Financial Consult for the Severely Anemic Resident Wallet Part 2: Choosing the Right Investment Fund
Wender Hwang, MD, Loma Linda University Medical Center, Loma Linda, and Erik W. Thurnher, MD, CFP, Kaiser Permanente Medical Group, Lakewood, and Physicians' Financial Advisors, Newport Beach, Calif
Published Online: May 17, 2007 - 11:48:20 PM (CDT)
Wender Hwang, MD Chief Resident Department of Emergency Medicine Loma Linda University Medical Center Loma Linda, Calif Erik W. Thurnher, MD, CFP Emergency Physician Kaiser Permanente Medical Group Lakewood, Calif Certified Financial Planner Physicians' Financial Advisors Newport Beach, Calif
The first part in this series (see June 2006 issue) discussed the basics of investments and defined the main terms you will need to know for making the investment that is right for you. The second article outlines the specifics of each investment option, including Roth IRA (Individual Retirement Account), section 529 plans, Coverdell savings accounts, and tax-deferred 401k/403b retirement plans. Consult the Action Checklist that appeared in June to recall the financial tasks you need to accomplish.
Roth IRA Roth IRA accounts are like any other investment account you open at a brokerage or bank-you can buy stocks, mutual funds, bonds, or even certificates of deposit in your account. The only differences are the account?s legal designation, contribution limits, and tax benefits.
Why is everyone raving about the Roth IRA? Because it has the most generous tax break of all the investment options. Other investments tax earnings, withdrawals, or both. Money in your Roth IRA account accumulates interest/earnings tax free, and all withdrawals during retirement are tax free. This is particularly useful for residents, because your tax bracket is likely to be much higher in retirement than it is now, and this more than offsets the fact that contributions are not tax deductible.
In addition, before retirement you can withdraw the principal (the money you put in) tax free for any reason. Preretirement withdrawals of more than your principal are subject to different penalties and taxes. This makes the Roth IRA an ideal account if you are saving for several purposes and have minimal savings. The best use of a Roth IRA is for retirement savings, because of its tremendous long-term tax advantages. It can, however, serve as a college-savings account or a place to accumulate a down payment if you have no other money. Thus, if you qualify, it deserves to be first on your list (Table 1).
The main drawbacks of a Roth IRA are the low-income phaseouts and contribution limits. Residents must start their Roth IRA while they still qualify for it based on income (Table 2). Get in before you make too much money after residency. You can make contributions for the previous tax year up until you file your April tax return.
529 Plans Section 529 plans (Table 3) are similar to Roth IRA accounts, except that you are saving for college rather than retirement-after-tax contributions grow tax free and withdrawals for college expenses are tax free. Almost every state offers its own 529 plan, managed by a large financial institution (nonresidents can participate, but some plans charge a nonresident fee). There is a large, heterogeneous selection of 529 plans available. The various plans differ in the following ways:
? Contributions are state-tax deductible for residents who contribute to their own state?s plan
If your state offers tax-deductible contributions, that is likely the best plan for you. If not, choose any state plan that offers investment options you like (most have age-based asset-allocation funds). Be careful of plans that charge a front-load sales fee or nonresident fee-avoid these if at all possible. The website www.morningstar.com has a nice compilation of all state 529 plans.
You can designate anyone as the beneficiary of the account regardless of your relationship to that person. Once defined, however, the beneficiary can only be changed to another member of the family, which is defined as: (1) a son or daughter, or a descendant of either; (2) a stepson or stepdaughter; (3) a brother, sister, stepbrother, or stepsister; (4) the father or mother or an ancestor of either; (5) a stepfather or stepmother; (6) a son or daughter of a brother or sister; (7) a brother or sister of the father or mother; (8) a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law; (9) the spouse of the beneficiary or of any of the other foregoing individuals; or (10) a first cousin of the beneficiary. For this purpose, a child includes a legally adopted child and a brother or sister includes a half-brother or half-sister.1,2
So if you do not have a child yet, you can designate yourself as the beneficiary and start contributing and accumulating earnings. Once you have a child, you can change the beneficiary to that child.
Once an account is established, anyone can contribute to it, even non?family members. The maximum one person can deposit in one year without triggering a gift tax is $55,000 ($110,000 for a married couple), without further contributions in the next 5 years.
In financial aid calculations, the account is considered a parental asset and generally assessed at up to 5.6% for aid purposes. This is far better than the rule regarding the uniform gift to minor account (UGMA) and the uniform transfer to minor account (UTMA), which are assessed as student assets at 100% for aid purposes, and, therefore, can reduce the amount of aid available.
Qualified expenses are tuition, fees, books, room and board, required supplies, and equipment for college and graduate school. Any remaining balance can be reassigned to another beneficiary per the ?member of the family? rule.
The independent 529 plan is a consortium of private colleges that allow you to purchase (invest in) a percentage of future tuition rather than increasing capital. That percentage will vary for each school, depending on its current tuition rate and certificate discount rate. This plan is superior to the standard 529 plan, if you believe tuition prices will rise faster than the stock market.
The tuition you purchase today is guaranteed to satisfy costs at the time your child enrolls. All member colleges offer a discount of at least 0.50% annually off their current tuition, which means that you are actually paying less than today?s price for tomorrow?s tuition. The value of the certificate discount compounds between purchase and redemption. That means the longer you hold a certificate, the greater the value of your purchase. Participating institutions carry the investment risk and protect you from future tuition increases. Participating in the independent 529 plan does not improve admissions. You can also opt for cash to use at a nonparticipating college, although the cash value may be less than certificate redemption.
Coverdell Accounts The Coverdell education savings account (Table 4) is very similar to the section 529 plan.3 But in contrast to 529 plans, contributions to Coverdells (Table 5) are phased out for incomes at $95,000 to $110,000 ($190,000-$220,000 for a married couple filing jointly). These phaseouts may potentially be bypassed by giving money to the child through a UGMA or a UTMA and having the child contribute to his or her own Coverdell account. Corporations may contribute to any Coverdell account, regardless of income level. If you are lucky, your company will match a percentage of the contributions you make to this account.
Tax-deferred Plans The 403b is the nonprofit corporation version of the 401k (Table 6), a way to set aside pretax money for retirement. You specify how much money is taken out automatically from each paycheck before any taxes. It grows tax-deferred until you start taking distributions (withdrawals), at which point it is counted as regular income and taxed at whatever tax bracket you end up in that year.
You can begin withdrawing money starting at age 59.5, although you are not required to do so until age 70 (10 additional years for compounding). Although it reduces the amount of money in your pocket from your paycheck, you have a smaller tax burden and ultimately more money than if you did not participate in the plan. For example, if you designate $500 of your $1500 biweekly paycheck toward your 403b account, you are taxed only on $1000 of that paycheck (Table 7).
Many plans have a small quarterly or annual maintenance fee (about $10 annually) but have no fees for joining or changing mutual funds offered by the plan. If your specific plan charges more excessive fees, complain to your human resources department. Even with relatively high fees, however, the tax savings are so high that it may still make sense to participate.
The annual contribution limits for tax-deferred plans are listed in Table 8.
Many plans allow you to borrow up to 50% or $50,000 of your retirement money (the lesser of the two) from the account. You can borrow the money for any reason for 1 to 60 months (61-180 months for mortgages) and set your own term (number of months). Although you are borrowing from yourself, it is still a loan, and you have to pay it back with interest.
The reasons for not borrowing from your retirement accounts are: (1) missed market opportunities, and (2) heavy penalties and taxes if you default, because you essentially received early distributions. Although this self-loan feature makes the 401k/403b plans ideal for investing for multiple purposes, it is generally ill-advised to borrow against your retirement account, given the missed long-term growth potential.
Conclusion The next article in this series will present tips on how to reduce your tax burden and increase the amount of money available for you to invest with each paycheck.
References 1. Internal Revenue Code. ?Dependent defined.? 26USC ?152(a) (2002). Available at www4.law.cornell.edu/uscode/26/152.html. Accessed January 13, 2006.
2. Internal Revenue Code. ?Qualified tuition programs.? 26USC ?529 (e)(2) (2002). Available at www4.law.cornell.edu/uscode/26/529.html. Accessed January 13, 2006.
3. Internal Revenue Code. ?Coverdell education savings accounts.? 26USC ?530 (2002). Available at www4.law.cornell.edu/uscode26/530.html. Accessed January 13, 2006.
