Building Your Investment Waterfall as a Physician

To review, your simple formula to reach financial freedom as a physician is to 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 and then re-balance yearly. But there remains the question of where to put your investments. The where consists of the various types of investment accounts available that you can utilize to invest. This eventually becomes your investment waterfall!

Let me explain…

The best way to think about these investment accounts is that they are like 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. Moreover, each investment account, or bucket, has special features, advantages, and disadvantages.

In this post, I want to review some of the more common investment accounts available to most people, especially physicians, as well as their pros and cons.

In general, your goal will be to prioritize these buckets based on their advantages. Then you will fill the first bucket (investment account) with money until it reaches the maximum amount. After this, your savings and investments above this amount will spill into the next bucket/investment account on your priority list. I like to think about this as an investment waterfall with each bucket spilling into the next.

The buckets of the investment waterfall

It is important to recognize however that doctors saving at least 20% of their income will need many, if not all, buckets in order to grow their margin sufficiently to reach financial freedom. That is why understanding where you can invest your margin is so important.

Taxable investment account

The first account we’ll review is a taxable investment account.

This is the account that most people think of when they image investing money in the stock market. This account does not carry any special considerations from the government or IRS. And anyone can open one of these accounts by signing up for one online with any brokerage like Vanguard or Fidelity for instance.

In general, the money that you put into this account has already been taxed via income taxes (post-tax money). And the government taxes any money made in the account when you take it out via capital gains taxes. These taxes can be either lower rate long term capital gains taxes or higher rate short term capital gains taxes depending if you keep the money in the account for more or less than 1 year. For some background on why this is important in our progressive tax system, check out this post.

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 receive a penalty. This is not the case with taxable accounts. Additionally, there is no limit to the amount of money that you can invest in a taxable account. All tax-advantaged accounts as discussed below will have an annual limit for contributions.

In general, you will want to contribute the maximum to your tax advantaged accounts (below) before contributing to your taxable account. This minimizes your tax burden – a big goal for high income earners like physicians.

401(k) investment accounts

A 401(k) investment account is probably the most common retirement investment account, especially for employees. Additionally, self-employed individuals can open a solo 401(k).

In a 401(k), the money you put in each year (limited to $20,500 in 2022) is pre-tax money. It then grows in the account and the government taxes it when you withdraw the money in the future. This is advantageous because your effective tax rate during your peak earning years is likely to higher than it will be in retirement when you will take the money out.

Often, employers will also contribute to your 401(k) as well. Commonly, employers offer a “match” 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 2022 is $58,000. If you are self-employed with a solo 401(k), don’t worry. You can contribute as both the employer and employee.

The price for this tax advantage is that you cannot withdraw the prior to age 59½. Take the money out before that age and you will pay a 10% penalty in addition to the typical taxes. Another disadvantage is that the types of investments that are available in a 401(k) (or 403(b) and 457 below) are limited to those offered by the brokerage that your employer hired to sponsor the plan. Though rare, it is therefore possible that your 401(k) would not offer low cost, diversified index funds to invest in. In these cases, you will need to weigh the benefits of the tax advantages in the 401(k) versus the benefits of investing with lower fees using index funds without tax advantages in a taxable account.

403(b) investment accounts

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 organizations like public hospitals. My current retirement plan with my employer is via a 403(b).

457 investment account

A 457 investment account is another retirement account with tax advantages. 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 after which the government taxes them only at withdrawal. The 2020 contribution limit is $20,500. While employer contributions are possible, the total limit stays $20,500. This means that if your employer will contribute $10,000, you can only contribute $10,500.

The disadvantage again is that you can only withdraw from this account without a 10% penalty at age 70½ or for other qualified emergencies. The other downside is that for 457s, the money you contribute technically becomes your employer’s money until you withdraw it again. This means that if your employer folds, you lose your 457 contributions and returns. That is why governmental 457s are superior. The government is much less likely to default compared to a private company.

Traditional IRAs

Next, a Traditional IRA or Individual Retirement Account is an investment account available to any individual generating income of any kind. Basically, if you are working, you can open an IRA. And you can do so with any brokerage just by going online.

You can contribute up to $6000 yearly (as of 2022) to a Traditional IRA. Money put into this account is pre-tax. Again, the money grows and the government taxes it upon withdrawal (when your effective tax rate is likely lower). You can withdraw the money without a 10% penalty beginning at age 70½.

The main issue with a Traditional IRA is that the initial tax deduction upon contributing money phases out for individuals making more than $75,000 or married couples making more than $125,000 in 2022. Physicians will be above this income limit and therefore, their contributions will see taxation twice – once at contribution and once at withdrawal. Thus, this type of investment account would offer no advantage compared to a regular taxable account. In fact, the IRA would be worse because there is an age minimum for penalty-free withdrawal as well as a yearly contribution limit.

Roth IRAs

Before I get into the way around this IRA issue, I’ll introduce the Roth IRA. The Roth IRA is named after Senator William Roth who introduced the concept. With a Roth IRA, the government taxes your money at the time of contribution. The money then grows tax-free and is NOT taxed upon withdrawal. The contribution limit in 2022 is $6000 and the general rule for age of withdrawal without penalty is 59½.

However, once again, there is an income limit to be allowed to contribute to a Roth IRA and receive these tax advantages. The income limit in 2022 is $139,000 for individuals and $206,000 for married couples. Most attending physicians will again be above these limits. However, this is a great investment account for resident physicians who will be below the income limit. Residents can thus contribute directly to a Roth IRA when they are in the lowest tax bracket that they will ever be in. Then their contributions can grow and be withdrawn tax free in the future. That’s why this is one of my 11 steps for residents that will make them >$1 million!

An important aside on the Backdoor Roth IRA

With that being said, there is however a way for high income earners to contribute to a Roth IRA. It is colloquially called a Backdoor Roth IRA. To illustrate, 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 contributing into a taxable investment 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. If you leave it in the Traditional IRA, 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 see taxation upon withdrawal. You are contributing to a Roth IRA legally through the backdoor…hence the nickname.

529 and HSA accounts

Next, I will briefly mention 529 and HSA (Health Savings Account) accounts. A 529 account is an education savings account. You contribute money tax free, invest it tax free, and withdraw it tax free so long as it goes towards your designated child’s qualified educational expenses. The IRS website defines qualified expenses. Any money withdrawn for non-qualified expenses get hit with an extra 10% penalty in addition to usual taxes. But don’t worry, if you have money left over from one dependent’s 529 account, you can always transfer it to another dependent or relative with education expenses.

An HSA meanwhile is an account available only to members of high-deductible insurance plans. With an HSA, you can contribute tax free money for 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. Thus, when used appropriately, the HSA is triple tax-free.

The extra nice trick with an HSA 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 the current year and withdraw the money from your HSA years later tax free using your saved receipt after it has had years to benefit from compound interest growth.

The “others”

There are a variety of other more advanced investment accounts with various tax advantages, especially for self-employed physicians and individuals. These include cash balance plans, SEP-IRAs, profit sharing plans, and beyond. If you are self-employed and interested in learning more about these tax-advantages accounts, I recommend seeking out and consulting with an experienced tax advisor. This is a great resource on the topic by the IRS.

I will also briefly mention pensions. While not as common as they were in the past, pensions are a type of defined-benefit plan compared to 401(k) accounts and the rest above, which are defined-contribution plans.

Pensions work as you contribute a certain, fixed annual amount to the pension. Your employer then invests the collective contributions as they see fit with a. promise to pay you a fixed amount of income during your retirement. The risk here is that your employer may not invest their pensions wisely resulting in lost money and evaporating pension payments for retirees. If deciding between a pension and a defined-contribution retirement plan, carefully consider all advantages and disadvantages of both within the context of your financial goals and seek professional assistance as necessary.

Tying it together to form your own investment waterfall

As I mentioned at the start of this post, our goal is to organize these accounts or buckets into an investment waterfall based on their advantages given our unique financial situations.

Once organized into the waterfall, we can just contribute money into the first bucket until it overflows into the second bucket and so on.

Like this…

While everyone’s financial situation and therefore investment account waterfall will be personal, I will provide a very reasonable example here:

401(k) or 403(b)
457(b)
Backdoor Roth IRA (if you are above income limits for direct IRA contribution)
If you are under the income limits for direct IRA contribution, 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.
529 (if you have dependents with current or expected education expenses)
HSA (if your insurance plan qualifies as high deductible)
Taxable Account

The steps to develop your own investment waterfall are:

Determine what tax advantaged accounts are available to you
Start with the most advantaged account and fill it with your savings
Once that bucket is full, spill into the next most advantaged account
And on and on

Your investment waterfall will depend on your own circumstances and which accounts are available to you. So while the exact waterfall will be different for everyone, it is important to plan your waterfall.

Ultimately, this waterfall then becomes an integral part of your written financial plan. In fact, simply by deterring your investment waterfall, you have already completed a big and very important portion of your written plan. Congratulations!

And remember, if you are still working on your financial plan, you can see my whole financial plan here!

What do you think? What investment accounts do you use? How have you organized them into an investment waterfall? Let me know in the comments below!