Podcast #95 Show Notes: The Speak Pipe Is Working
This episode is almost entirely full of questions from Speak Pipe. Your questions have been rolling in like crazy lately and it is a lot of fun to get your voices on the podcast. The first mission of the White Coat Investor is to boost financial literacy among high-income professionals. I believe answering your questions on the podcast is really helping meet that mission because many of you have the same questions. In this episode we discuss contributing to a Roth IRA when you are married filing separately, 401(k) loans, when filing as an S Corp makes sense, funding an HSA properly for part-year eligibility, opening a join brokerage account, and more.
Our second mission is to feed my entrepreneurial spirit. That means creating jobs, building something bigger than existed before and making money. This is a for-profit business. But the third mission is to connect you with the good guys in the industry so make sure you check out our recommended pages. I have taken a great deal of time and effort to vet these recommendations for you for various financial services professionals. You can find the list of professionals above under the recommended tab. So please use them and give us feedback when you do.
Now on to the episode!
In This Show:
Sponsor
At some point in our financial lives, it will be time to buy a home.
A physician mortgage can be a good vehicle for a young doctor who’s just out of school and has a more effective place to use their money than on a big down payment. These loans allow doctors to secure a mortgage with fewer restrictions and a lower down payment than a conventional mortgage. But if you’re further advanced in your career or deeper into your journey to financial freedom, buying a home with a conventional mortgage and then, later on, potentially refinancing that loan to a better rate with a shorter time frame could be a great move.
Wherever you are in your financial journey, make sure you use the mortgage that will be most financially beneficial for you. Hop over to our recommended tab to learn more about all of your mortgage and refinancing options at whitecoatinvestor.com/mortgage.
You can do this and The White Coat Investor can help.
Quote of the Day
Our quote of the day today comes from Warren Buffet who said,
“If a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle.”
I agree with that. He, unfortunately, passed away in January. We are really going to miss him. He has done a lot for the American investor for sure.
Reader and Listener Q & A
Roth IRA Contributions When Married Filing Separately
Keith is married to another resident and both contributed a lump sum of $5,500 each to their Roths last year with money they received from their wedding. They are married filing separately because he has greater than $350,000 in loans and she has none.
He is going for public service loan forgiveness and after running the numbers it made sense to file separately. His question,
“Since I am filing separately, I don't qualify for direct Roth contributions. So what do you recommend me to do this year since we don't have a lump sum ready to contribute? Should we, A: save up $12,000 over the year and do a back door like near the end of the year or, B: contribute to our individual IRAs monthly and do backdoor contributions once per month? I'm only asking because option B allows me better coverage of the market trend and smoother contribution rate in that I get an average of the yearly market by contributing monthly and not just have my contribution made at one point in time.”
How much you can contribute to a Roth IRA if you are filing married, filing separately is limited by your living arrangement and your income, but typically it's severely limited. If you live with your spouse at any point during the year and you make more than $10,000 per year, you cannot contribute directly to a Roth IRA. If you don't live together at all that year, the income limit is much higher. But basically, if you're doing the married filing separate thing in order to minimize your income-driven repayment payments during residency in order to maximize your public service loan forgiveness then you are not going to be able to contribute directly to a Roth IRA.
You're going to have to do it through the back door just like you will once you're an attending. A typical attending has enough money to make their entire Roth IRA contribution in one fell swoop. But the issue is with a resident, they don't have that much income and it's really hard to come up with six grand all at once as a resident. It is much easier to come up with $300 or $400 a month to put in there and gradually max it out over the course of the year. When I was a resident, that was how we made our Roth IRA contributions. But we were married filing joint so we could just make them directly. I would probably contribute to a traditional IRA as the year went along. But rather than doing the conversion every month after making a contribution, I would probably go ahead and just do the conversion once during the year. Now that probably means you're going to have some gains on that traditional IRA and that is not the end of the world.
You want to have some gains. That is the purpose of investing as you go along. But you are going to have to pay taxes when you do the conversion. For example, if you get $6,000 in there over the year and by the time you do the Roth conversion at the end of the year at $6,300 you're going to owe taxes on that $300 when you do the Roth conversion. You have two other alternatives if you don't want to do that:
- Every time you make a contribution, just do a Roth conversion. That's not a big deal. I mean, you basically just add it all up at the end of the year when you report it. It'll probably be reported just like you had done it all at once. But there will be a few dollars you made on interest in between the contribution and conversion steps. The problem is you're going to have to log in and do that conversion every month that you make a contribution.
- Save up the money in a money market fund on the side or a high yield savings account and make the contribution at the end of the year and then do the conversion the next day. And that would keep things very simple. You would earn whatever you're getting in the money market fund. But you would miss out on what stocks were earning or bonds were earned if you would have invested the money there.
A couple of other observations on this situation though. First of all, in case it's not clear, you can't actually put wedding money into retirement accounts. The only money that can go into retirement accounts is earned income. Now you can spend wedding money on your living expenses rather than spending the money you're earning in your job. But the bottom line is you cannot contribute more to a retirement account then your earned income in that year.
Also, bear in mind, if your goal is really to minimize your income-driven repayment payments in order to maximize how much you get forgiven through public service loan forgiveness, you might want to consider making tax-deferred contributions to any account that you can, whether that be IRAs or 401ks. The reason why is any money that goes in there basically comes out as a tax deduction and lowers your income. The lower your income, the lower your IDR payments and the more that is left over after 10 years to be forgiven through public service loan forgiveness. Now that contrasts a little bit with my usual advice for residents. I generally tell residents that they want to invest in Roth accounts, Roth IRAs, Roth 401ks, Roth 403Bs because you'll never be in such a low tax bracket the rest of your life. But it is possible in some situations, especially when you're sure you're going for public service loan forgiveness, that you'd be better off using a tax-deferred account in order to lower those IDR payments and increase how much goes toward public service loan forgiveness. You just have to run the numbers for you and decide whether that's worth it.
401(k) Loans
What are my thoughts on the advantages and disadvantages of taking a 401(k) loan and thoughts on this idea of the money that you use to pay back the loan being double taxed?
401k loans are not a great idea and the reason why is the money in the 401k should be making money. This is money that you're supposed to put in there because you want to retire on it. This is not an ATM that you want to raid in order to buy your next Tesla or in order to go on a vacation or really even to cover emergencies. Hopefully, you've got a separate emergency fund for that, but if you want to borrow from your 401kK you are allowed to do that. The maximum is either 50% of the value of the 401k or $50,000 whichever is less. That's the most you can borrow. And you have to pay interest to the 401K for that loan. The longest a loan can be is five years.
This used to be a really terrible idea because if you got fired, you had to have that loan paid back within 60 days of separation from the company. People got burned and ended up having to pay the penalty on that loan. If you don't pay it back within 60 days, not only do you have to pay the taxes on that withdrawal, but you have to pay a 10% penalty on it. They changed that law with the 2018 tax changes. Now instead of only having 60 days, you have until your next tax day to get that money back into the account.
In fact, if you file an extension, you could get even more months to get that money back into the 401k. So that makes it not quite as dumb of an idea as it was before, but it's still probably a dumb idea. Now, is it better than borrowing from a bank or better than borrowing from somebody else? Well, it might be. It depends on the terms you're getting from the bank and what the money would have made in the 401k.
One way to look at a 401k loan that you're paying back is that it's really kind of a fixed income or a bond in that 401k. Maybe what you should do when you borrow from the 401k is change the asset allocation of the money that's left so it's more stock heavy. That way the money you're paying into the 401k in interest is kind of like the bond portion of the portfolio.
But the question this listener asked is about this double taxation myth. I say myth because it is a myth. People say, “Well if I borrow from my 401k, then I have to pay that money back with after tax money and then I have to pay taxes again on that money when I pull it out of the 401k.” But that's not the way it works. Any loan is after tax. So the money you borrow out of the 401k is after tax. So the money you put back into the 401k has to be after tax. The money comes out after tax, it goes back in after tax and then when you finally withdrawal it in retirement, it's pre-tax and you have to pay taxes on it. It only gets taxed once, when you pull it out of the 401k.
Probably the best example I know that explains this is a blog post written way back in 2008 by the Finance Buff, in which he talks about 401k loans. That is certainly worth taking a few minutes to read if you're really worried about this. The post is called the 401k Loan Double Taxation Myth. If you want to borrow from your 401k, don't let the double taxation myth be what keeps you from doing it. Let the idea that it is generally a bad idea to be raiding your retirement accounts for your spending needs now keep you from doing it.
Tax Advantage Investment Options for People with 1099 Income in Addition to W-2 Income
Many doctors have side gigs these days which are bringing in some kind of 1099 money. With a separate source of income from your W2 job, you can have a separate retirement account. There are a few rules about it though. You could use a sep IRA. I would generally recommend against that because it screws up your backdoor Roth IRA prorata calculation. Remember, you have to have a $0 balance in all of your traditional IRAs, simple IRAs and Sep IRAs in the year that you do a Roth conversion or that conversion is going to be prorata.
An individual 401k is best in this situation. The $19,000 employee contribution has already been used in the employer's 401k so all you have left is what we call employer contributions, which is 20% of your net income from self employment. Net income is your profit minus half of the Social Security and Medicare tax that you owe from that income. 20% of that is what can be contributed to a Sep IRA or a solo 401k.
This listener is making $35,000 in 1099 income. So he'd be able to put maybe $7,000 in a solo 401k. That is a nice tax break. That $7,000 won't be taxed at his marginal tax rate and it is money that will now somewhat be asset protected as well. It is worth doing I think for that amount of self employment income for sure.
Personal Capital's Market Sector Approach
“I just got off my second phone call with Personal Capital and I just wonder if you would comment on their market sector approach with the 10 stocks per sector and rebalancing versus index investing, pros and cons.”
This is a complicated question. He is asking about an active management technique used by a financial advisor and wants my opinion on it.
In general, I'm not a big fan of active management. I prefer passive investing strategies and if you ask Personal Capital whether this is active or passive, they're going to call it passive. But in reality, this is kind of a factor based, somewhat active strategy.
They are mostly doing what we call equal weighting. The idea behind equal weighting is rather than taking your stocks and weighting each of them by how much that company is worth, that's what we call capitalization weighting and what most index funds do, they decided to put equal amounts into each sector and then within each sector equal amounts into each of 10 or 12 stocks in that sector.
So basically they're creating their own mutual fund, their own kind of passively managed index fund, but it's equally weighted rather than the capitalization weighted. There's a few downsides to doing this.
- It is not terribly tax efficient. So you can run into some issues if you're doing this in a taxable account. There is lots more buying and selling going on and every time you do that, you have to pay capital gains. Especially if you end up having to pay short term capital gains.
- It is a lot more complicated. You have to pay somebody to do this. Personal Capital charges 0.89% per year. So if you're doing this just to try and get some out performance from this technique, it has to be a least 0.89% per year better than just a standard buy the index funds capitalization weighted plan.
The idea here behind most equal weighting plans, and the reason why a lot of times the backtested data shows that they outperformed is usually attributed to factor investing. That is this idea that over the long-term small stocks and value stocks outperform large stocks and growth stocks. By equally weighting it, more of the money is being put into smaller stocks and value stocks rather than large growth companies like Apple or Walmart. That is why this theory is supposed to work. Now whether it will work and whether it will work better than 0.89% per year after tax going forward that is anybody's guess. This is investing. You make your bets and you take your chances and you get what you get. But whether you want to go and do that, I'll leave up to you.
Personally, I do not invest that way. But it is not some insane method of investing. As reasonable investment strategies go, it probably falls into the realm of reasonable. It's just a matter of whether you think it's better than the default capitalization weighted index funds and whether you're willing to pay for it.
Fund an HSA Properly for Part-Year Eligibility
Daniel was in a job for only half of a year that offers a qualifying high deductible health plan and wanted to know can he fund only half of the HSA?
If you are eligible for an HSA for four months out of a year, you can make 4/12 of the contribution for that year. For 2019 an individual can contribute $3,500 to an HSA. So if Daniel was just an individual without any family members and was eligible for 1/3 of the year, he could contribute 1/3 of $3,500. The limit is $7,000 for a family. That can be you and a child or that can be you and a spouse.
However, there is one interesting twist on this. It is what they call the last month rule. If you have an HSA eligible plan, a high deductible health plan. That is not necessarily one that just has a high deductible, but it is one the government calls a high deductible health plan. If you have it in place on December 1st you can make the whole year's contribution. The only catch is you have to keep that plan for the next year. You have to be eligible for the entire next year or basically, it goes back to just letting you make one month's contribution worth to the HSA.
Filing as an S-Corp
When does it make sense for a small business to file as an S-corporation?
This is actually a complex question to start with and it just became more complex in the last year. Let me outline a few general principles. And then the truth of the matter is anybody who really wants the answer to this is going to have to run the numbers themselves. They might even have to hire a professional to help them do it.
The general reason why a typical doctor forms an S-corp is in order to split his income into two categories. The first is salary, and the second is distributions. The benefit of putting as much as you can into distributions rather than salary is you don't have to pay payroll taxes like Social Security and Medicare on the amount that you called distribution.
Now, for a typical doc, you have to pay yourself a reasonable salary anyway, and that's going to be a high enough number that you've maxed out your Social Security taxes. But you still could save some money on Medicare tax. It is 2.9%, with half of that being a tax deduction for the business. So in reality, maybe it's 2.2% once you take into account that deduction. What is that worth? Well, if you can call $100,000 distribution instead of salary, you just saved $2,200 in Medicare tax.
There is a certain amount of hassle involved with forming an S-corp, a lot of paperwork hassle. At a certain point, if you're not saving a significant amount of taxes, it's not worth the hassle. My general rule for that in the past has been $100,000. If you're not calling at least a $100,000 distribution for a typical doctor, it's probably not worth forming an S-corp to try to save those Medicare taxes. But if you can call at least $100,000 distribution, then I think it was probably worth doing.
Now bear in mind that the money that you call distribution is not eligible to count toward the amount you need to make to max out your retirement accounts. So if you want to max out an individual 401k, and you've already used your employee 401k contribution in a different plan, you have to make a lot of money in order to max that out. I mean, this year the maximum is $56,000. So basically multiply that by five and that is the amount of salary you have to pay yourself.
So unless you're making pretty good money at that 1099 job, it is going to be tough to have enough above and beyond that to justify the hassle of the S-corp.
So as you can tell, it was a complex decision, even a couple of years ago, but it just became more complex with the new 199A law. This is the new tax deduction for self employed individuals. You actually calculate this differently for a sole proprietorship versus an S-corp. If you have an S-corp that deduction can be no larger than 50% of what you're paying out as salary. So now there is an additional factor going into this and really I can't give any sort of general rule of thumb here anymore. You really have to run the numbers yourself and see which way you're going to come out ahead. Is the additional Medicare tax savings going to make up for the loss of the 199A deduction, et cetera? You just have to run the numbers and you're probably going to need some help from your accountant unless you're preparing your own taxes. If you are preparing your own taxes, good luck. You're going to have to sit down and work your way through this 199A law, which I think all of us are struggling a little bit with this year. I'm planning on writing a blog post on it, but I probably won't write it until I figure out what my deduction is going to be and work through that tax form myself. I think I'll understand it a lot better by then. But really that factor has to be taken into account now that we have this new deduction available.
Invest or Save for Medical School
“I was recently accepted into medical school. I am currently in my second gap year working at the NIH in Bethesda. I'm trying to decide if I should open and max out a Roth IRA or keep this money to use during medical school. I'll be taking all loans for tuition and other expenses I will likely take loans from my parents interest free, of course. Is it worth starting retirement savings early or keeping that money in order to lower my loans?”
First, remember any time that a parent gives a loan, the amount of interest forgiven, because you're required when you give a loan to charge at least a minimum amount of interest, the amount that you're forgiving is considered a gift. So be aware of the gift tax laws when you do that.
There is no right answer to this question. I Love Roth IRAs. Getting that money in there, get it compounding. It's tax free forever. It's asset protected. Estate planning is facilitated with it. You can leave it to your kids and stretch it out even longer. Roth IRAs are a great thing, but so is minimizing your debt.
Bear in mind when you are in med school or going into medical school, the greatest investment you can make is in yourself and your future earnings ability. And so that's not a bad thing either to reduce your loans and given what most medical students are borrowing at these days, which is 6 or 7%, that's essentially a 6 or 7% guaranteed investment.
I think I might pass up a Roth IRA if I had a 6 or 7% guaranteed investment. It'd be a difficult decision, but I think I might just do that if that was the other option. Just stack that money up in cash, use it that first year of med school to reduce how much you borrow and get used to living frugally as much as you can to minimize those loans.
To a lot of medical students, it just feels like Monopoly money. It's more money than they've ever made in their life and they just keep borrowing it and they become debt numb to it and all of a sudden, 15 years later they still owe hundreds of thousands of dollars in student loans. I think that's a worthy goal to try to lower your loans. That is what I would use the money for in this situation rather than maxing out a Roth IRA. But it's not like that's a bad thing to do. It's not a bad idea and I'll have to leave it up to you as far as how you're going to decide.
1035 Exchange for Annuities
“I'm a physician in my mid-50s looking toward retirement soon. I came across your site only about a year ago, but better late than never. Thanks for what you do. I fired my financial advisor and I'm still cleaning up the mess. I had a question about an annuity. I own an annuity from the previous financial advisor. I've held it for over eight years and it's worth about $100,000. I've been reading that it might be a wise move to do a 1035 exchange into an annuity with cheaper fees. Can you comment on this?”
It is hard to know the best thing to do with this annuity without knowing what the basis is. Maybe she can just cash it out and won't have to pay much in taxes on it cause it never appreciated much. But I suspect she's got a fair amount of appreciation in there. So it's probably worth exchanging it to a low cost variable annuity, like those that are offered by Vanguard.
This is called a 1035 exchange. Basically, all the cash value from one goes into the cash value of the other, but you instantly have better investments in there and you have lower fees. So it's a no brainer to do that. The only other alternative would be if it is worth just cashing out and investing in a taxable account or using the money to pay off debt or using the money to max out retirement accounts, et cetera. But certainly getting out of some old crummy high expense annuity with crappy investments is usually worth doing.
Joint Brokerage Account
Can you open a joint taxable brokerage account under both of your names? The answer is yes. You can open an individual one or you can open a joint one.
The downsides to a joint one is that your spouse can clean you out. I mean, it's joint and you both own the whole thing. And so you have to watch out for that, I suppose. Another downside is in the event of liability, if for some reason that one person is sued and the other one is not, that joint account becomes something that the creditors can grab.
So I suppose it could be a bit of an asset protection technique to have two separate brokerage accounts. In some states, you're allowed to title your brokerage accounts as tenants by the entirety, in which case two spouses would not have to split that up to get that same level of asset protection. In fact, it's even more asset protection because no matter which spouse was sued, the money would not be reachable. So that's a great way to title a joint brokerage account in the seven or eight states that allow that. But yes you certainly can open a joint brokerage account. That's how Katie and I have our brokerage account.
The nice thing about that is if one of us died, the other one would just keep on going, nothing would have changed really. Plus we both have access to it. It just seemed the right way to do it to us. We have both of our names on the house. We have both of our names on most of our vehicles. Although I think technically she owns the boat. I guess the day we bought that I felt like that was going to give me some additional asset protection or something. But we have both of our names on our brokerage accounts and our bank accounts as well. And I think that's what most people do.
Ending
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Full Transcription
Intro: This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high income professionals stop doing dumb things with their money since 2011. Here's your host, Dr Jim Dahle.
WCI: Welcome to the White Coat Investor podcast. This is Episode 95. the speak pipe is working. At some point in our financial lives, it will be time to buy a home. A physician mortgage can be a good vehicle for a young doctor who’s just out of school and has a more effective place to use their money than on a big down payment. These loans allow doctors to secure a mortgage with fewer restrictions and a lower down payment than a conventional mortgage. But if you’re further advanced in your career or deeper into your journey to financial freedom, buying a home with a conventional mortgage and then, later on, potentially refinancing that loan to a better rate with a shorter time frame could be a great move.
Wherever you are in your financial journey, make sure you use the mortgage that will be most financially beneficial for you. Hop over to our recommended tab to learn more about all of your mortgage and refinancing options at whitecoatinvestor.com/mortgage.You can do this and The White Coat Investor can help.
WCI: Our quote of the day today comes from Warren Buffet who said, “If a statue is ever erected to honor the person who has done the most for American investors, the hands down choice should be Jack Bogle.” I agree with that. He really has done a lot. Unfortunately passed away in January. And we're really gonna miss him. He's done a lot for the American investor for sure. And you are doing a lot for your patients, so thank you for what you are doing. I don't know if any of them told you thanks today, but if they didn't, at least you've heard it from one person.
WCI: Make sure you've checked out our recommended pages on the White Coat Investor website. I have taken a great deal of time and effort to come up with these recommendations for you for various financial services professionals.
WCI: In fact, that's actually one of our three missions at the White Coat Investor. Our first mission is to help you get a fair shake on Wall Street. Our second mission is to feed my entrepreneurial spirit. That means creating jobs, building something bigger than existed before. But also involves making money. This is a for profit business. But the third mission is to connect you with the good guys in the industry.
WCI: And the main way I do that is through the recommendations pages on the website. There you can find student loan refinancing companies, doctor mortgage lenders, independent insurance agents, financial advisors, contract review companies, tax strategists and other financial professionals. These are people that we've done some initial vetting on and that have had continual vetting from White Coat investors just like you who have used them.
WCI: Basically, people send me feedback and if the feedback is positive then we keep them on the list. If the feedback is negative, we take them off the list. And so, be sure to use those when you're searching for a reliable professional and of course send us feedback about your experience.
WCI: Today we are going to do almost entirely questions from Speak Pipe. They've been rolling in like crazy lately and it's a lot of fun to get your voices on the podcast. So that's almost completely what we're going to do today. Let's take our first question from Keith. This is one member of a two resident couple.
Keith: Quick question about my Roth for 2019. my wife and I both contributed a lump sum of $5,500 each to our Roth's last year. We did so with money that we received from our wedding. This year is a bit trickier. We're married filing separately because I have greater than $350,000 in loans and she has none.
Keith: We make the same salary and I'm going for public service loan forgiveness. As you mentioned in a prior podcast, I think it makes sense after running the numbers to file separately. But back to the Roth. Since I am filing separately, I don't qualify for direct Roth contributions. So what do you recommend me to do this year since we don't have a lump sum ready to contribute? Should we, a, save up $12,000 over the year and do a back door like near the end of the year or, b, contribute to our individual IRAs monthly and do backdoor contributions once per month?
Keith: I'm only asking because option B allows me better coverage of the market trend and smoother contribution rate in that I get an average of the yearly market by contributing monthly and not just have my contribution we made at one point in time. Am I overthinking it? Thanks a lot.
WCI: Basically the question is what to do about that Roth IRA. In case you have no idea what he's talking about, how much you can contribute to a Roth IRA if you are filing married, filing separately as limited by your living arrangement and your income, but typically it's severely limited.
WCI: If you live with your spouse at any point during the year and you make more than $10,000 per year, you cannot contribute directly to a Roth IRA. If you don't live together at all that year, the income limit is much higher. But basically, if you're doing the married filing separate thing in order to minimize your income driven repayment payments during residency in order to maximize your public service loan forgiveness, forgiveness, then you are not going to be able to contribute directly to a Roth IRA.
WCI: You're going to have to do it through the back door just like you will once you're an attending. It's not that hard to do. It's no big deal. You can do it. Lots of attendings are doing it all the time, but that's the way you have to contribute to your backdoor Roth IRA.
WCI: A typical attending has enough money to make their entire Roth IRA contribution in one fell swoop. I mean, if you're making enough money that you have to do it through the back door, you should be making enough that you can do it all at once. It's only $6,000 for you and $6,000 for your spouse. Even if you've got to do your spouse's next month, you can do it for you this month, et cetera.
WCI: But the issue here is with a resident, they don't have that much income and it's really hard to come up with six grand all at once as a resident. So it's much easier to come up with $300 or $400 a month to put in there and gradually max it out over the course of the year. When I was a resident, that was how we made our Roth IRA contributions. Now we're married filing joint so we could just make them directly. It was no big deal.
WCI: But in this case, this couple is filing married filing separately so they can't do that. They have to do the back door. And so what I would do, I would probably contribute to a traditional IRA as the year went along. But rather than doing the conversion every month after making a contribution, I would probably go ahead and just do the conversion once during the year. Now that probably means you're going to have some gains on that traditional IRA and that is not the end of the world.
WCI: I mean, you want to have some gains. That's the purpose of investing as you go along. But you are going to have to pay taxes when you do the conversion. For example, if you get $6,000 in there over the year and by the time you do the Roth conversion at the end of the year at $6,300 you're going to owe taxes on that $300 when you do the Roth conversion. You have two other alternatives if you don't want to do that.
WCI: The first one is every time you make a contribution, just do a Roth conversion. That's not a big deal. I mean, you basically just add it all up at the end of the year when you report it. It'll probably be reported just like you had done it all at once. But there'll be a buck or two, a few dollars you made on interest in between the contribution and conversion steps. The problem is you're going to have to log in and do that conversion every month that you make a contribution. That's not a big deal to you, I guess you can do that.
WCI: The other alternative is just save up the money in a money market fund on the side or a high yield savings account and make the contribution at the end of the year and then do the conversion the next day. And that would keep things very simple, but you would miss out on any earnings that money could have had during the year.
WCI: I guess you don't miss out on all the earnings. You would earn whatever you're getting in the money market fund. But you would miss out on what stocks were earning or bonds were earned if you would've invested the money there.
WCI: A couple of other observations on this situation. First of all, in case it's not clear, you can't actually put wedding money into retirement accounts. The only money that can go into retirement accounts is earned income. Now you can spend wedding money on your living expenses rather than spending the money you're earning in your job. But the bottom line is you cannot contribute more to a retirement account then your earned income in that year.
WCI: Also, bear in mind if your goal is really to minimize your income driven repayment payments in order to maximize how much you get forgiven through public service loan forgiveness. You might want to consider making tax deferred contributions to any account that you can, whether that be IRAs or 401ks. And the reason why is any money that goes in there basically comes out as a tax deduction and lowers your income.
WCI: The lower your income, the lower your IDR payments and the more that is left over after 10 years to be forgiven through public service loan forgiveness. Now that contrasts a little bit with my usual advice for residents. I generally tell residents that they want to invest in Roth accounts, Roth IRAs, Roth 401ks, Roth 403Bs because you'll never be in such a low tax bracket the rest of your life.
WCI: But it's possible in some situations, especially when you're sure you're going public service loan forgiveness, that you'd be better off using a tax deferred account in order to lower those IDR payments and increase how much goes toward public service loan forgiveness. You just have to run the numbers for you and decide whether that's worth it.
WCI: Okay. Let's take our next question. This one's from Mark.
Mark: Hi Jim. My name is Mark and I'm an anesthesiologist in the Pacific Northwest. I had a question for you about taking out a loan against your 401k. I'm wondering if you could speak briefly about the advantages and disadvantages and specifically, I'm curious your thoughts on this idea of the money that you use to pay back the loan being double taxed. There seems to be some differing opinions on the various forums online. Thanks so much. Appreciate what you do.
WCI: Okay. Mark's asking about loans against 401ks. First of all, let's talk about 401k loans. 401k loans are not a great idea and the reason why is I want that money in the 401k making money. I mean, this is money that you're supposed to put in there because you want to retire on it.
WCI: This is not an ATM that you want to raid in order to buy your next Tesla or in order to go on a vacation or really even to cover emergencies. Hopefully, you've got a separate emergency fund for that, but if you want to borrow from your 401kK you are allowed to do that. The maximum is either 50% of the value of the 401k or $50,000 whichever is less. That's the most you can borrow. And you have to pay an interest rate to the 401K for that loan. The longest a loan can be is five years.
WCI: This used to be a really terrible idea because if you got fired, you had to have that loan paid back within 60 days of separation from the company and when you get fired, that's a time in your life when you probably don't have a lot of money because you're not making anything.
WCI: And so it was a particularly difficult time to pay the loan back and that is the reason why a lot of people got burned and ended up having to pay the penalty on that loan. Because if you don't pay it back within 60 days, not only do you have to pay the taxes on that withdrawal, but you have to pay a 10% penalty on it. They changed that law with the 2018 tax changes. And now instead of only having 60 days, you have until your next tax day. So if you take out a loan in February, you have until April of the next year to get that money back into the account.
WCI: In fact, if you file an extension, you could get even more months to get that money back into the 401k. So that makes it not quite as dumb of an idea as it was before, but it's still probably a dumb idea. Now, is it better than borrowing from a bank or better than borrowing from somebody else? Well, it might be. It depends on the terms you're getting from the bank and what the money would have made in the 401k.
WCI: One way to look at a 401k loan that you're paying back is that it's really kind of a fixed income or a bond in that 401k. And so maybe what you should do when you borrow from the 401k is change the asset allocation of the money that's left. So it's more stock heavy. And that way the money you're paying into the 401k in interest is kind of like the bond portion of the portfolio.
WCI: But the question that Mark is asking is this double taxation myth. And I say myth because it is a myth. People say, “Well if I borrow from my 401k, then I got to pay that money back with after tax money and then I got to pay taxes again on that money when I pull it out of the 401k.” But that's not the way it works.
WCI: You see, any loan is after tax. So the money you borrow out of the 401k is after tax. So the money you put back into the 401k has to be after tax. Right? So the money comes out after tax, it goes back in after tax and then when you finally withdrawal it in retirement, it's coming out, it's pre-tax and you have to pay taxes on it. Okay? But it only gets taxed once. It gets taxed when you pull it out of the 401k.
WCI: I hope that helps. If you are still a little bit confused about that, probably the best example I know of it, is a blog post written way back in 2008 by the finance buff, in which he talks about 401k loans. And that's certainly worth taking a few minutes to read if you're really worried about this.
WCI: The post is called the 401k Loan Double Taxation Myth. And he has a nice diagram there and a nice explanation of why that's really not an issue. So if you want to borrow from your 401k, don't let the double taxation myth be what keeps you from doing it. Let the idea that is just generally kind of a bad idea to be raiding your retirement accounts for your spending needs now is a bad idea. Okay, next question comes from Jesse.
Jesse: Dr Dahle, thank you for what you do. I'm a physician and receive the majority of my income as a W-2 employee, but also receive about 35,000 in 1099 income each year. I'm already maxing out a backdoor Roth IRA for myself and my spouse as well as HSA and my employer 401k. What, if any, are the tax advantage investment options for folks that have 1099 income in addition to the W-2 income?
WCI: Okay, this is a question I get all the time. Jesse made $35,000 in 1099 income, but as his main job as a W-2, right? He already maxed out his 401k there. So he's already put his entire $19,000 employee contribution into the 401k plus whatever he could get from the employer.
WCI: The good news is, if you have a separate source of income, a separate company, in this case, the one that Jesse owns himself, that is bringing you income, you can have another retirement account for that. Okay? And there's a few rules about it. First of all, you could use a sep IRA. I would generally recommend against that. And the reason why in this scenario is because it screws up your backdoor Roth IRA prorata calculation.
WCI: Remember, you've got to have a $0 balance in all of your traditional IRAs, simple IRAs and Sep IRAs in the year that you do a Roth conversion or that conversion is going to be prorata.
WCI: And so you generally don't want to use a sep IRA if you're doing backdoor Roth IRAs. So what does that leave you? That leaves you an individual 401k and in this situation where the $19,000 employee contribution has already been used in the employer's 401k, all you have left are what we call employer contributions, which is 20% of your net income from self employment.
WCI: So net income is your profit minus half of the Social Security and Medicare tax that you owe from that income. 20% of that is what can be contributed to a Sep IRA or a solo 401k. It's actually the same contribution amount in this situation. So in this case, he's making $35,000. So he'd be able to put what in there? Maybe $7,000. Something like that into an individual 401k. That's a nice tax break. At $7,000, it won't be taxed as marginal tax rate and it's money, that'll be now somewhat asset protected as well.
WCI: So it's worth doing I think for that amount of self employment income for sure. Our next question comes from Gary.
Gary: I am a longtime listener of the podcast and I'm a multiple year reader of the book and your blogs. I just got off my second phone call with the personal capital and I just wonder if you would comment on their market sector approach with the 10 stocks per sector and rebalancing whatever and just versus index investing that's often discussed with you guys and many of the Vanguard folks and whatever. So please comment on their approach if you would, pros and cons. Thanks.
WCI: Okay. This one is a complicated question. He's asking about an active management technique used by a financial advisor and wants my opinion on it.
WCI: Well, in general, I'm not a big fan of active management. I prefer passive investing strategies and if you ask personal capital whether this is active or passive, they're going to call it passive. But in reality, this is kind of a factor based, somewhat active strategy.
WCI: And what they are doing is they are mostly doing what we call equal weighting. And the idea behind equal weighting is rather than taking your stocks and weighting each of them by how much that company is worth, that's what we call capitalization weighting. That's what most index funds do. They decided to put equal amounts into each sector and then within each sector equal amounts into each of 10 or 12 stocks in that sector.
WCI: So basically they're creating their own mutual fund, their own kind of passively managed index fund, but it's equally weighted rather than the capitalization weighted. There's a few downsides to doing this.
WCI: One of the downsides is that it's not terribly tax efficient. And so you can run into some issues if you're doing this in a taxable account. There's lots more buying and selling going on and every time you do that, you gotta pay capital gains. Especially if you end up having to pay short term capital gains. So that's one issue.
WCI: The other issue is it's a lot more complicated. You've got to pay somebody to do this. Personal Capital charges 0.89% per year. And so if you're doing this just to try and get some out performance from this technique, it's gotta be a least 0.89% per year better than just a standard by the index funds capitalization weighted plan.
WCI: The idea here behind most equal weighting plans, and the reason why a lot of times the back tested data shows that they outperformed is usually attributed to factor investing. That's this idea that over the long-term small stocks and value stocks outperform large stocks and growth stocks.
WCI: You see, by equally weighting it, more of the money is being put into smaller stocks and more of the money is being put into value stocks rather than large growth companies like Apple or Walmart. And so that is why this theory is supposed to work. Now whether it will work and whether it will work better than 0.89% per year after tax going forward. Well, that's anybody's guess. This is investing. You make your bets and you take your chances and you get what you get. But whether you want to go and do that, I'll leave up to you.
WCI: Personally I do not invest that way. But it's not like it's some insane method of investing. As reasonable investment strategies go, it probably falls into the realm of reasonable. It's just a matter of whether you think it's better than the default capitalization weighted index funds and whether you're willing to pay for it.
WCI: Our next question comes from Daniel.
Daniel: Hey Jim, thanks a lot for the podcast and the White Coat Investors site. I feel like it's been an immense help to me and my family already. Regarding my question, it's about how to fund an HSA properly. If I'm in a job for only half of a year that offers a qualifying high deductible health plan, does that mean I can only fund half of the HSA?
WCI: He's basically asking how to fund an HSA properly for part year eligibility. So the way this works is if you are eligible for an HSA for four months of a year, you have a high deductible health plan for four months of the year, you can make four out of 4/12 of the contribution for that year.
WCI: For 2019, a single person, an individual can contribute $3,500 to an HSA. So if Daniel was just an individual without any family members, no kids, no spouse, and was eligible for 1/3 of the year, he could contribute 1/3 of $3,500. That limit is $7,000 for a family. And that can be you and a child or that can be you and a spouse.
WCI: However, there is one interesting twist on this and it's what they call the last month rule. If you have an HSA eligible plan. Okay? A high deductible health plan. That's not necessarily one that just has a high deductible, but it's one of the government calls a high deductible health plan. If you have it in place on December 1st you can make the whole year's contribution. Pretty cool, right?
WCI: You just have it for a month or two at the end of the year and you can do an entire year's HSA contribution. The only catch is you have to keep that plan for the next year. You have to be eligible for the entire next year or basically it goes back to just letting you make one month's contribution worth to the HSA. So good question. It's important for those who aren't eligible for a high deductible health plan for the entire year. Next question comes from Jeremy.
Jeremy: Hi Jim. Thanks for what you do. I'm hoping you can talk about your experience with the White Coat Investor filing as an S-corp this year. And I'm hoping that you can kind of put your thumb on the point when it makes sense for a small business to file as an S-corporation and when the added complexity just simply does not add any value.
Jeremy: To give you a background, I live in Massachusetts and on the Massachusetts form you must have a balance sheet. So on the federal, you have to have a Schedule L and M-1 regardless of income. We have a corporate effective tax rate of 9.5% with a minimum tax of $456. I'd love to hear your thoughts. Thank you.
WCI: Okay, so Jeremy is asking when does an S-corp makes sense? All right. This is actually a complex question to start with and it just became more complex in the last year. So let me outline a few general principles. And then the truth of the matter is anybody who really wants the answer to this, is going to have to run the numbers themselves. And they might even have to hire a professional to help them do it.
WCI: The general reason why a typical doctor forms an S-corp is in order to split his income into two categories. The first is salary, and the second is distributions. And the benefit of putting as much as you can into distributions rather than salary is you don't have to pay payroll taxes like Social Security and Medicare on the amount that you called distribution.
WCI: Now, for a typical doc, you've got to pay yourself a reasonable salary anyway, and that's going to be a high enough number that you've maxed out your Social Security taxes anyway.
WCI: But it might not be, but you still could save some money on Medicare tax. Well, how much has medicare tax? Well, it's 2.9%, with half of that being a tax deduction for the business. So in reality, maybe it's 2.2% once you take into account that deduction. And so, what is that worth? Well, if you can call $100,000 distribution instead of salary, you just saved $2,200 in Medicare tax.
WCI: And so there's a certain amount of hassle involved with forming an S-corp, right? There's … he mentioned some of the tax returns and I'm familiar with them cause I've been filling out these tax returns the last couple of years, but there's a bit of hassle there and you've got to send in all this money and you got to file W-2's and there's a lot of paperwork hassle. At a certain point, if you're not saving a significant amount of taxes, it's not worth the hassle.
WCI: And my general rule for that in the past has been $100,000. If you're not calling at least a $100,000 distribution for a typical doctor it's probably not worth forming an S-corp to try to save those Medicare taxes. But if you can call at least $100,000 distribution, then I think it was probably worth doing.
WCI: Now bear in mind that the money that you call distribution is not eligible to count toward the amount you need to make to max out your retirement accounts. So if you want to max out a 401k, an individual 401k, and you've already used your employee 401k somewhere, employee 401k contribution in a different plan, you have to make a lot of money in order to max that out. I mean, this year the maximum is $56,000. So basically multiply that by five and that's gotta be the amount of salary you have to pay yourself.
WCI: And so unless you're making pretty good money at that 1099 job, it's going to be tough to have enough above and beyond that to justify the hassle of the S-corp.
WCI: Okay. So as you can tell, it was a complex decision, even a couple of years ago, but it just became more complex with the new 199A law. Okay? This is the new tax deduction for self employed individuals. And so you actually calculate this differently for a sole proprietorship versus an S-corp.
WCI: And if you have an S-corp, basically it comes down to also a factor that applies that, that deduction can be no larger than 50% of what you're paying out as salary. And so now there's an additional factor going into this and really I can't give any sort of general rule of thumb here anymore. You really have to run the numbers yourself and see which way you're going to come out ahead.
WCI: Is the additional Medicare tax savings going to make up for the loss of the 199A deduction, et cetera? You just have to run the numbers and you're probably gonna need some help from your accountant unless you're preparing your own taxes. And if you are preparing your own taxes, good luck. You're going to have to sit down and work your way through this 199A law, which I think all of us are struggling a little bit with this year.
WCI: I'm planning on a blog post on it, but I probably won't write it until I figure out what my deduction is going to be and work through that tax form myself. I think I'll understand it a lot better by then. But really that factor has to be taken into account now that we have this new deduction available. All right? Well, that was a lot of questions from guys.
WCI: I need some questions from women here. Let's go over to the email box here for a second and I've got a question from a woman who says, “I was recently accepted into medical school. I'm very excited to get the Texas in-state tuition.” I would be too. Texas is a great place to go to medical school. “I am currently my second gap year working at the NIH in Bethesda. I'm trying to decide if I should open and max out a Roth IRA or keep this money to use during medical school. I'll be taking all loans for tuition and other expenses I will likely take loans from my parents interest free, of course.”
WCI: That's nice. Appreciate that. Remember by the way, anytime that a parents give loans that the amount of interest is forgiven, because you're required when you give a loan to charge at least a minimum amount of interest, the amount that you're forgiving is considered a gift. So be aware of the gift tax laws when you do that.
WCI: But she says, “I'll still have to pay that back to my parents. Is it worth starting retirement savings early or keeping that money in order to lower my loans?”
WCI: There's no right answer to this question. I Love Roth IRAs, right? Getting that money in there, get it compounding. It's tax free forever. It's asset protected. The estate planning is facilitated with it. You can leave it to your kids and stretch it out even longer. Roth IRAs are a great thing, but so is minimizing your debt.
WCI: Bear in mind when you are in med school or going into medical school, the greatest investment you can make is in yourself and your future earnings ability. And so that's not a bad thing either to reduce your loans and given what most medical students are borrowing at these days, which is 6 or 7%, that's essentially a 6 or 7% guaranteed investment.
WCI: And I think I might pass up a Roth IRA if I had a 6 or 7% guaranteed investment. It'd be a difficult decision, but I think I might just do that if that was the other option. And just stack that money up in cash, use it that first year of med school to reduce how much you borrow and get used to living frugally as much as you can to minimize those loans.
WCI: I tell you what, for a lot of medical students, it just feels like Monopoly money. It's more money than they've ever made in their life and they just keep borrowing it and they become debt numb to it and all of a sudden, 15 years later they still owe hundreds of thousands of dollars in student loans. So I think that's a worthy goal to try to lower your loans. I think that's probably what I would use the money for in this situation rather than maxing out a Roth IRA.
WCI: But it's not like that's a bad thing to do. It's not a bad idea and I'll have to leave it up to you as far as how you're going to decide. All right? While I was combing through my email box, I actually got two more questions in on the Speak Pipe. This is great.
WCI: If you want to leave Speak Pipe questions, we're really enjoying these. Just go to speakpipe.com/whitecoatinvestor and we'll get your voice on the podcast. But these two more that we're going to do in the podcast are both from women. So here's the first one.
Juliana: I'm a physician in my mid-50s looking toward retirement soon. I came across your site only about a year ago, but better late than never. Thanks for what you do. I fired my financial advisor and I'm still cleaning up the mess. I had a question about an annuity. I own an annuity from the previous financial advisor.
Juliana: I've held it for over eight years and it's worth about $100,000. I've been reading that it might be a wise move to do a 1035 exchange into an annuity with cheaper fees. Can you comment on this? Thanks a lot.
WCI: All right, so Juliana is asking what to do with this annuity. It sounds like she was sold some crappy annuity from some crappy financial advisor and has been stuck with it for a long time, but she's got a hundred grand in it now and she wants to know what to do with it.
WCI: Well, the best thing to do with it at this point. I mean, it's hard to know without knowing what the basis is. I mean, maybe she can just cash it out and won't have to pay much in taxes on it cause it never appreciated much. But I suspect she's got a fair amount of appreciation in there. So it's probably worth exchanging it to a low cost variable annuity, like those that are offered by Vanguard.
WCI: This is called a 1035 exchange. And basically all the cash value from one goes into the cash value of the other, but you basically instantly have better investments in there and you have lower fees. So it's a no brainer to do that. The only other alternative would be is it worth just cashing out and investing in a taxable account or using the money to pay off debt or using the money to max out retirement accounts, et cetera.
WCI: But certainly getting out of some old crummy high expense annuity with crappy investments is usually worth doing. All right, our final question is from Nicole.
Nicole: Hi Jim. My husband and I are finally maxing out all of our tax advantaged accounts this year and going to be opening brokerage accounts. I'm wondering if we can open a joint to taxable brokerage account under both of our names or if we need individual ones. Thanks for everything that you do.
WCI: So this one's pretty easy. This is a simple question. Can we open a joint brokerage account? And the answer is yes. You can open an individual one, you can open a joint one, you can do whatever you like.
WCI: The downsides to a joint one is that your spouse can clean you out. I mean, it's joint and you both own the whole thing. And so you've gotta watch out for that, I suppose. Another downside I suppose is in the event of liability, if for some reason that one person is sued and the other one is not, that joint account becomes something that the creditors can grab.
WCI: So I suppose it could be a bit of an asset protection technique to put … to have two separate a brokerage accounts. In some states, you're allowed to title your brokerage accounts as tenants by the entirety, in which case two spouses would not have to split that up to get that same level of asset protection.
WCI: In fact, it's even more asset protection because no matter which spouse was sued, the money would not be reachable. So that's a great way to title a joint brokerage account in the, I dunno, I think it's seven or eight states that allow that. But yeah, you certainly can open a joint brokerage account. That's how Katie and I have our brokerage account, it is joint.
WCI: And so the nice thing about that is if one of us died, the other one would just keep on going, nothing would have changed really. Plus we both have access to it. It just seemed the right way to do it to us. We have both of our names on the house. We have both of our names on most of our vehicles. Although I think technically she owns the boat. I guess the day we bought that I felt like that was going to give me some additional asset protection or something. But we have both of our names on our brokerage accounts and our bank accounts as well. And I think that's what most people do.
WCI: All right. Be sure to check out our recommendations page. We have a recommendation for just about every financial professional you want to get in touch with.
WCI: At some point in our financial lives, it will be time to buy a home. A physician mortgage can be a good vehicle for a young doctor who’s just out of school and has a more effective place to use their money than on a big down payment. These loans allow doctors to secure a mortgage with fewer restrictions and a lower down payment than a conventional mortgage. But if you’re further advanced in your career or deeper into your journey to financial freedom, buying a home with a conventional mortgage and then, later on, potentially refinancing that loan to a better rate with a shorter time frame could be a great move.
Wherever you are in your financial journey, make sure you use the mortgage that will be most financially beneficial for you. Hop over to our recommended tab to learn more about all of your mortgage and refinancing options at whitecoatinvestor.com/mortgage.You can do this and The White Coat Investor can help.
WCI: Head up, shoulders back. You've got this and we can help. We'll see you next time on the White Coat Investor podcast.
Disclaimer: My dad, your host, Dr Dahle, is a practicing emergency physician, blogger, author, and podcaster. He's not a licensed accountant, attorney or financial advisor. So this podcast is for your entertainment and information only and should not be considered official personalized financial advice.
