Tax-deferred Retirement Accounts: A Gift from the Government

AUGUST 11, 2016
James M. Dahle, MD, FACEP
Anybody with a reasonable understanding of math, the US tax code, and the typical earnings cycle of a physician can quickly see that one of the greatest gifts the government has ever given physicians is the ability to use tax-deferred retirement accounts. Despite this, there are many people out there that would try to convince you otherwise.

Sometimes these people have ulterior motives, wanting you to pull money out of your retirement accounts in order to purchase an investing or insurance product that will pay them a big commission. Others, including at least one prominent radio host, advocate that you always use a tax-free (Roth) account preferentially when available. Even well-meaning folks may cause you to worry unnecessarily about large required minimum distributions, investing fees, difficulties accessing money in retirement accounts prior to age 59 ½, and rising taxes. However, the truth is that for most physicians, the very best place to invest their next dollar is inside a tax-deferred retirement account such their employer’s 401(k), 403(b), defined benefit/cash balance plan, or even 457(b), and in the case of a self-employed physician, an individual 401(k) or cash balance plan.

In order to understand why a tax-deferred retirement account is such a great deal, it is critical to understand the typical earnings cycle for a physician. A typical doctor has no significant income until his late 20s when he enters residency. Then, for a period of 3-6 years during training, he has a low income, which rises rapidly over the next 2-5 years to his peak income, usually by his late 30s or early 40s. His income then remains high for 15-25 years before decreasing for a few years as he cuts back on work and then retires completely typically between ages 60 and 70. The vast majority of his retirement savings will come from earnings during the peak earnings years of his late 30s, 40s, and 50s, when he is in the highest tax brackets of his life.

It is also critical to understand the difference between a tax-deferred account, such as a 401(k), and a tax-free account, such as a Roth IRA. When you contribute to a tax-deferred account you contribute pre-tax money, which then grows in tax-protected manner until it is pulled out, at which time you owe taxes on the withdrawal at your ordinary income tax rate. When you contribute to a tax-free account, you contribute post-tax money, which also grows in a tax-protected manner just like a tax-deferred account, but then can be withdrawn completely tax-free in retirement. However, if the marginal tax rate on the contribution and the withdrawal are exactly the same, the two accounts are essentially equivalent. Consider an investor with a 30% marginal tax rate now and a 30% marginal tax rate in retirement. If he earns $5,000 and wants to put it toward his retirement, he may have the choice between a tax-deferred and a tax-free account. He can either put the $5,000 into a tax-deferred account, or he can pay the taxes due and put $3,500 into a tax-free account. After 20 years at 8% growth, the tax-deferred account has grown to $23,305 and the tax-free account has grown to $16,313. However, once you subtract the taxes due on the tax-deferred account ($6,991) you end up with precisely $16,313, the exact same amount as the tax-free account. So despite the fact that you would pay over four times as much in taxes on that tax-deferred money ($6,991 vs the original $1,500), you would end up with the exact same amount of money after-tax.

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