Comparing Retirement Accounts

Transcription

1 Comparing Retirement Accounts When I speak at conferences, I often use a slide entitled Suitcases and Swimsuits to demonstrate the difference between investments (the clothes) and the accounts they can be put into (the luggage.) You can put any type of clothing into any type of bag. This helps docs understand the difference between retirement/investing accounts like Roth IRAs, 401(k)s, and defined benefit plans and investments like stocks, bonds, and mutual funds. One difference I have found among physician investors compared to those with lower incomes is the great difficulty they have in understanding all these different types of accounts and using them effectively. For Joe WhiteCollar with an income of $50-100K, pretty much all of his retirement savings goes into his 401(k) at work and maybe a Roth IRA on the side. He probably doesn t even max those accounts out and certainly doesn t need to get creative in looking for other accounts. A physician trying to put $50,000, $100,000 or even more toward retirement each year, however, is a different story. In this post, I m going to compare the various types of retirement accounts by quality of the available investments, tax shelter features, cost, asset protection features, estate planning features, and bonus features. In the overall weighting, I ve doubled the value of the investments, the tax shelter, and the costs as these are the most important aspects of a retirement account. I m hoping having this information together in one place will help people get a grip on these various types of accounts, and which ones they would like to use for their individual situations. This is a very long post, and if you just want the bottom line, well, skip to the handy summary chart at the bottom of the post.

2 Comparing Retirement Accounts: Individual (or Solo) 401(k) Investments You can easily purchase essentially any stock, bond, mutual fund, ETF, or similar asset including low-cost Vanguard index funds. Depending on where you open your Individual 401(k), there are some minor limitations that probably won t matter to you. Direct real estate investing is difficult in an IRA, but nearly impossible in an Individual 401(k), thus the reason it only gets 4 stars. Tax Shelter If there is a better tax shelter out there, I m not aware of what it is. Your entire contribution (up to $52,000 per year) is deducted from this year s taxes, essentially splitting the account into a portion that belongs to you and a portion that belongs to the government. Your portion then grows tax-free until the time of withdrawal, perhaps years away, longer if a stretch IRA is then used. As an additional bonus, you can reclaim a significant chunk of the government s portion of the account if your effective withdrawal tax rate is lower in retirement than your marginal tax rate at contribution during your peak earning years, which is quite likely, even if rates go up. As if that isn t good enough, you can also get an Individual Roth 401(k) option. It s hard to beat an Individual 401(k) as a tax shelter. Cost One of the main benefits of an Individual 401(k) as compared to a 401(k) offered by an employer is that it can be much cheaper. The ability to minimize costs by choosing your 401(k) provider and your individual investments wisely may be worth hundreds of thousands of dollars over time for the typical physician.

3 Asset Protection While asset protection law is state-specific, 401(k) assets are generally totally protected from creditors, and often receive slightly better protection than an equivalent IRA. Estate Planning The ability to designate beneficiaries (thus avoiding probate) and stretch a 401(k) (via conversion to an IRA) make these retirement accounts a no-brainer from an estate planning standpoint. Flexibility One downside of traditional retirement accounts is that it can be tricky to get to the money before retirement without paying a penalty. However, since this is RETIREMENT money we re talking about anyway, I don t see that as a huge issue. Plus, there are so many ways to withdraw it without penalty, that I think this is almost a non-issue. However, once you re over age 70, you ll be required to withdraw Required Minimum Distributions. These restrictions decrease your flexibility, so only 2 stars for this category. Bonus There are not a lot of bonus features here, but some Individual 401(k)s do allow you to borrow money. Overall Cost 1/4 There are no perfect accounts, but the Individual 401(k) is about as close as they come.

4 Employer-offered 401(k) or 403(b) Investments In reality, the investments available in your employer s 401(k)/403(b) may be 1 star or 5 star. There is a great deal of variability. And forget about the types of alternative investments you could get in a self-directed IRA, real estate, or small businesses. So 3 stars on average. Tax Shelter Still a good tax shelter, but the fact that employees are usually limited to deducting just $17,500 ($23,000 if 50 or older) [Update 2018: Annual 401k contribution limits have been raised to $18,500 and to $24,500 if 50 or older.] is a serious difference from using an Individual 401(k), SEP-IRA, or Profit-sharing plan. You still get the up-front tax break, tax-free growth and tax-rate arbitrage of course, just not on as much money as you otherwise could get if you were in business for yourself. Roth 401(k)/403(b) options may be available. Cost Again, there is a great deal of variation in 401(k) fees and expenses. I have a pretty good 401(k) (not quite as cheap as my Individual 401(k), but many of them absolutely stink with only expensive funds available and many add on fees. 3 stars on average. Asset Protection While asset protection law is state-specific, 401(k) assets are generally totally protected from creditors, and often receive slightly better protection than an equivalent IRA. Estate Planning

5 The ability to designate beneficiaries (thus avoiding probate) and stretch a 401(k) (via conversion to an IRA) make these retirement accounts a no-brainer from an estate planning standpoint. Flexibility 1/2 Similar to above, except you usually can t do a rollover to a better plan until you separate. Bonus Just like with an individual 401(k) you can usually take a loan of 50% of the balance up to $50,000. You also may be eligible from a match from your employer. Not getting that is like leaving part of your salary on the table. Overall 1/2 Overall, a great retirement account you should probably be maxing out. Profit-Sharing Plan Investments Similar to above Tax Shelter Many doctors have a Profit-Sharing Plan combined with a 401(k), with the main benefit that they can save $52K per year instead of just $17.5K. Since these doctors are often partners as well, they are usually able to get better investments and lower fees than a typical employer offered 401(k), so one more star in all 3 of those categories.

6 Cost Similar to above Asset Protection Similar to above Estate Planning Similar to above Flexibility Similar to above. Bonus Loans usually available, but like with a straight 401(k), often limited to the lesser of 50% of the balance or $50,000. Overall Better than a 401(k) due to the higher contribution limits. SEP-IRA Investments 1/2 Essentially any paper asset can be put into a SEP-IRA, and using a self-directed IRA, you can often get hard assets like precious metals or real estate in there. There aren t quite as many options as a taxable account, but it s pretty darn close. Tax Shelter Although you can still shelter $52,000 [Editor s Note: $55,000

7 for 2018] like with an Individual 401(k), you need to have a higher income to do so when using a SEP-IRA. Plus, you can t do a Backdoor Roth IRA, generally making a SEP-IRA inferior to an Individual 401(k) for the self-employed. There is also no such thing as a Roth SEP-IRA. Cost The ability to minimize costs by choosing your SEP-IRA provider and your individual investments wisely may be worth hundreds of thousands of dollars over time for the typical physician. Asset Protection While asset protection law is state-specific, IRA assets are generally totally protected from creditors, although protection may be slightly less when compared to 401(k)s. Estate Planning The ability to designate beneficiaries (thus avoiding probate) and stretch the IRA make these retirement accounts a nobrainer from an estate planning standpoint. Flexibility Although you still have the age 59 1/2 requirements to get around and RMD issues, you can roll a SEP-IRA into a traditional IRA at any time, improving your investment options further. Bonus Can t borrow from an IRA. Overall A SEP-IRA is a great option, but I see little reason to use one over an Individual 401(k).

8 SIMPLE IRA Investments Essentially any paper asset can be put into a SIMPLE-IRA. You are usually limited to the mutual funds available at the SIMPLE-IRA provider. Depending on the provider, that might be pretty good or pretty poor. Tax Shelter One of the biggest downsides of a SIMPLE over an individual 401(k) or a SEP-IRA is the low contribution limit, just $12,000 per year ($14,500 if over 50.) That s quite a bit less than even an employer-provided 401(k). It also screws up your Backdoor Roth IRA pro-rata calculation and there is no Roth option. Cost If at a good provider, could be quite low. If not, may be relatively high. Asset Protection Similar to above Estate Planning Similar to above Flexibility 1/2 Age 59 1/2 requirements and RMD issues limit you to just 3 stars. You can do a rollover into a traditional IRA without separating, but must wait at least 2 years to do so.

9 Bonus Can t borrow from an IRA. Overall The only reason doctors might use a SIMPLE IRA is if they have a lot of employees and are trying to avoid 401(k) associated expenses and hassles. Probably not a wise move. I only included this one in the list for completeness sake. Traditional IRA Investments 1/2 Not quite as many options as a taxable account, but pretty close. Tax Shelter If you don t have a retirement account at work, these deductions are deductible to you. But otherwise, most physicians make too much to deduct personal or spousal contributions to traditional IRAs. You also have to deal with age 59 1/2 requirements and RMD issues. The only reason most doctors in their accumulation years should have a traditional IRA is to do Backdoor Roth IRA contributions. Cost Since you re in control, you can go to a low-cost provider. Asset Protection Similar to above Estate Planning

10 Similar to above Flexibility Age 59 1/2 requirements and RMD issues are present, but at least you can easily roll it over to another provider at any time. Bonus Can t borrow from an IRA. You can do spousal contributions without any spousal earnings. Overall Not very useful for a high earner during peak earnings years primarily due to the income limit. Roth IRA Investments 1/2 Not quite as many options as a taxable account, but pretty close. Tax Shelter While there is no up-front tax-break (and thus no arbitrage), Roth IRA contributions are never taxed again, which is pretty darn valuable. Because you re contributing after-tax dollars but the contribution limits are the same, you re also able to contribute more money on an after-tax basis than a comparable non-roth account. There is a little bit of a hassle for high earners, but thanks to the backdoor Roth IRA workaround, this can usually be worked out. Cost

11 Since you re in control, you can go to a low-cost provider. Asset Protection Similar to above Estate Planning Similar to above, except a Roth IRA is even better to stretch than a Traditional IRA, not to mention is free of RMD restrictions. Flexibility Age 59 1/2 requirements still in place, but contributions can come out any time, making this among the most flexible of all retirement accounts. You can also withdraw earnings for a handful of other reasons without any penalty or tax. Bonus Can t borrow from an IRA, but since you can withdraw money for just about any reasonable use without penalty or tax, it s still pretty nice. You can also do spousal contributions without any spousal earnings. Overall 1/4 This highest-scoring retirement account should be used by any physician (and/or spouse) able to do the Backdoor Roth IRA. 457 Account Investments Completely employer dependent. Could be 4 star, but often only high expense mutual funds available. Tax Shelter

12 Just like a 401(k) or 403(b), these contributions are taxdeferred, so you get tax-free growth and probably an arbitrage on the tax rate at contribution and at withdrawal. Cost Completely employer dependent. Asset Protection These assets are completely protected from your creditors, however, they are accessible by your employer s creditors. While I think most doctors still ought to use these plans due to the tax benefits, some choose not to as they are concerned their employer may go out of business! Estate Planning Similar to other retirement accounts in that beneficiaries can be named to avoid probate. Many 457s can also be rolled into IRAs and stretched. Flexibility Unlike most retirement accounts, there is no Age 59 1/2 requirement, but there are RMDs. You can start withdrawing money as soon as you separate from your employer. Bonus Loans generally not available. Overall 1/4 Not the greatest retirement plan in the world, but most who have access to them should probably be using them as their options are limited. Defined Benefit Plan

13 Investments While the investments are often just fine in these plans, you have very limited control over them. Tax Shelter Just like a 401(k), these contributions are tax-deferred, so you get tax-free growth and probably an arbitrage on the tax rate at contribution and at withdrawal. Although dependent on many factors, you may also be able to shelter vast quantities of money from taxes using a DBP, up to $100, ,000, giving this one a full five stars as it can be the largest of all tax-deferred retirement accounts. Cost Although these costs can be reasonable, they are almost always more than a typical 401(k) because it takes a lot more paperwork (and actuarial input) to run these plans. Asset Protection Like most retirement plans, protected from creditors in most states. Estate Planning Since most of these stop paying when you die, they have little benefit for estate planning. However, if you roll the assets into an IRA, those can have a beneficiary and stretching. Flexibility Contributions and withdrawals tend to be very inflexible compared to most defined contribution plans. Bonus

14 No loans, but there may be some useful withdrawal options available, including a rollover to an IRA upon separation. Overall Like a 457, probably shouldn t be your first choice. But for someone looking for additional tax deferral, a DBP may be worth the downsides. Health Savings Accounts (Stealth IRA) Investments Most of what you can buy in an IRA can be bought in an HSA. Tax Shelter The only triple-tax free account. Contributions are pre-tax, the account grows in a tax-protected manner, and if spent on health care (either in the year you make the withdrawal or in prior years), are withdrawn tax-free. Cost Easy to find low-cost options. Asset Protection Asset protection law still not entirely clear in most states, but probably not protected unless in Florida, Mississippi, Oregon, Tennessee, Texas, and Virginia. Estate Planning Beneficiaries can be named, helping you avoid probate. And if you leave the HSA to your spouse, it continues to be an HSA. However, for any other beneficiary it is fully taxable income in the year of your death.

15 Flexibility Since you can spend this money on health care at any time without tax or penalty, and on anything you want without penalty after age 65, these are pretty flexible accounts. Of course, you have to have a high deductible health plan in order to make the contribution in the first place. Bonus No loans or rollovers to other accounts, but you can move from one HSA provider to another. Overall 3/4 Another great supplementary retirement plan many doctors should be using. The Taxable Investing Account Investments The most flexible of all investing accounts. Real estate, stocks, bonds, mutual funds, precious metals, beanie babies you name it, you can buy it. Tax Shelter 1/2 While obviously completely unsheltered from taxes, there are so many exceptions to the rule that this account still gets 2 1/2 stars. Real estate has numerous tax advantages. Taxefficient investments like I-Bonds, municipal bonds, and stock index funds minimize any tax due, as does a buy and hold philosophy. Tax-loss harvesting and donating appreciated shares to charity can further decrease the tax bill. The stepup in basis at death also can eliminate a great deal of longterm capital gains tax. Cost

16 Easy to find low-cost options. Asset Protection While there are some options like UGMAs, family limited partnerships, LLCs, and certain types of trusts, there is essentially no asset protection for taxable assets. Buy insurance. Estate Planning The step-up in basis at death is awesome, but you re going to want to place these assets into a revocable trust if you don t want them going through probate. Flexibility Exceedingly flexible, although if you have low basis (an are thus facing high capital gains taxes), you might want to think twice before selling something, especially if passing them to heirs via the step-up in basis is an option. Bonus You could borrow using the assets as collateral instead of liquidating them. Overall 1/2 You ll notice this account is ranked higher than many of the other retirement accounts. Many doctors use a taxable account as part of their retirement savings strategy. Variable Annuity Investments There is a great deal of variability in investments available

17 in VAs. The Vanguard VA offers investments similar to its best index mutual funds. Tax Shelter I actually consider a VA WORSE than a typical taxable account as a tax shelter. There is no tax-loss harvesting, no step-up in basis, and no donation of appreciated shares to charity. When you pull money out of a VA it is taxed at your regular marginal rate instead of the lower qualified dividends/longterm capital gains rates. To make matters worse, when you pull money out of a VA, the earnings come out first and the principal last. The only tax benefit of a VA is that it eliminates the tax-related drag on growth of the investment. That s worth less than 0.5% on the most tax-efficient investments, which is usually a much lower figure than the fees associated with the VA. Cost Although there are some low cost options like Vanguard and Jefferson National, the cost of an investment like Total Stock Market Index Fund in a Vanguard VA is still nearly 10 times the cost of it in a taxable account. Most VAs have expenses that make terrible mutual funds look good. Asset Protection Some states do provide significant asset protection for VAs, but it is generally markedly inferior to both retirement accounts and cash value life insurance. Estate Planning You can name beneficiaries (thus avoiding probate) but if the beneficiary isn t your spouse, they will be limited to taking a lump sum, taking payments over 5 years, or annuitizing the

18 contract immediately, none of which are particularly attractive compared to stretching an IRA. The VA earnings are subject to income and estate tax with no step-up in basis. Flexibility VAs are subject to the Age 59 1/2 rule and you will probably need to do a 1035 exchange if you wish to change VA providers or investments. Bonus No borrowing from VAs. Overall One of the worst retirement accounts out there. Most physicians will find little need for these, even if using a low-cost VA holding very tax-inefficient assets like REITs or TIPS. Whole Life Insurance Investments Whole life is such a terrible investment that those who sell it don t even like referring to it as an investment. Expect negative returns for the first decade. If you hold it for your entire life, expect guaranteed returns of around 2% and projected returns of 4-5%. Not besting inflation despite holding the investment for 4-5 decades is a real possibility. Tax Shelter After-tax dollars are used to pay whole life premiums. The money grows in a tax-deferred manner. If you surrender the policy, all earnings are fully taxable at your marginal rate. You can borrow from the policy in a tax-free, but not interest-free, manner. Although often sold as a tax shelter,

19 it is markedly inferior to traditional retirement accounts like 401(k)s and Roth IRAs in this aspect. Upon death, the death benefit is income, but not estate, tax-free. Cost Perhaps the worst aspect of whole life insurance is the high expenses. The commissions are approximately % of the first year s premium. There are administrative and insurance related costs that cause the investment to require years just to break even. Asset Protection Most states provide at least some protection from your creditors for cash value life insurance. However, state guaranty corporations usually only protect something like $250,000 from insurance company failure. Despite statements to the contrary, many life insurance companies failed in the Great Depression and there was a 6 month insurance holiday where investors were unable to get their cash value. Overall, 3 stars. Estate Planning Whole life insurance can be pretty handy for estate planning. Heirs get the death benefit income tax-free and the policy can provide liquidity that may be needed to pay estate taxes or split up particularly illiquid estates. Buying a policy in an irrevocable trust can also help avoid estate taxes. Flexibility Whole life insurance proponents love to point out all the stuff you can use a whole life policy for. You can spend dividends, use them to reduce required premiums, or use them to purchase more insurance. You can borrow from the policy before or after age 59 1/2 to provide spending in early

20 retirement. You can also exchange the cash value into another life insurance policy, a VA, or even long-term care insurance. However, these options are really only useful AFTER you ve been making payments for decades, which must be made or the policy lapses. Surrender fees are heavy, and if you change your mind about the policy in the first decade you will almost surely take a loss. 80%+ of those who purchase these policies surrender them prior to death, almost ensuring a poor investment outcome. Like a marriage, you should go into a whole life policy with your eyes wide open, because if you want out before death it is going to be very expensive. Bonus You can borrow some of your cash value from your policy at any time. Although these products have very high expenses, those expenses do purchase you something- a death benefit in case you die early. Overall 1/2 WL is a relatively inferior retirement account, even when compared to a fully taxable account, primarily due to low returns, high costs, and lack of flexibility in the early years of the policy. The rare physician who places high value on the death benefit or estate planning benefits may find a use for it. Variable Life Insurance Investments The vast majority of variable universal life insurance (VUL) policies contain terrible, expensive investments. There are a couple of them that use Vanguard, DFA, and TIAA-CREF based investments however. Since the investments range from one star to 5 stars, I ll give 3 for this category. This is the main advantage of VUL over WL.

21 Tax Shelter Similar to above. Cost Similar to above. The best policies minimize costs, but compared to low-cost taxable or retirement accounts, any VUL has very high expenses. Asset Protection Similar to above Estate Planning Permanent life insurance can be pretty handy for estate planning. VULs are less useful than whole life as returns are less predictable Flexibility Another benefit of universal and variable life insurance over whole life is the flexibility of changing the death benefit and premiums due. However, with that flexibility comes the possibility of having a policy fail (and causing earnings to become taxable) if earnings are poor or too much is borrowed from the policy. Bonus Similar to above Overall 3/4 While VUL can be significantly better than a WL policy, it is absolutely critical that you buy a good policy with low expenses and good investments. A bad VUL (the vast majority) is an absolutely horrid retirement account.

22 The Overall Rankings Account Investments Tax Shelter Cost Asset Prot Est. Plan Flexibility Bonus Overall Solo 401(k) (k)/403(b) / PSP SEP 4 1/ SIMPLE / Trad. IRA 4 1/ Roth IRA 4 1/ DBP H.S.A Taxable 5 2 1/ VA WL VUL Agree with my rankings? Disagree? Which accounts do you use and why? Comment below!