Before diving into the allocation strategy, let’s briefly revisit the fundamental differences between Roth and traditional IRAs.
Roth IRA: Contributions are made with after-tax dollars, but qualified withdrawals, including earnings, are tax-free.
Traditional IRA: Contributions are made with pre-tax dollars, providing an immediate tax deduction. Withdrawals, however, are subject to income tax.
Assessing current and future tax scenarios
To craft a personalized strategy, it’s crucial to evaluate the current and anticipated future tax scenarios for doctors. Consider factors such as current income, expected retirement income, and potential changes in tax laws.
Allocating high-return investments to Roth IRAs
Given that Roth IRA withdrawals are tax-free, strategically allocating higher-return investments to Roth accounts can lead to substantial tax savings in the long run.
Doctor A allocates $10,000 to a Roth IRA and $10,000 to a traditional IRA. Both investments yield an annual return of 10 percent over 20 years.
Roth IRA: After 20 years, the account grows to $67,275, and all withdrawals are tax-free.
Traditional IRA: The account also grows to $67,275, but withdrawals are subject to income tax. Assuming a 30 percent tax rate, the after-tax value is $47,092.
This example illustrates the potential tax advantage of allocating higher-return investments to Roth IRAs, as the entire growth is shielded from taxation.
Considerations for doctors
For doctors, whose income may fluctuate throughout their careers, it’s essential to revisit the allocation strategy regularly. During years of higher income, contributing to Roth IRAs allows them to lock in tax-free withdrawals in retirement. Conversely, during lower-income years, contributing to traditional IRAs can capitalize on immediate tax deductions.
Leveraging tax diversification
A well-crafted asset allocation strategy also involves tax diversification. By maintaining a balance between Roth and traditional IRAs, doctors can create flexibility in managing their tax liabilities during retirement.
Doctor B allocates funds evenly between Roth and traditional IRAs. In retirement, this doctor can strategically withdraw from each account, optimizing tax efficiency based on the current tax landscape.
The power of Roth conversions
Exploring Roth conversions can be a game-changer for doctors with existing traditional IRAs. Converting a portion of traditional IRA funds to Roth IRAs allows for strategic tax planning, especially during lower income years.
Doctor C converts $50,000 from a traditional IRA to a Roth IRA during a year of lower income. While taxes are paid on the conversion amount, this can create tax-free income in retirement.
Monitoring legislative changes
Tax laws are dynamic, and doctors must stay informed about legislative changes that could impact Roth and traditional IRA rules. Being proactive in adjusting the asset allocation strategy based on new laws is integral to optimizing tax efficiency.
Strategically allocating assets between Roth and traditional IRAs is a potent tool for doctors seeking to enhance their financial future while minimizing tax burdens. By harnessing the tax advantages of Roth IRAs, especially with higher-return investments, doctors can create a tax-efficient retirement income stream, providing financial security and peace of mind in their well-deserved retirement years. As always, consulting with a financial advisor for personalized guidance tailored to individual circumstances is recommended.
Amarish Dave is a board-certified neurologist with over 20 years of experience in both neurology and active stock investing. In addition to his medical career, he holds a background in business from the University of Michigan and has successfully passed the SIE exam administered by FINRA. Dr. Dave is founder, FiscalhealthMD.com, a website dedicated to educating doctors at all stages of their careers, ranging from residents to retirement, about financial planning.