Three ways to make the best of a bad (401k) situation | W. Ben Utley CFP® writes for Orthopreneur

We see the changes that physicians make to improve their financial security, but one item is usually beyond their control: their 401(k) plans. Unless you are self-employed, there is practically nothing you can do about your 401(k)’s underwhelming investment options, ridiculously low contribution limits or perverse tax consequences. If your 401(k) is your main (or maybe your only) investment vehicle for retirement, we have good news for you. It is possible to work around your 401(k) plan’s limitations, so that you can get back on track toward retirement.

Low Limits Many physicians operate under the mistaken belief that if they max out their 401(k) plan contributions, they will be set for retirement. But did you know that the maximum amount of money you can elect to defer into your 401(k) this year is only $17,500 ($23,000 if you will be age 50 or older by December 31)? That’s roughly $1,400 deducted from your paycheck each month ($1,900 per month if you are age 50 or older).

Have you ever met a physician who could live well on $1,400 a month? We haven’t. In fact, the physicians whom we serve are planning to spend more like $10,000 per month in retirement, and that’s after tax. It would take a miraculously high rate of return to turn $1,400 per month pre-tax into $10,000 per month after-tax. As you can see, many physicians are well on their way to a retirement disaster.

To improve your odds of reaching your retirement goal, you can save outside of your 401(k) plan. Even if you cannot deduct the contributions you make to a Traditional IRA, you can still contribute $5,500 this year ($6,500 if you will be age 50 or older by December 31), and if you max out your own IRA, your spouse can also contribute up to $5,500 to his or her IRA ($6,500 if he or she will be age 50 or older by December 31), even if they are not earning an income. Depending upon your tax situation, it might also make sense to convert these contributions to a Roth IRA, doing what is known as a backdoor Roth IRA contribution. Once the money is in a Roth IRA, it can grow tax-free for the rest of your life. Of course, this still might not be enough to allow you to retire comfortably, so you should consider investments outside of your 401(k) plan and IRAs.

Underwhelming Options You probably haven’t read the fine print behind your 401(k) plan, but you are betting that your practice manager has carefully vetted both your 401(k) plan provider and the investments offered inside your plan. Don’t believe it! We have found that busy managers either fail to read the fine print or lack the experience to understand what they have read. Despite new laws requiring plain English disclosures of investment-related fees, many employers continue to keep physicians locked into expensive plans with unpalatable investment options.

If your plan charges more than 50 basis points (0.50 percent) on top of mutual fund operating expenses, your plan’s costs are draining an unfair share of your retirement savings. To get this under control, you need to raise your voice, but carefully. We regularly see very expensive plans that persist simply because of office politics.

It’s more common to see an investment lineup consisting mostly, if not entirely, of actively managed mutual funds. This is a sign of ignorance on the part of your plan fiduciaries. At a time when most prudent investors recognize that passively managed index funds have been shown to have delivered better results at a lower cost than the average actively-managed fund, there’s no good reason that your plan should continue to limit you to subpar investment options.

To work around these issues, look at your retirement investments holistically. Think about your 401(k) plan, your Traditional IRAs and your after-tax accounts (mutual funds and brokerage accounts) as if they were all one retirement portfolio. Then use the least-bad investment options from your 401(k) and pair them with the best options available within other accounts that make up the balance of your portfolio.

Tax Time Bomb You already know that physicians pay more than their fair share of taxes. But did you know that you are probably setting yourself up to pay more taxes on your 401(k) than you really should? That’s right. There’s a perverse little wrinkle in the tax code that can turn your 401(k) plan into a tax time bomb.

To understand this trap, you need to know a little bit about how investments are taxed. Withdrawals from your 401(k) plan will be taxed at your marginal income tax rate, which may be as high as 39.6 percent for Federal income tax. At the same time, capital gains and qualified dividends from mutual funds held in taxable accounts outside your 401(k) plan are taxed at a maximum Federal rate of 23.8 percent (which is 20 percent plus the new 3.8 percent Medicare surtax).

This means that your 401(k) nearly doubles the tax rate you pay on capital gains and qualified income by effectively converting these tax-favored returns into tax-trapped ordinary income. Consider holding equity mutual funds in a taxable account, or better yet, own them in your Roth IRA or the Roth subaccount of your 401(k) if you have one.

If your 401(k) is a lousy place to stash your stock funds, what should you hold there instead? Consider low growth, income-producing investments, including bond funds and stable value funds. If you have an appetite for more aggressive fare, consider high yield (junk) bond funds or emerging market bond funds. Outside of your 401(k) plan, these investments may be taxed at your highest marginal rate, so it’s a good idea to protect your income by keeping it inside of the tax shelter of your 401(k) plan.

Again, the best workaround for this tax trap is to view your entire retirement portfolio, including your 401(k) plan, your IRAs and your other accounts that are earmarked for retirement, as one portfolio. Choose to own the best investments in the accounts that make the most sense from the standpoint of expense, risk, return and taxation.

Summary Even if you are stuck with a stinky 401(k) plan, you can still make the best of a bad situation. All you have to do is take a look at the big picture, think outside the box and make smart moves to put yourself on track for a solid retirement.


W. Ben Utley, CFP®, is an attending advisor with Physician Family Financial Advisors, a fee-only financial planning firm helping physicians throughout the U.S. to save for college and invest for retirement.

Lawrence B. Keller, CFP®, CLU®, ChFC®, RHU®, LUTCF, is the founder of Physician Financial Services. Based in New York. He offers income protection and wealth accumulation strategies for physicians nationwide.

This article originally appeared in Orthopreneur with the title "Overcome 401 (k) LImitations: Three Ways to Make the Best of a Bad Situation".

Ins and outs of "backdoor" Roth IRA contributions for physicians

Roth IRA's are powerful tax fighting vehicles most physicians can use to save for retirement, yet many doctors haven't the foggiest notion about Roth IRA's and next to none of them understand the "backdoor Roth IRA contribution" that makes a Roth IRA possible. Now you can be the first kid on your block to "get" the Roth IRA thing. Keep reading...

 What is a Roth IRA? and why should physicians care?

The Roth IRA is one of the most powerful tax deferral vehicles a physician family has at its disposal. Two features make them great:

  1. Roth IRA's grow tax-free… forever. Unlike Traditional IRA's, you can leave the money in your Roth IRA until the day you die. There are no required minimum distributions that would otherwise begin at age 70 1/2.

  2. Qualified Roth IRA distributions are tax-free. For most physicians, that means you can spend the money after you've reached age 59 1/2 and pay zero income taxes.

Every nickel you cram into a Roth IRA has the potential to grow like a weed and never, ever be taxed. Traditional 401ks, municipal bonds and variable annuities cannot lay that claim.

 So why doesn't every physician have a Roth IRA?

It's simple: the average doctor is not allowed to make a direct contribution to a Roth IRA, so they don't contribute. The IRS says that physician families (married, filing jointly) who earn more than $188,000 (in 2013) are NOT ELIGIBLE to make a diret contribution to a Roth IRA. Period.

Don't worry. You can still get money into a Roth IRA using a "backdoor" contribution. Even though this tax planning strategy has been covered by The Wall Street Journal and explained in excruciating detail by The Journal of Accountancy , many financial advisors and tax preparers still overlook it. If it's news to you, you're not alone.

 Which doctors should install a backdoor to their Roth IRA's?

You're a good fit for a backdoor Roth IRA contribution if:

  • you don't qualify to make a direct Roth IRA contribution (as above),

  • you are covered by a retirement plan at work, and

  • you have already maxed out your tax-deductible contributions to that plan.

 What exactly is a "Backdoor Roth IRA"?

Truth be told, there is no such thing as a "Backdoor Roth IRA". What I'm saying here is that there are still only two kinds of IRA's: Traditional, and Roth. Your Backdoor Roth IRA is nothing more than a regular old Traditional IRA that you yourself earmark as a "backdoor" to get money into your Roth IRA.

 How does the backdoor Roth IRA contribution work?

In the simplest case, it goes like this:

  1. Dr. Young and her husband have never saved a dime for retirement, so she has a zero balance in her retirement accounts at the beginning of this example.

  2. She starts work at a clinic making $300,000 per year, where she also maxes out her 401k or 403b plan.

  3. She opens both a Traditional IRA and a Roth IRA.

  4. She contributes $5500 to the Traditional IRA and, because she is covered by a retirement plan at work, she cannot deduct this contribution from her taxes and receives no immediate tax benefit.

  5. She then completes a one-page form known as a Roth Conversion Form and submits it to her brokerage.

  6. The brokerage removes or "distributes" the money from her Traditional IRA and plops it into her Roth IRA, thus completing the conversion.

  7. Voila! Dr. Young has pushed cash through her Traditional IRA into her Roth IRA via a Roth conversion, thus making an indirect contribution through the "backdoor".

  8. Early next year, her brokerage sends her a Form 5498 showing that she made the Traditional IRA contribution and a Form 1099-R showing that she made a distribution from that Traditional IRA.

  9. In April of next year, Dr. Young diligently reminds her tax preparer that she made a backdoor Roth IRA contribution so that she will not owe tax on the $5500 that was distributed from her Traditional IRA.

  10. She does the whole thing over again next year.

 Is the backdoor Roth IRA really that simple for the average physician?

In a word, the answer is "no". Most physicians already have a Traditional IRA and there is money in that account from either fully deductible contributions, rollover contributions, or both. This matter is more complicated when a self-employed physician owns a SEP-IRA or SIMPLE-IRA, both of which are counted as IRA's for the sake of Roth conversions.

When you do a Roth conversion, you cannot pick and choose which part of the IRA to convert, so physicians in this situation need to exercise great care (or get help from a great financial advisor) to avoid triggering a huge tax bill.

Here's an example of how NOT to do the backdoor Roth IRA contribution:

  1. Dr. Old has a Traditional IRA that holds $44,500 that was rolled over from an old 401k and he also has a $50,000 SEP-IRA that he started last year.

  2. He contributes $5,500 to his Traditional IRA account, bringing the balance up to $50,000.

  3. He then converts $5,500 worth of the Traditional IRA to a Roth IRA, thinking he won't owe any taxes on his backdoor contribution.

  4. When April 15 rolls around, Dr. Old is shocked to learn that 94.5% of the $5500 he converted is going to be taxed as ordinary income, since only 5.5% of the conversion is treated as "basis" from his recent non-deductible contribution. (The basis is $5,500, but it's only 5.5% of the overall IRA balance which now stands at $100,000 because the SEP-IRA and all of the rollover amount in the Traditional IRA is included in the calculation).

Roth IRA conversions obey what tax guru Ed Slott refers to as the "cream in the coffee" rule. When you take a "sip" from your Traditional IRA by converting some of it to a Roth IRA, you cannot choose to drink only the cream (the non-deductible portion). You must also drink a lot of the coffee itself (the tax-deductible portion), so be careful as you set up your backdoor Roth IRA contributions if you have a bunch of money in your IRA's already.

How to fix your broken backdoor

Some physicians will be able to avoid the "cream in the coffee" prorata taxation thing I mentioned above by rolling their old Traditional IRA into their 401k or 403b plan at work if their employer's plan allows it. This requires a lot of paperwork and planning but I believe the end result, a fat Roth IRA, is well worth the effort.

And before I go, let me leave you with one more tip. Your Roth 401k is NOT the same as your Roth IRA. Making contributions to aRoth 401k at work is probably a really bad move for the average physician. Most physicians will be better off making contributions to the Traditional sub-account of their 401k/403b since this allows you to defer taxes into retirement when you may be in a lower tax bracket.

Every physician family's backdoor Roth IRA contribution strategy is different and each one seems to have its own cute little twist, so make sure you really know what you're doing before you dive in, or ask your tax guru and your financial advisor to team up to make this easy for you.

Many thanks to Janet Davis, a Certified Public Accountant who works with physician families, for fact checking my post.

9 Questions Physicians Should Ask Before Enrolling in a Retirement Plan at Work

Physicians know there are only two certainties in life: death and taxes. But actually, there is a third: retirement. It’s that period right before death, and right after taxes.

And since you are going to retire some day, you might as well enroll in your employer’s retirement plan (or your retirement plan if you are self-employed).

But before you do that, you should get the answers to a few questions about each plan.

  1. What kind of plan is it? There are two main types of plans. The most common type are defined contribution plans that start with a “4”, like 401k, 403b, 401a, 457b and 457f. (All of these number/letter combinations refer to sections of the Internal Revenue Code.) Defined contribution plans limit the amount you can contribute. On the other hand, “defined contribution” plans limit the amount of money you can expect to receive at retirement. These may include “pension” plans like a cash balance plan.
  2. Can I control how much money goes into it? A no-brainer question, right? Wrong. If you have a 401a or 457f plan, your employer makes the contribution and they decide how much goes into the account.
  3. What is the maximum amount I can contribute each year? For most defined contribution plans, the limit will be $17,500 per participant in 2013 with a $5,500 “catch up” allowance for physicians aged 50 and over. Defined contribution plans, however, may allow you to contribute more than $100,000 per year.
  4. Does it have a Roth component? The answer to this question really depends on the language in your plan (see your Summary Plan Description) but many 401k’s and 403b’s have a Roth component. Generally speaking, it’s a mistake for physicians to contribute to the Roth portion of the plan, or to do an in-plan Roth conversion.
  5. Who is the custodian? The word “custodian” means “the company who is holding your money.” For example, your money might be with Fidelity or Vanguard or Principal or TIAA-CREF. Every custodian has strengths, weaknesses and idiosyncrasies.
  6. Who is responsible for the investment decisions? In some cases, your employer might appoint an advisor to manage your money. In other cases, the onus is on you to take care of it.
  7. What investment options are available? Some plans offer as few as six options, while others offer dozens or hundreds of options. Some will offer actively managed mutual funds while others offer low-cost index funds from Vanguard or even exchange-traded funds. Choosing the right options will help you earn a better return and save money on investment-related expenses.
  8. If I leave this employer, can I rollover my money to an IRA? Some deferred compensation arrangements, like Section 457 plans, may not allow you to make an IRA rollover and may require you to take all of your money with you when you retire or move on to another job.
  9. What happens if my employer becomes insolvent or goes bankrupt? Certain plans—including 457b and 457f plans—may have a “substantial risk of forfeiture” that puts your entire account balance at risk, regardless of how it is invested. In these situations, you could lose all of your money if the employer goes bankrupt, so read the fine print before you enroll in the plan.

 If you do a little due diligence before you invest, you can save yourself a lot of time and money after you have made the decision to enroll in the plan. Ask your H.R. person for a Summary Plan Description and read it before you sign up.