Retirement Funds 101

Just a few years out of residency, hospitalist Brad Bialczyk has a lot of priorities ahead of retirement saving. He and his wife, Heather Votava, also a physician, have two careers and two young children to nurture.

Sure, they’re maxing out their 401(k) plans at work and trying to make sensible decisions about spending. Don’t look for a Lexus in their driveway - it’s a Toyota 4Runner and a RAV4 for this family.

But with healthcare reform looming, volatile financial markets, and dire predictions about the likely state of Social Security by the time today’s 30-somethings retire, they admit to a bit of unease when it comes to knowing if they’re truly on track for the long term. Although they’re diligent about not getting carried away with big-ticket luxuries, they sometimes start to sweat the smaller stuff.

“When you start to make more money you end up wasting a lot,” says Bialczyk, who lives near Minneapolis. “You get home from work and don’t want to cook so you go out. It all adds up.”

Another challenge comes in deciding how aggressively to invest money for a retirement that is decades away. Conventional wisdom used to dictate young savers keep a very large percentage of their long-term money in the stock market, but financial advisers today are much more cautious.

Despite all the uncertainty, there are a few ways to get some control over retirement saving, no matter your risk tolerance and asset allocation. Setting an aggressive savings target and socking away the money in the right type of retirement accounts will help start you on your way.

401(k): start here

If your practice offers a 401(k) plan, this is most likely the best haven for your first retirement dollars saved. Many tax-exempt healthcare employers offer 403(b) plans, which are similar to a 401(k) and have come under new regulations designed to stiffen fiduciary standards, making them even more like 401(k)s.

“You want to look first at the no-brainer things that physicians will clearly want to do for retirement,” says Marshall Gifford, Bialczyk’s financial adviser. Contribute the maximum allowed annually to your workplace plan before considering alternatives like annuities or life insurance policies, says Gifford, who is senior partner for North Star Resource Group in Minneapolis.

How to tell if your workplace plan is a good one? Look for low-cost index fund options with a broad exposure to world markets. A good place to see how your plan stacks up is www.brightscope.com. This free service rates thousands of plans, including plans for Clarian Health Partners, Inova Health System, Iowa Health System, and the Marshfield Clinic. The site not only gives the expense ratios (annual charges) of funds in your plan, but also estimates what you’re paying in transaction costs and other charges in the underlying investments. Then it compares those charges to other similar employers in an industry.

For his younger physician clients, Gifford typically recommends saving in a Roth 401(k) if that option is available at work. With these plans, contributions are deducted from your paycheck, but you receive no tax deduction on the money. Down the road, however, withdrawals in retirement come out essentially tax free.

Gifford’s reasoning on foregoing the tax break today: With such a long time horizon, most under-40 physicians will be better off with a tax-free income stream in retirement, rather than taking the break now. Plus, by contributing the entire maximum in today’s dollars to the Roth, you’re effectively contributing a higher amount than in a deductible plan.

The contribution limit for 401(k) plans in 2010 is unchanged at $16,500. Don’t assume this is all you’ll need to save, however.

If you started saving in your 20s, putting away 10 percent of gross pay each year would probably get you close to your retirement goals. If life - in the form of medical school, for example - got in the way and you didn’t start saving until your 30s, you’ll probably want to aim for saving at least 20 percent to 25 percent.

For most physicians, that means finding other vehicles beyond your workplace account.

Next step: the IRA

If you’re already covered by a 401(k) plan, your ability to make tax-deductible contributions to an IRA is phased out above certain income thresholds.

Beginning this year, however, you can make nondeductible contributions to a traditional IRA and then convert it to a Roth IRA, regardless of your income. For 2010, the IRA contribution limit is $5,000, or $6,000 for people 50 and older.

Here’s the catch with conversions: If you’ve built up substantial assets in a deductible IRA over the years, that will affect the taxes you’ll owe on the conversion to a Roth. You aren’t allowed to just convert the nondeductible contributions to the new Roth IRA, says Ed Slott, an accountant and IRA expert. Instead, whatever amount you decide to convert to the Roth will come out according to the proportion of deductible and nondeductible funds you have in all your traditional IRAs, he says.

Say you have a traditional IRA worth $100,000, and 90 percent of that account was made up of deductible contributions. If you now want to convert $10,000 from a traditional IRA to a Roth, then you’ll owe income tax on $9,000 of the conversion.

Prime candidates for Roth conversions are the young and wealthy, because their future tax rates stand to stay the same or move higher, and younger savers have a long time horizon to make up for the “penalty” of using after-tax money for contributions. And heirs will love the tax-free accounts that carry no requirement for minimum distributions.

Who should think hard before converting? If you might be in a lower tax bracket in retirement, it doesn’t make sense to pay taxes at your highest marginal rate today on the conversion, experts say. A middle-aged couple who are in a high bracket now but who haven’t saved a big pile of money for retirement (think about that late start mentioned earlier) might want to stay in a tax deductible IRA.

In a gray area? Consider a blend. You could save half the year in a Roth 401(k), then half in a traditional plan. Or you could do a new Roth conversion on your IRA, but save at work in a traditional 401(k).

IRAs for solo practitioners

For solo doctors, there are IRAs that potentially allow you to sock away even more.

With a SEP-IRA, for example, you can contribute, tax-deferred, 25 percent of income up to a $49,000 cap. SEP stands for simplified employee pension, and it can be set up through banks or brokerages by small business owners and self-employed workers. As with any IRA, remember to shop for low fees and strong investment choices - there are lots of providers vying for your business.

Solo 401(k) plans are worth a look for their simplicity and low cost to operate, but higher income physicians will typically find the contribution limit formula of the SEP-IRA allows you to sock away the most.

Late in the game but haven’t saved much for retirement? A defined benefit pension for a self-employed physician can make some sense, but consult a financial adviser who has plenty of experience setting them up and can help you navigate the required red tape. These plans allow you to put large lump sums into the plan relatively quickly and offer some creditor protection as well, but fees can be high.

Beware the risks of 457s

Some nonprofit employers offer yet another tax-deferred savings vehicle, called 457 plans.

These accounts allow savers to defer compensation on a pretax basis, but by law the money must remain “at risk” and under the ownership of the employer. That means your funds could wind up paying creditors in a bankruptcy situation, for example. For that reason, Gifford typically advises clients to steer clear.

Last resort: life insurance

If you’ve maxed out all these avenues, a final place to consider putting cash on a tax-advantaged basis is in a permanent life insurance policy, Gifford says. You can over-fund the policy, or contribute higher than the annual premium, to boost the savings component in the policy, he says. Be certain to hire an experienced adviser to help you purchase the policy, however, because these are highly individualized and complex contracts.

After all these tax-advantaged avenues are exhausted, you’ll be left with saving in a regular, taxable account. For these, look to low-cost, low-turnover mutual funds or individual stocks, which will generate less in transaction costs and taxes.

“Most younger clients agree they’re not going to get much from Social Security to replace their incomes in retirement,” Gifford says. “I tell them if they save 20 percent of gross income to build wealth for 20 years, they should be financially independent.”

Janet Kidd Stewart is a freelance writer based in Marshfield, Wis. As a contributing columnist for the Chicago Tribune, she writes a weekly, syndicated retirement column called “The Journey” that appears in Tribune newspapers across the United States. She holds a master’s degree from the Medill School of Journalism at Northwestern University. She can be reached via physicianspractice@cmpmedica.com.
This article originally appeared in the May 2010 issue of Physicians Practice.