We’ve spent a bunch of posts discussing how to invest wisely in the stock market.
But where do we invest that money?
To review, save at least 20% of your income. Invest in broadly diversified low-cost index funds along with bonds and possibly real estate according to your chosen asset allocation. Then re-balance yearly.
Follow that advice above and you will be fine. It’s that easy.
But there stills remains the question of where to put your investments. The where consists of the various types of accounts that you can utilize to invest.
These accounts are the buckets that you put your money into. Within each bucket, you can choose the type of investment that you would like to invest in…like broadly diversified low-cost index funds.
Each account, or bucket, has special features, advantages, and disadvantages.
In this post, I’ll review some of the more common accounts available to most people, especially physicians, as well as their pros and cons.
The first account we’ll review is a taxable investment account.
This is the account that you probably think of when you image investing your money in the stock or bond market. This account does not carry any special considerations from the government or IRS.
Anyone can open one of these accounts by signing up for one on Vanguard (my recommendation), Fidelity, or any other brokerage.
In general, the money that you put into this account has already been taxed (post-tax money) and any money made in the account is taxed when you take it out via capital gains taxes (long term capital gains taxes for money left in the account greater than 1 year are less than short term capital gains taxes).
However, you can remove the money from the account at any time without a penalty. Other accounts, as you will see, have age limits for withdrawal. Take money out before a certain age limit and you will be penalized. This is not the case with taxable accounts.
In general, you will want to contribute the maximum to your tax advantaged accounts (below) before contributing to your taxable account.
A 401(k) investment account is probably the most common retirement investment account offered by employers. Additionally, self-employed individuals can open a solo 401(k).
In a 401(k), the money you put in ($19,500 limit in 2020) is not yet taxed (pre-tax money). It then grows in the account and is taxed when you withdraw the money in the future. This is advantageous because your effective tax rate during your peak earning years in very likely to higher than it will be in retirement when you will take the money out.
Often, employers will contribute to your 401(k) as well. Commonly, a “match” is offered in which the employer will contribute a certain amount if you contribute to the 401k to a certain level. The maximum combined employer-employee contribution in 2020 is $57,000. If you are self-employed with a solo 401(k), don’t worry. You can contribute as both employer and employee.
The price for this tax advantage is that the money cannot be withdrawn prior to age 59½. Take the money out before that age and you will pay a 10% penalty in addition to the typical taxes.
By broad strokes, a 403 (b) account is very similar to a 401(k) with the exception that it is available to employees of public schools and certain tax exempt organization.
A 457 investment account is another tax advantaged retirement account. It comes in two flavors: governmental 457 and non-governmental 457.
Governmental 457 accounts are more common and cater to local and state public workers rather than for-profit employers like 401(k)s.
Non-governmental 457s are available to certain tax-exempt non-governmental institutions. They are similar but, in general, governmental 457s are a bit better.
Like 401(k)s, 457s allow pre-tax contributions that grow within the account and are taxed upon withdrawal. The 202 contribution limit is $19,500. While employer contributions are possible, the total limit stays $19,500. This means that is your employer will contribute $10,000, you can only contribute $9500.
The disadvantage again is that you can only withdraw from this account without a 10% penalty at age 59½ or for other qualified emergencies, etc.
Next, a Traditional IRA or Individual Retirement Account is an investment account available to any individual.
You can contribute up to $6000 yearly (as of 2020) to a Traditional IRA. Money put into this account is not taxed. Again, the money grows and then is taxed upon withdrawal (when your effective tax rate is likely lower).
Money can be withdrawn without a 10% penalty beginning at age 70½.
The main issue with a Traditional IRA is that the initial tax deduction upon contributing money is phased out for individuals making more than $75,000 or married couples making more than $125,000 in 2020.
Physicians will be above this income limit and therefore, their contributions will be taxed twice – once at contribution and once at withdrawal!
Before I get into the way around this double tax whammy, I’ll introduce the Roth IRA.
The Roth IRA is named after Senator William Roth who introduced the concept.
With a Roth IRA, your money is taxed at the time of contribution. The money then grows tax-free and is NOT taxed upon withdrawal. The contribution limit in 2020 is $6000 and the general rule for age of withdrawal without penalty is 59½.
Ok, here’s the kicker…there is an income limit to be allowed to contribute to a Roth IRA. The income limit in 2020 is $139,000 for individuals and $206,000 for married couples. Most physicians will again be above these limits.
With that being said, there IS a way for high income earners to contribute to a Roth IRA. It is colloquially called a Backdoor Roth IRA.
I won’t get into the nitty gritty of exactly how to do this here, but will describe the general idea.
Let’s say your income as a married couple is above $206,000. You already maxed out your 401(k) and 457(b) options. You want to maximize your tax advantaged investing before going into a taxable account.
What you can do is contribute $6000 to a Traditional IRA. Because you are above the income limit, your contributions will then be taxed. Leave it in the Traditional IRA and your money will be taxed again upon withdrawal.
BUT…the government will now allow you to roll your (now after-tax) Traditional IRA contributions into a Roth IRA once a year. Once this rollover is done, the money will grow tax free and not be taxed upon withdrawal. You are contributing to a Roth IRA through the backdoor…hence the nickname.
For the sake of brevity, I will only briefly mention 529 and HSA (Health Savings Account) accounts.
A 529 account is an education savings account. Contribute money tax free, invest it tax free, and withdraw it tax free so long as it goes towards your designated child’s education.
An HSA is an account where you contribute tax free money to be used towards health care expenses. While in the account, it grows tax free and is withdrawn tax free, so long as it goes towards health care expenses.
Triple tax free – no other account does that!
The extra nice trick is that you don’t need to withdraw money to pay for health care expenses right when they are due.
You can save the receipt for a health expense in 2020 and withdraw the money from your HSA in 2050 tax free using your saved receipt after it has had 30 years to benefit from compound interest growth.
That’s why it is often referred to as a Stealth IRA.
There you go! A general guide to the main accounts available to you for investing your money wisely.
Since you will be contributing to multiple of these investment accounts, I’ll leave you with my account priority contribution list:
- 401(k) or 403(b)
- Backdoor Roth IRA
- If you are under the income limits, favor a Traditional IRA if your tax rate is higher now than later or a Roth IRA if your tax rate will be higher later than it is now.
- Taxable Account
Now you have the where in addition to the how. Nothing left but to get started!
What do you think? What investment accounts do you use? With what priority do you contribute to each account? Did I miss any big ones? Leave a comment below!