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Why All the 401k-IRA-SEP-Roth-Profit- Sharing-Confusion? by Douglas Carlsen, DDS

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Why is there so much confusion in the world of personal finance? Because it’s almost impossible to read or listen to all the gibberish! Any tax-advantage financial course, whether dental-related or not, normally provides higher sleep disorder benefit than Ambien or Restoril.

Bottom Line

Finance Lingo Decoder
TIPS =
Treasury Inflation-protected Securities
REIT =
Real Estate Investment Trust
ETF =
Exchange Traded Funds
IRA =
Individual Retirement Account
AGI =
Adjusted Gross Income
CPA =
Certified Public Account
Most financial gurus make the case to tax-defer as much savings as possible to maximize your nest egg. Or is it to maximize their nest egg?

Invest primarily in index funds. This is your simplest tax-reducing strategy. Other tax-advantaged investing is almost always prudent. IRAs, any Roth and many other 401(k) plans offer increased wealth accumulation for doctors. More complicated plans offer positive net return especially for older doctors, yet due diligence is vital as fees and risk may overcome any benefit.

That’s it! If you wish further financial anguish, read on...

Taxable Income

Let’s look at the different types of taxes you face and the effects on your assets.

Ordinary Income

10 to 43.4 percent federal taxes; minimize this.
  • Your income.
  • Interest from U.S. Treasury and corporate bonds.
  • Interest and annual principle adjustments from TIPS.
  • Around 70 percent of REIT income.
  • Gains from ETFs that invest in collectibles like gold.
  • Interest on inflation-adjusted Series I savings bonds when sold.

Short-term Capital Gains

10 to 43.4 percent federal taxes; minimize this.
  • Profits on sales of stocks, bonds, mutual funds and other assets held a year or less.
  • 40 percent of the gains on commodity futures (ETFs).
Long-term Capital Gains

0 to 23.8 percent federal taxes; this is OK!
  • Profits on sales of stocks, bonds, mutual funds and other assets held longer than a year.
  • 60 percent of the gains on commodity futures ETFs.

Qualified Dividend Income

0 to 23.8 percent; this is OK!
  • Dividends from U.S. stocks and some foreign stocks. REIT income, collectible ETFs and commodity futures ETFs all have higher tax rates than stocks, bonds, mutual funds and most ETFs held longer than a year.

The preceding amounts are summarized from “Take These Steps to Cut Your Losses,” Money Magazine, May 2011, with adjusted 2014 tax update. Also note, the numbers listed include the additional 3.8 percent Medicare tax if you are a single filer with more than $200,000 in Adjusted Gross Income or file as a married couple with AGI income more than $250,000.

To Minimize Taxes

Where should the prudent dentist place different assets to minimize taxes? Below is the traditional rule of thumb:

Taxable Accounts: These are often called after-tax or cash accounts. Place municipal bonds, I-Bonds, and stock and bond index funds and ETFs in taxable accounts.

Tax-deferred Accounts: Tax-deferred accounts shelter investments from taxes until funds are taken out. These are commonly called “retirement accounts.” Common accounts include 401(k)s and IRAs. More exotic forms include cash balance, pension equity, profit sharing and target-benefit plans.

Place actively traded stocks or mutual funds, Treasury bonds, TIPS, corporate bonds, REITs, commodity ETFs like gold, other taxable bonds, and stock and bond index funds and ETFs in tax-deferred accounts.

Tax-exempt Accounts: Tax-exempt accounts are not subject to taxes at retirement. Contributions to the account are made with after-tax dollars. The investment returns grow tax-free. The Roth IRA is the major example.

Invest funds as you would in tax-deferred accounts.

There have been numerous studies showing that you maximize growth by utilizing the tax-deferral strategy. The financial gurus are right, especially in our current higher tax environment. According to Kevin Trout of AAII (American Association of Individual Investors):

The new maximum tax bracket and new net investment income surcharge (3.8%) make it important to reassess your asset location decisions. For instance, bonds traditionally have been a better asset than stocks to place in a tax-deferred account because the interest is taxed annually at the ordinary tax rate. However, given the current low yield on bonds and higher tax rates for some investors on dividends and capital gains, investors may find it preferable to place high-dividend stocks in a tax-deferred account instead of low-yielding bonds.The benefit of placing an asset in a tax-deferred account increases with the higher tax rates and the investment income surcharge.1

Trout says there are reasons to put almost any type of investment into a tax-deferred account today.

Why in the previous listings are stock and bond index funds and ETFs listed for tax-deferred, taxable and taxexempt funds? Walter Updegrade of CNN Money:

Since index funds track a specific benchmark, such as the S&P 500 or Russell 2000, their selling is largely limited to getting rid of securities that leave the index or providing cash to redeeming shareholders, and even in those cases there are techniques managers can use to limit taxable gains.2

Index funds don’t create many capital gains in any given year and can be placed in any fund.

Traditionally, doctors have often been oversold on plans with high administrative and fund expenses. Fees for IRAs and 401(k)s are now often affordable.

Simple, Safe and Least Expensive

Unless stated, deductions for sole-proprietors and incorporated doctors are the same.

Maximum Contribution Per Year

SEP-IRA
$52,000

Profit-Sharing Keogh
$52,000

Simple IRA
$20,311 for sole proprietor and $21,000 for corporation

For over age 50, a sole proprietor’s maximum contribution for a Simple IRA is $22,811 and for a corporation is $23,500. Vanguard offers low fees and extensive fund choices. Find more information at https://investor.vanguard.com/what-we-offer/small-business/overview. Other brokerages also may have low fees and expenses.

401(k) plans:
  • Safe Harbor 401(k)
  • Traditional 401(k)

For 401(k) plans, a top recommendation is Employee Fiduciary at http://www.employeefiduciary.com. They have very low fees for 401(k)s: $500 to start a new plan, and $1,000 to convert an old plan. Fees are $1,500 a year plus 0.08 percent of assets under management. You have access to a huge number of fund families (including Vanguard) and many ETFs.3 Vanguard personnel personally recommended this company to me. Vanguard also has its own 401(k) through Ascensus.

401(k) plans may or may not offer additional benefit beyond IRA and profit-sharing plans. Either Vanguard or Employee Fiduciary can provide honest answers.

The Exotic: Defined Benefit Plans:
  • Traditional Defined Benefit
  • Cash Balance
  • Target Benefit

Using defined benefit plans, doctors can, in some instances, tax-defer more than $250,000 late in one’s career. These plans often have high expenses due to actuarial fees, IRS reporting, employee payout obligations and greedy administrators. Yet, for some doctors, the tax benefits outweigh the fees.

Defined benefit plans also pose significant risk. In his New York Times article, Paul Sullivan says, “The problem with these is you have to fund to a certain level each year and you also have to have an actuary do your actuarial analysis each year.”4

For any defined benefit or hybrid plan, have a competent CPA, tax attorney and actuary evaluate thoroughly. You may find either the risk level or expenses too high to be of worth.

This is but a summary of tax-advantaged information. For more complete information, go to either White Coat Investor, for MDs and dentists, at http://whitecoatinvestor.com, or Dentaltown financial threads at http://www.dentaltown.com/MessageBoard/forum.aspx?s=2&f=214

Note that there are a myriad of advisers that can maximize your tax-deferral. I’ve mentioned a couple that have excellent educational offerings provided at the indicated URLs.

As for the optimal way to invest, I’ve touted index funds as the go-to method, minimizing fees and maximizing growth.

Warren Buffett:

Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after expenses and fee) delivered by the great majority of investment professionals.5

References
  1. Kevin Trout, “An In-Depth Look at the Tax Consequences of Asset Location,” Journal of The American Association of Individual Investors, March 2013.
  2. Walter Updegrade, “Index funds: A simpler, cheaper way to invest,” downloaded at http://money.cnn.com/2012/12/11/pf/expert/index-funds.moneymag/index.html on July 22, 2013.
  3. http://whitecoatinvestor.com/your-small-practice-401k-may-be-ripping-you-off-friday-qa-series
  4. Paul Sullivan, “Save for Retirement in Just 10 Years? It’s Doable, but Risky,” NY Times, Nov. 30, 2012, downloaded at http://www.nytimes.com/2012/12/01/your-money/defined-benefit-plans-allowfast-retirement-saving-but-with-risks.html
  5. Warren Buffett’s Letter to Shareholders of Berkshire Hathaway, 1996.
  Author's Bio
Dr. Douglas Carlsen has delivered academic-based financial education since retiring from private practice in 2004 at age 53. He has no connection with any company or individual and speaks his mind freely.

Carlsen is very interested in speaking to your study club! Contact at 760-535-1621 or drcarlsen@gmail.com.

Over 25 videos available: search Dr. Doug Carlsen YouTube. Additional Carlsen Dentaltown articles are at: www.dentaltown.com. Search "Carlsen." Carlsen website is at www.golichcarlsen.com.
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