The Roth 401(k) is the mostexciting tool to enter thefinancial market for physiciansin the past 20 years.Beginning Jan. 1, 2006,a little known provision from theEconomic Growth and Tax ReliefReconciliation Act of 2001 (EGTRRA)takes effect, enabling retirement plansto allow Roth contributions to a401(k) plan. The Roth 401(k) grantsphysicians the right to contribute after-taxdollars into an account that growscompletely tax-free for retirement.This especially benefits up-and-comerswho will eventually experience significantincome increases, and high-incomeprofessionals on track to be ina similar income range during retirementas they are today.
Benefits of a Roth 401(k)
Roth IRAs, though a fantastic plan,were never available for most practicingphysicians since their income exceededthe allowable contribution limits. TheRoth 401(k) plan does not have any incomelimitations, so even the highestincome professionals can make full contributionsto the plan. Other upgrades inthe Roth 401(k) plan include contributionlimits as high as a traditional 401(k).Therefore, beginning in 2006, physicianscould invest $15,000 into the plan andhave those funds grow completely tax-freefor retirement, assuming the lawdoesn't change by then.
The growth is still tax-deferred, butthe income comes out tax-free as longas the normal 401(k)/IRA incomeguidelines are followed. Since it is a pureinvestment product, there are no insuranceexpenses to navigate. Also,employers will be able to make matchingcontributions to most plans, albeitwith tax-deferred dollars.
The following example compares thenew Roth 401(k) to a traditional physician'splan. Examples assume maximumannual contribution ($15,000), a30% federal tax rate, a 5% state taxrate, and an 8% rate of investmentreturn. A matching contribution is notconsidered since it would produce thesame results in any scenario.
If a 35-year-old physician maximizedcontributions to their traditional 401(k)until age 60, they would end up with$1,015,000. They would still, however,owe $340,000 in taxes on the traditional401(k) plan, meaning their net gainwould only be $675,000. In contrast, ifthe physician maximized contributionsto a Roth 401(k) plan instead, then theywould end up with the same $1,015,000at age 60 and not owe any taxes.
Naysayers will claim that the loss ofthe tax deduction is significant becauseit would take more physicianearnings to contribute $15,000 inafter-tax money than it would in tax-deferredmoney. Although this statementis correct, it does not impact thevalidity of the recommendation. Let'snow assume that the same 35-year-oldphysician can only afford to makecontributions to the plan of $15,000in tax-deferred dollars. After-tax contributionswould need to be reducedby their taxes, and they would not beable to contribute as much money.
If this physician were to use thetraditional 401(k) plan, they wouldend up with the same account balanceof $1,015,000 at age 60, butstill owe $340,000 in taxes in retirement.This is a net of $675,000. Thissame physician could pay the taxeson their $15,000 before they investedit and now they would only have$9975 per year to contribute to theRoth 401(k) plan. At retirement agethey end up with $675,000—theexact same amount the tax-deferredcontributions brought them.
Understanding federal tax codecomplexities usually causes a migraine.My advice is simple. Take twoaspirin and call your financial plannerin the morning.
currently leads the medical
division of Phillips Financial Services, a large,
fee-based financial planning firm in Fort
Wayne, Ind. The medical division provides
comprehensive financial planning and asset
management services for health care professionals. Phillips'
clients include the presidents and physicians of several large
medical practices in Indiana, Ohio, and Michigan. Mr. Martin
recently became the first Certified Wealth Preservation
Planner in the state of Indiana. He welcomes questions or
comments at firstname.lastname@example.org.