you want insured. We highly encourage you to work with an insurance professional to navigate which type of policy is right for you.

Which option you select depends on your goals and what you want to cover.

Life insurance is a key piece of the financial puzzle

Creating a financial plan allows you to set goals and keep track of financial benchmarks throughout the year. Creating a year-to-year plan can ensure you are staying on track to accomplish your short-term and long-term goals. Each year, I provide a checklist to get you started on creating a plan. There will certainly be other things you want to address; however, getting these 8 financial priorities in place is a good start.

Whether you want to be debt free in 10 years or own a home in 3, you are more inclined to save if you have specific goals. Factor these goals into a budget, and figure out where you can squeeze the extra money from to make these goals realities.

Every effective financial plan starts with a budget. Identify necessary spending and savings items. Give yourself a little leeway but try to stay disciplined to your budget.

 These can be a financial lifesaver! A sudden job loss, major surprise expense, or unexpected health issue can change your financial picture quickly. The general rule of thumb is to maintain an emergency fund equal to 3 times your monthly living expenses if you are a dual-income household and 6 months of monthly living expensesif you are a single-income household or if one person’s income is relied upon to provide for the family’s standard of living. During the COVID-19 pandemic, it is a good idea to bolster these funds with an extra month or two of savings.

 Look to see if there is some high-interest debt (like credit cards!) that can be paid off. With interest rates near record lows, putting extra money towards low-interest debt may not be the best idea. If you think you can earn a higher rate of return than the interest being charged on your debt by investing that extra money, you should come out ahead in the long run. Some forms of debt, such as a mortgage on a house, may also be acceptable due to the tax deductibility of the interest.

 If you already contribute to an employer plan such as a 401(k) or 403(b), keep it going. The Internal Revenue Service increased the maximum contribution amount to $20,500 per year ($27,000 per year for individuals older than 50 years). You should max out 401(k)s and 403(b)s before utilizing other tax-advantaged retirement accounts because they are protected by federal law if you are ever sued and have a judgment against you. If you own your practice, determine whether you are utilizing the best type of retirement plan for your specific situation.

Traditional and Roth individual retirement accounts (IRAs). 

If you are already maxing out employer-provided retirement accounts and wish to save additional amounts toward retirement, consider contributing to a traditional or Roth IRA. These accounts also offer excellent tax-advantaged growth and are protected in most states from lawsuits. The contribution limit remains unchanged at $6000 per year for 2022 ($7000 for individuals older than 50 years). Please note: Deductibility and the ability to contribute are determined by your income, so it is important to be aware of the limitations.

Often overlooked, disability and life insurance are actually very important components of financial security. Disability insurance supplements a portion of your income in the event you are sick or disabled and unable to work. In the event of a long-term disability, it could ensure you stay in your home and/or are still able to save for financial goals like retirement. All eligible physicians should have comprehensive disability coverage that provides at least 60% of their pre-disability income. Life insurance is slightly more situational, but if you own a home with a mortgage or have any other debts that would not be absolved at your death, have children whose college educations you would want to guarantee, and/or have an individual or organization you would want to provide for in the event of your death, then life insurance should be considered.

 The complexity of an estate plan may vary based on your assets and needs, but having basic estate planning strategies in place is important. Work with an estate planning attorney to review whether you need wills, powers of attorney, trusts, etc.

Having these 8 important components well in hand will give you a good foundation to start moving toward a financially secure future. We recommend speaking with your financial advisor about other areas of your financial plan that could use improvement.

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Having a year-to-year strategy helps you achieve short- and long-term goals.

Jeff Witz, CFP

Articles

What to consider when weighing pre-tax, Roth IRAs

Rising interest rates could affect your investments

Life insurance is a key piece of the financial puzzle

8 steps to create your 2022 financial plan