This series is developed in partnership with Dr. Jim Dahle’s The White Coat Investor, the leading source of financial tools and information for doctors, and Doximity Careers and Curative (a Doximity company), where doctors can find their next long-term or locum tenens position.
Most locum tenens physicians are independent contractors. Unlike employees, who often have a retirement plan such as a 401(k) provided by their employer, independent contractors are required to set up all of their own benefits, including retirement accounts. This represents both a challenge and an opportunity.
There are five tax-advantaged accounts that are worth discussing for independent contractors:
- Individual 401(k)s,
- Personal defined benefit (cash balance) plans,
- Backdoor Roth IRAs, and
- Health Savings Accounts.
Each has its own set of rules and contribution limits and it is worth being familiar with all of them. There are essentially three tax advantages available, and each account offers a combination of them.
The first tax advantage is being able to contribute to the account with pre-tax dollars. This is often the largest tax deduction for a physician. For example, if a physician has a marginal tax rate of 40%, a pre-tax contribution of $50,000 would reduce her tax bill by $20,000! In addition to this large tax deduction, most doctors who contribute to pre-tax accounts during their peak earnings years will be able to withdraw money in retirement at lower tax rates in retirement. They will “fill the tax brackets” with those retirement withdrawals, allowing a significant arbitrage between the high marginal rate at which they made the contribution and the lower effective tax rates at which they withdraw the money later.
The second tax advantage is to not have to pay taxes on the dividends and capital gains that an investment produces as it grows. This makes the investments more tax-efficient and produces a higher return by eliminating the tax drag that normally occurs in a non-qualified (i.e. taxable) account.
The third tax advantage available in some accounts is to allow for tax-free withdrawals. When available, withdrawals from these accounts are completely tax-free. Having a mix of pre-tax and tax-free accounts allows a retiree to essentially choose their own tax rate.
The mainstay of retirement planning for an independent contractor is the individual 401(k). An individual 401(k) is for a business without employees (other than a spouse). While similar to the 401(k)s offered by a typical employer, the individual 401(k) is simpler, cheaper, and requires no significant testing for highly compensated employees.
In 2020, an independent contractor under 50 can contribute their first $19,500 in earnings to the 401(k) as an “employee contribution.” If 50+, they are allowed another $6,000 “catch-up contribution” as part of the employee contribution. In addition to this contribution, the independent contractor can also contribute another 20% of earnings as an “employer contribution” up to a total account contribution of $57,000 ($63,000 if 50+).
While the $57,000 limit is a per- 401(k) limit, the $19,500 limit must be shared across all 401(k)s, so an independent contractor who also has an employee job with a 401(k) may only be able to make employer contributions. While the employer contribution is always a pre-tax contribution (with fully taxable withdrawals), the employee contribution can be either pre-tax or Roth. Roth contributions go into a separate account and benefit from tax-free withdrawals in retirement.
Defined Benefit/Cash Balance Plan
For independent contractors interested in very large pre-tax contributions, it is worth considering a personal defined benefit or cash balance plan. These are technically defined benefit plans, but act as another 401(k) masquerading as a pension. The costs are a bit higher than a 401(k), but it is possible to make pre-tax contributions as high as $100-200,000 per year.
Another common retirement account used by independent contractors is the SEP-IRA. These accounts have two small advantages over an individual 401(k).
- You can make your contribution up until Tax Day, giving you additional months to fund it while still getting a deduction.
- The required paperwork is also simpler than with an individual 401(k). However, there are no Roth contributions, you often need to earn more money to max out the account at a full $57,000, and it can cause you pro-rata issues if you are also doing Backdoor Roth IRAs.
Backdoor Roth IRA
You do not have to be an independent contractor to do a Backdoor Roth IRA, but like most doctors, it is a good idea for independent contractors to also max out this account. The 2020 contribution limit is $6,000 per year ($7,000 if 50+) and you can also fund one for your spouse, even if your spouse does not work.
It is called a Backdoor Roth IRA because high earners are not allowed to contribute directly to a Roth IRA. They must first contribute to a traditional IRA, a contribution for which they usually do not receive a deduction due to their high income and their work-related retirement account. Then they can move that money to a Roth IRA, a transfer called a Roth conversion. This is technically a taxable event, but since they did not get a deduction for the original contribution, there is no tax cost to the conversion. However, due to the way this conversion is reported to the IRS (on IRS Form 8606), it is critical that the investor have no money in a traditional IRA, SEP-IRA, or SIMPLE IRA on December 31st of the calendar year in which the conversion is done or else the conversion will be pro-rated and lose much of its benefit. For this reason, most independent contractors should be using an individual 401(k) instead of a SEP-IRA and should transfer any IRAs into that 401(k) to prevent pro-ration. Roth IRA contributions and earnings are tax-free when withdrawn in retirement.
Health Savings Account (HSA)
Finally, the most tax-advantaged retirement account available to investors is not even a retirement account, it is a Health Savings Account (HSA). With a 2020 contribution limit of $3,550 ($7,100 family) these accounts are the only triple tax-free account out there. You get a pre-tax deduction, just like with a traditional 401(k) contribution. The money is protected from taxes as it grows and if spent on health care either now or in retirement, comes out tax-free. Even if you spend it on something besides health care, after age 65 there is no penalty, you just have to pay taxes on it as if it were a pre-tax 401(k).
Besides reducing taxes and thus boosting investing returns, each of these accounts can also improve your estate planning and asset protection. Locum tenens doctors should take advantage of the retirement accounts available to them. Doing so will allow them to build wealth faster and in turn allow them to focus on their patients, families, and own wellness.
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