By David Lockey
Thought about making a practice shift toward something less stressful, but also less lucrative? What about taking an early or partial retirement? Ever wanted a second home, yacht or other expensive toy? Are you saving the right way for your children’s education?
You’ve received plenty of advice about saving and investing for retirement, but there are other things in life you can and should be planning and investing for that you will either need or want before 59½. That means you will need savings tools and investment strategies in addition to IRAs, 401(k)s and 403(b)s.
Whether you’re using an evidence-based platform for investing, a traditional investment advisory service or are a DIY investor, here are three financial scenarios physicians should be prepared for and the (sometimes counterintuitive) strategies to employ.
Scenario #1: Leaving practice early or making a change due to desire or circumstance.
Between government mandates, the rise of electronic medical records and declining reimbursements, it’s no wonder that nearly 75 percent of physicians may be contemplating a career or practice change1. Even if you’re not thinking about quitting cardiology to become a candle maker in a village in the foothills of the Italian Alps, you still need to be prepared should an illness or disability limit your ability to practice.
That’s why all physicians should diversify not only their assets, but also their tax structure between tax-deferred, taxable and tax-free structures.
Diversifying Taxes on Investments
Dumping money into a 401(k) or traditional IRA is certainly worthwhile and will lower your tax bill today. But it’s only tax-deferred, meaning that you will have to pay income taxes on it when you access the account after 59½. Under the current tax regimen, for instance, that means if you withdraw $1 million at age 60, you will be paying close to $400,000 in taxes on it.
There are two big advantages to keeping a significant portion of your retirement savings in a taxable general investment account, despite not getting the tax deduction today.
- If your circumstances change or you need or want proceeds from investments early/immediately, there is no penalty to access it. If you’ve done well saving and investing, this can ease the process of retiring earlier or transitioning your practice or career.
- Only the long-term capital gains are taxed when you access the investment – typically, a much lower rate than income tax. Since you’ve been paying taxes on realized gains and dividends over the life of the investment, a $1 million will be much closer to $1 million. For example, if you’ve invested $350,000 after tax dollars over a period of 20 years and already paid annual taxes on $250,000 of cumulative dividends, interest and realized gains and the account is now worth $1 million, your tax burden is much less. In fact at today’s rates, if you were to withdraw $1 million, you would only pay 20 percent on the $400,000 of capital gains growth – or $80,000.
A Word on Asset Protection
One reason physicians are often advised to put as much money as possible into retirement accounts and cash-value life insurance policies, besides the tax benefits, is because these accounts are typically protected from creditors. However, physicians can also protect general investment accounts from creditors using various legal frameworks such as limited family partnerships or LLCs (laws governing these tools vary state-by-state, so check with a CPA or attorney).
Accessing Retirement Accounts Early and Without Penalties
Should you need or want to access a qualified retirement plan (401(k), IRA, etc…) before 59½ without the accompanying hefty penalty, you can do it under the IRS’s 72T rules.
Under 72T rules, individuals can access a certain percentage of qualified retirement accounts each year. The catch is two-fold:
- The exact percentage individuals are allowed to access is determined by the IRS based on current age and life expectancy.
- Individuals who access retirement accounts early must withdraw the same amount for five consecutive years or until age 59½ – whichever is later.
However, you can still continue to work while using your retirement as a supplement.
Scenario #2: Buying a Big Ticket Item
If you’ve always wanted a condo on Rivera Maya or a yacht, with the financial rewards of being a successful physician, you should be able to make that a reality without being financially irresponsible.
Start with a Plan
Regardless of what you are saving or investing for, start with a plan. Even if the time horizon for achieving the goal is short, plan on investing rather than parking the money in a savings account which won’t provide any growth.
Plan on putting at least 20 percent down on any purchase.
Financing Your Fun – A Second Look at Home Equity Loans
After the housing crash and ensuing financial crisis, home equity loans got a bad rap. Indeed, many people found themselves in deep financial trouble after using their house as an ATM. But generally, medical professionals are high earners in high-demand, stable occupations.
If you have significant equity in your home, using it to finance a second home or other big ticket expense is often the most practical, cost-effective way to buy. In fact, it may even be a better option than cash if you’re purchasing an appreciating asset such as property. Here’s why:
- Home equity loans carry better interest rates than a new loan from a financial institution.
- The interest expense on home equity loans is tax deductible.
- If adding a monthly payment to your budget isn’t a big deal, using the bank’s money at 5 percent interest is likely preferable to using all your own cash, which could be earning 8 percent interest in an investment account.
Of course, you should never get fully leveraged on your home, but if you have $600,000 equity in a $1 million home, taking out $250,000 to buy a dream may be reasonable.
Scenario #3: Setting Your Kids Up for Success with a College Savings Plan
Physicians value education, and there are few things more important than your children’s education. Regardless of your specialty or how many children you have, the fact of the matter is that your kids will not receive any type of need-based financial aid no matter how expensive the college is.
Financing Higher Education Easy as 5, 2, 9
Over the decades, various states have offered various savings plans to entice parents to start a college savings plan. The 529 College Savings Plan is one of the best vehicles for saving for the rising cost of a college education. Most states offer their own 529 vehicles handled through an outside investment firm, but administered through the state treasurer’s office.
There are a number of benefits to the 529:
- While 529 contributions are not federally tax deductible, most states allow part or full deduction on state income taxes.
- 529 plans grow tax free and can be withdrawn and used for qualified education expenses tax free.
- In some states, 529 plans are creditor protected.
Typically, you can start a 529 through the state website or a financial advisor. Generally, states allow anyone – resident or not – to invest in their 529 plan, so don’t feel obligated to purchase your state’s 529 plan. Shop around. However, some states will tax earnings on an out-of-state 529 plan and may not allow the tax deduction on the contributions to an out-of-state plan.
Of Eggs and Baskets
Just as with your retirement, you probably shouldn’t go all in saving for college through a 529 plan. It’s a great tool, but again, consider a general investment account with investments designated for college as a supplement. This will give you more flexibility, as 529 plans can only be used for qualified education expenses. If the funds are withdrawn for reasons other than for qualified education expenses, the earnings will be taxed as income plus a 10 percent penalty.
Remembering Why You Work
Being financially successful should be about more than having a comfortable retirement. As a medical professional, you are keenly aware that lives can be altered forever in a moment. So don’t feel like you have to wait to retire to enjoy your success. With the right strategies, you don’t.
1. “3 in 4 Physicians Could be Contemplating a Career Change.” 2016. HealthLeaders Media.http://www.healthleadersmedia.com/physician-leaders/3-4-physicians-could-be-contemplating-career-change