Contributing toward Retirement

About Retirement Accounts:

Note that when you place money into a pre-tax retirement account, you receive a tax deferral and not a true deduction or credit. You’re deducting it from this year’s taxes, but you’re going to pay money on the distribution (when you take the money out) instead of the contribution (or in a Roth, on the contribution but not the distribution). Contrast that with the mortgage interest tax deduction, which is a true tax deduction: you simply get to keep the taxes that would be due on that money, period.

This isn’t to say that the tax deferral doesn’t have real tax benefits—it does! It’s just that quantifying this benefit isn’t as simple as taking the deduction and multiplying it by your marginal tax rate to get your savings. In a pretax account, you get to earn investment gains on money that would have been lost to taxes, even if the total income eventually gets taxed. Likewise, you won’t pay taxes on any dividends or investment growth itself while the money remains in the account. Leave it alone and the number will generally get bigger and bigger over time. The exact retirement contribution tax benefits will depend on the tax bracket (federal + state) when you contribute, the tax bracket (federal + state) when you take a distribution, the earnings of the investment, and the length of time invested.

On a related note, it’s actually good to have a combination of both pre- and after-tax retirement accounts such that you can combine withdrawals from them in retirement to limit taxes. Remember we talked about “filling up” tax brackets as you increase in income, so the idea is to use a combination: taxable pre-tax money until you fill up the cheap tax brackets and then switching to Roth money to avoid the increased marginal tax rates at higher income levels.

If your tax bracket at contribution and distribution are the same (both state and federal), the pretax and aftertax options are equivalent.

But most importantly, using these accounts works in your favor.


Get the employer-match

Many employers offer a match on retirement contributions. These can take multiple forms: 100% match up to 3% of compensation, 50% match up to 5%, 100% match up to 4% vesting 20% every year of employment over 5 years, etc.

If your employer offers matching contributions, then you should contribute up to the match limit. Whatever system they use, it’s free money. Obviously, if you’re training in a high cost of living area and surviving on ramen you steal from a roommate you found on Craigslist, then I guess never mind.

From there, if you have more money, what to do next depends on the status of your loans and your risk tolerance.

If you need to pay off your loans:

There are no investments that are guaranteed to outperform the interest rate on your student loans, so in the event you plan on paying them off yourself (i.e. not going to stay in academics/public service and achieve PSLF), then you’ll need to decide how risk tolerant you are: the certainty of paying down moderate-to-high interest debt versus the relative uncertainty of investing. If you’re in REPAYE, as we discussed earlier, pretax retirement savings reduce your AGI, increase your subsidy, and decrease your effective interest rate. So that’s one reason to invest.

For loans with interest rates in the 5-7% range, the math favors taking extra income and filling up your tax-advantaged accounts before putting extra money toward your loans. In the long term, this is likely to work out in your favor given historical investment returns. In the short term, market volatility can have impressive effects on investor psychology. If you choose to invest over paying off your loans, don’t change plans when the market inevitably dips. In fact, when it dips is (perhaps counterintuitively) the best time to invest. One of the “perks” of retirement accounts is that you generally can’t use the money without penalties, so it’s difficult to sabotage yourself even if you get spooked. Do yourself a favor and invest in low-cost passive index funds and don’t pay attention to what happens.

If you’re leaning toward the predictability of repayment and are doing IDR making only partial interest payments, then you could put that money you wanted to use toward your loans temporarily in an interest-bearing savings account (e.g. Ally bank) or CD until you have enough money saved up to pay all the accrued interest so you can finally lower the principal and actually slow the rate of interest accrual. That way you can make a little bit of extra interest on the money earmarked for your loans before putting it to its intended use.

If your effective REPAYE rate is low or you’ve already refinanced to a lower interest rate, your money will go even farther in a retirement account than paying down low-interest loans, assuming you can take the financial uncertainty and loss of liquidity. If you can’t, just pay off those loans and be content in watching the number drop.

If you’re hoping for PSLF:

If you’ve already saved up a 2-3-month emergency fund and are making supplemental income you don’t need but are attempting to qualify for PSLF, then you really don’t want to pay down your loans directly. Any dollar you spend toward your loans is another that won’t be forgiven by PSLF. If you’re not sure but are in REPAYE making interest-only payments anyway, then again chipping away at your interest isn’t going to make a big long-term dent since nothing is capitalizing anyway. We discussed this at length in the Maximizing PSLF chapter.

While Roth (after-tax) 401(k)s and 403(b)s are generally great options for low-earning residents, they have no effect on student loan payments. To reiterate: only contributing to a pretax account will reduce your adjusted gross income and lower your income-driven repayment. A $50,000-earning resident making a $2,500 403(b) contribution will reduce their total repayment the following year by $250 (an automatic 10% return). Ultimately, you may decide that the Roth version still makes sense, especially if you are concerned taxes will be higher when you retire decades from now.

Whichever you choose, you don’t have to feel bad about choosing to invest in a tax-advantaged retirement account. The tax savings and likely yield of your investment may not always add up to more than the interest accruing on your loans at any given time, but it’s still a financially responsible decision. Ultimately, if forgiveness is a possibility, it’ll be safer to invest than throwing money into a loan that you might not need to pay off anyway.

Maximizing your tax-advantaged space:

First, max out your employer match. If you still have more money, the order of account filling again depends on whether or not you have loans and are trying to maximize the theoretical yield and flexibility of the retirement contribution or maximize PSLF. We’re double-covering this information because it’s important forever.

What percentage of your income you need to save for retirement depends on how much you make, how many years you’ll be working, and how much you want to retire on. 15-20% of gross income is commonly recommended. Less than 10% is considered imprudent over the long term. You may not be able to do as much early in your career as you get settled, but the earlier you start the more time you give each dollar to grow.

The Roth IRA:
A great option for residents (especially non-PSLF bound) is to try to max out your Roth IRA up to the annual limit of $5,500 (and the same amount for your spouse for a total of $11,000, if the situation applies/allows). That’s as much (and probably more) than you’re likely to have sitting around as a resident. In this situation, you are putting after-tax money away while in a relatively low tax bracket that can then grow and be dispersed tax-free.

If your combined household income is above the Roth limit (single $120,000 phase-out/ineligible at $135,000; married $189,000 phase-out/ineligible at $199,000 in 2017), then you should consider the “backdoor Roth IRA,” which is a Roth conversion that involves moving money originally contributed to a traditional IRA over to a Roth account. (You’ll want to Google it if this applies to you.)

If your Roth IRA is full:
Consider utilizing a Health Savings Account if available, as we discussed in the Maximizing PSLF chapter. HSAs allow you to put money away triple-tax-free (no taxes on the contribution, earnings, or distribution) for health expenditures or like a regular 401(k) for non-health expenditures. HSAs are offered in association with High Deductible Health Plans, so these aren’t universally available. Don’t confuse them with the much more common Flexible Spending Accounts (FSA), which do allow for tax-free contributions for health care expenditures but also must be used up annually or the money is forfeited.

Then you’d likely want to sock away the money in either your employer 401(k)/403(b) (if they provide one) or a solo 401(k) (that you can set up if you moonlight and receive income as an independent contractor on a 1099). If you become a loan-free resident, you’d likely benefit from the Roth option of those accounts if one is available. If not, a regular pretax retirement account will work just fine.

If you can save more than that:
In order to need even more tax-efficient saving options, you’ll have managed to max out a Roth IRA for yourself (and your spouse) and max out the personal contribution limit of your 401(k)/403(b) ($19,000 in 2019) (and your spouse too if they have enough income to do the same). That’s considerably more than most residents can afford and as much (and often more) than a lot of early career docs can swing.

Your next options are a 457(b) account (another pretax retirement vehicle commonly offered at academic institutions with another $19k per year limit) or a solo/individual 401(k) (as mentioned above), which is an individual account you can start as the sole proprietor of your one-(wo)man 1099-earning business. While the $189 personal limit is summed across all accounts, your “business” can put up to 20% of its profits to your 401(k) on your behalf (25% if you structure your business as a corporation) up to the annual (2017) contribution limit of $56,000 total (personal + profit-sharing).

So, for example, if you had maxed out your $19k contribution to your hospital 403(b) and then you made another $10k moonlighting as an independent contractor, you could basically put another $2,000 into the individual 401(k). Note: the calculation of acceptable contributions for a solo 401(k) is a bit more complicated than multiplying by 0.2, but online calculators exist, and tax software can also do this for you. There are a bunch of options for opening a Solo 401(k) account, including companies that allow for both Roth and traditional pre-tax options, so you can choose how much tax you feel like paying now versus later.

If you have kids, and everything else is maxed, you could start a 529 account to start paying for college. Your state may offer you a deduction for the 529 contribution, but the feds do not. In general, you want to have your own financial house in order before trying to pay for your kid’s college.


What about my mortgage?

If you own a house or condo and thus have a mortgage, paying it down faster makes less sense financially than contributing to tax-advantaged retirement accounts given the currently available interest rates, with the main practical exceptions that, psychologically, having no mortgage makes people happy, and you can also potentially get the money back earlier in your lifetime if you need to by selling the house or refinancing.

Unlike every other loan you have, mortgage interest payments are generally completely tax-deductible, which means that your effective rate is even lower than what it is on paper. Paying down the mortgage is generally a better option once retirement accounts are maxed.


Roth Conversions during school or residency

If you have any pretax retirement accounts from a former employer, a Roth conversion during school or even residency is something to consider. This means taking your previously untaxed contributions and converting them to an after-tax Roth account by paying the income tax on them now.

Doing this as a student with little or no income can result in no taxes due on the converted money, which can then be withdrawn tax-free in retirement. Clever conversion timing can sometimes shield income from the taxman entirely.


Closing thoughts

Ultimately, even as a resident, you’re already starting the retirement game late compared to those who entered the job market directly without an expensive 4-year graduate degree. The more years your money is sitting in an account, the more years it has a chance to grow. But more than that, even putting away a small amount of money (which is unlikely to make a significant difference in your overall portfolio) jumpstarts the savings behavior early. And that will keep you honest so that you can “pay yourself first” when you really begin to make the money that will be very tempting to spend and lose to lifestyle inflation.

There are no “wrong” or “bad” choices between saving for retirement and paying off your loans responsibly because both are “good” things to do with your money. Everyone has different financial goals and risk tolerance. In doing either you’ll do much better than the average person.

Do yourself a favor and at least contribute to the company match during training (if one is available). Make contributing to your retirement something automatic: a payroll deduction that you never really see, so that you’re doing right by yourself from the very start of your career.


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