Today, we are diving deep into all things Roth. We give a general review of what a Roth is and then answer your questions about the Backdoor Roth, different Roth accounts, when the Backdoor process won't work, why I hate SIMPLE IRAs, and more. We also discuss why so many docs are looking into side gigs and FIRE right now. There is a lot more in here, as well, so read on. Another very exciting thing happening at WCI is we have released our brand new No Hype Real Estate Investing course. This is a fantastic course with more than 27 hours of content. You can also join us for a webinar on September 20 to see all the various options that are available for real estate investing and to figure out if real estate investing is right for you.
Listen to Episode #279 here.
In This Show:
- Roth Overview
- Backdoor Roth IRA Issue
- Do 50-50 Contributions Mess Up the Backdoor Roth IRA Process?
- Backdoor Roth Conversions
- SIMPLE IRA
- Why Are So Many Docs Going for FIRE?
- Moving Away from a Financial Advisor
- Achieving Passive Cash Flow Sources – Which to Choose?
- Sponsor
- No Hype Real Estate Investing Course
- Quote of the Day
- Milestones to Millionaire Podcast
- Full Transcript
Roth Overview
Let's talk about Roth. Roth comes from Senator William Roth. I think it was 1997 when they came up with the Roth IRA. In subsequent years, they came up with Roth options in qualified retirement accounts. What is a Roth option? It's basically when you put money into an account after it's been taxed. Then it grows in a tax-protected way, just like it would in a tax-deferred account. But when the money comes out, typically in retirement after age 55 or 59 1/2, depending on the account, it doesn't get taxed at all. It's tax-free forever. If you leave it to your heirs, they don't pay taxes on it either.
It's cool in that if it's been taxed, it's not going to get taxed again. In fact, sometimes if you can get money in there without it being taxed in the first place, it never gets taxed. For example, if you have a business and it's not a corporation but it's a business where the only owners are their parents and you pay them, that money is typically not taxed. They typically don't earn enough to pay income taxes on it. You don't have to pay payroll taxes on it. Then, if they use it to make Roth IRA contributions, it never gets taxed.
Everybody's into tax-free. Tax-free is great. Tax drag is a major expense, perhaps the largest expense when it comes to investing, and eliminating that boosts your returns. You simply end up with more money. Your money grows faster by not paying taxes. There are Roth options in all kinds of accounts.
If you want to contribute to a Roth IRA, however, your income has to be below a certain amount. I think if you're married filing jointly, it's just over a couple hundred thousand. I think if you're single, it's around $135,000. These are modified adjusted gross incomes, and those go up each year with inflation. But you can still contribute to a Roth IRA. You just have to do it indirectly, aka the Backdoor Roth IRA process, which is basically a two-step plan. First, you contribute the money to a traditional IRA, and you probably don't get a tax deduction for that. It's non-deductible traditional IRA money. Then the next day you convert it to a Roth IRA. Since you got no deduction, there's no tax cost on the conversion. In the end, it's just like you had contributed it directly into a Roth IRA.
Obviously, there are a few little things to be paying attention to; otherwise, you wouldn't see so many questions about the process. You have to be aware of the pro-rata rule, which means you can't have money in other IRAs, SEP IRAs or SIMPLE IRAs at the end of the year when you do a Roth conversion during that year, or that conversion gets pro-rated. You don't want that. That's the main thing to avoid. Of course, you have to make sure you report it correctly on IRS Form 8606 with your tax return. IRAs are individual, so there is one of those for each spouse if you're filing a Married Filing Jointly return.
But other accounts can also have Roth options. You can have a Roth option in your 401(k). You can have a Roth option in your 403(b). You can have a Roth option in your 457(b). All of those can have Roth options. The nice thing about that is you get the choice. In fact, even if you don't like the choice you made, many plans will even allow you to do an in-service conversion, meaning you move money from the tax-deferred portion of the account into the Roth account, paying the taxes on that.
Look for those options in your plan. It's plan dependent. The IRS lets them do in-service conversions. It lets them do Roth contributions, but the plan may not have that option. You have to get the details on that from your HR folks and figure out what your plan allows. The nice thing about making Roth contributions as opposed to tax-deferred contributions is the government lets you make a contribution of the exact same size. For example, the employee 401(k), 403(b) contribution, which is precisely the same size as the 457(b) contribution (at least when you don't take catch-ups into consideration), is $20,500 this year for those under 50. You can put $20,500 into your Roth 401(k), or you can put $20,500 into your tax-deferred 401(k).
But the truth is if you're like me in a relatively high bracket, you're actually putting more money in on an after-tax basis if you're making the Roth contribution. Really what you should be comparing is putting $20,500 into a Roth account or putting something like $13,000 into a tax-protected account and investing another $7,000 or so into a taxable account. The idea is that you can actually put more money in when you're putting it into a Roth account. That's why if the tax rates are the same upon contribution as upon withdrawal, Roth actually comes out ahead. However, that's not actually the case for most docs in their peak earning years. Most docs in their peak earning years are in the 32%, 35%, 37% bracket. When they take that money out during retirement years, they're going to be able to withdraw it, filling the brackets as they go. If they don't have any other taxable income before they start getting Social Security or there's no rental property income or some pension or something, basically you take out the standard deduction amount tax free.
If you got a 37% deduction when the money went in and you pull it out at 0%, that's a huge arbitrage. That's why tax-deferred accounts work really well during your peak earnings years. Then, you can take out a certain amount more, $20,000 or so out at 10%, another $50,000 or so out at 12%, and another $75,000 out at 22%. The idea is you put money in there saving 32%, 35%, 37%, when the money goes in and then only have to pay 0%, 10%, 12%, 22% when you take the money out. That's a huge arbitrage, and that's the best argument against using a Roth contribution. It’s just because of the tax savings, the additional tax savings aside from having decades of tax-protected growth that you get from using a tax-deferred account. But if for whatever reason you're going to be filling those brackets with other income—a pension from the military, or a bunch of rental property income or Social Security payments, etc.—then Roth starts making a lot more sense.
It also makes a lot of sense if you're a super saver. If you're going to end up with $20 million in retirement, you're going to have some huge tax-deferred IRAs eventually. Those sorts of reasons are reasons why you may want to do more Roth now. It also can help you save on state taxes because the stupid IRS, they look at a dollar in a Roth account as exactly the same as a dollar in the tax-deferred account. If you're knocking on the door of the estate tax exemption, doing Roth conversions or preferentially making Roth contributions can help you avoid estate taxes, as well. Lots of benefits there.
Those are things to keep in mind when you're trying to decide whether to do Roth contributions or tax-deferred contributions. Honestly, these are two good things. You're choosing between two winning ideas here. It's not like one is dramatically better than the other, but in some situations, it's better to use one. In some situations, it's better to use the other. Keep in mind: your employer match is always tax-deferred money, even if you make a Roth contribution.
More information here:
Backdoor Roth IRA Millionaire
Backdoor Roth IRA Issue
“Hi, Jim. Call me Raj. Hey, my question is my tax guy, he filed my 1040 without knowing that I converted that into Roth. So, he used 4b, and he had $6,000 in the 4b, which is taxable. Now I'm trying to file 8606 and an amendment. Maybe a quick help from you to understand. Can I do that? Can I claim it again, or what's the right process to do it? Thank you.”
Sorry you're having to deal with this. I couldn't quite tell if you have an incompetent tax guy or if you didn't actually give him all the information that he needed to do his job. Typically, when you do a Roth conversion, your IRA custodian will send you a 1099 of some type, a 1099-R or whatever, that shows the conversion. Whether you gave that to him or not, I don't know. Because a lot of those, especially from Vanguard, they don't necessarily tell you how much of that is taxable. If you don't know how much is taxable to put into your tax form, you might mistakenly claim it all. But what's happened here is that you claimed a Roth conversion and told the IRS that the money had not yet been taxed. If you're doing a Backdoor Roth IRA, that's not the case. So basically, you filed your taxes wrong and paid too much in taxes.
What you need to do is file your taxes again. That is called an amended tax return. You use IRS Form 1040X, and you don't have to fill out the whole tax thing. You just fill out what was changed. You'll change that line 4b, and you'll include forms 8606 that you didn't send in earlier. That document shows why you shouldn't have to pay taxes on that $6,000 conversion. Your tax guy ought to be doing that. I mean, that's why you're paying a tax guy to do this stuff is you shouldn't have to do it. One way or the other, either hire someone to do your taxes or do it yourself, but you shouldn't have to do both.
Go ahead and get that cleaned up. It's no big deal. I've filed lots of 1040Xs over the years because for many years I did my own taxes and made lots of mistakes. And guess what? When my tax preparer does them, she also makes mistakes and has to file 1040Xs. This is not a big deal. If you've never filed a 1040X, consider yourself lucky. Some of us do it almost every year for some little thing like this that gets messed up. It's not a big deal. It doesn't mean they're going to come audit you and knock down your door at night. It's a normal thing when it comes to paying taxes, especially as you get more and more complicated tax returns.
Do 50-50 Contributions Mess Up the Backdoor Roth IRA Process?
“If I partially contribute Roth to a 403 to do 50-50 traditional and Roth contributions, this should not affect my ability for the Backdoor Roth IRA, right?”
Why would somebody do 50-50 contributions? It's because they're not sure. They're not sure of what they should be doing with their contributions. That's not a bad thing. Lots of people aren't sure because it's not clear, right? In order to know for sure, you have to know a bunch of information that is not only unknown but is unknowable. Like what tax rates are going to be in the future, what other sources of income you might have, how wealthy you're going to be, how long you work. Those sorts of questions affect that decision.
What a lot of people choose to do is just split the difference. They're like, “Eh, I don't know what's right. I'm going to minimize regret. I'm going to do half traditional and half Roth.” That's fine. It's a totally reasonable approach. Obviously, you're going to be wrong with half your money, but at least you're going to know for sure you're not wrong with all of it. But at any rate, to answer your question, money in a 403(b) or a 401(k) or a 457(b) or a defined contribution cash balance plan or a defined benefit cash balance plan, none of that counts toward the pro-rata calculation for the Backdoor Roth IRA process.
If you look at IRS Form 8606 line six, you'll see that it asks for the balance of your traditional IRAs, your SEP IRAs, and your SIMPLE IRAs. That includes rollover IRAs. It does not include inherited IRAs. It does not include Roth IRAs. And it certainly doesn't include any qualified retirement plans from your employer, like 401(k), 403(b), 457(b), 401(a), etc. You're fine. You can make Roth contributions. You can make traditional contributions in your 403(b) or your 401(k). It has nothing to do with your Backdoor Roth IRA process.
Backdoor Roth Conversions
“Hi, Dr. Dahle. This is Tom from California. I have a question on Mega Backdoor Roth conversions. I work for an organization that has a 403(b) that allows for both pre-tax and post-tax contributions from the employee, as well as the 403(b) plan allows for in-plan conversions. Can you please go over in greater detail the strategies behind when one would want to do a Mega Backdoor Roth conversion? Is it based simply on your marginal tax rate at the time that you are considering to do this? In my case, I'm in my late 50s. Would it make sense to do this, or would it make more sense to do it after I retire—say, at age 63 or 65—when I would have, in theory, lower marginal tax rates and do the Mega Backdoor conversion at that point? Question one. And question two. Is it possible for you to specify which portion of the 403(b) plan of the contributions that you would like to have moved over through the Mega Backdoor Roth? Could you specify to say I only want my Roth contributions to the 403(b) to be converted over to the Roth?”
That got really confusing at the end. I think most listeners would agree. I think the reason why you've got questions is because you're confused about what's going on here. Let's talk about the Mega Backdoor Roth IRA in general here. We've talked about the Backdoor Roth IRA process. This is something you do with IRAs. You put money in a traditional IRA, then you convert it to a Roth IRA because you didn't get the deduction. There's no tax cost on the conversion. In the end, it's as though you put $6,000 (or $7,000 if you're 50+) directly into a Roth IRA. You just got to be aware of that pro-rata rule.
The Mega Backdoor Roth IRA has nothing to do with an IRA despite the name. Despite the fact that it shares a Backdoor Roth IRA with that other thing, it's different. The Mega Backdoor Roth IRA is something you do typically in a 401(k). Maybe it can be done in a 403(b) too, but typically it's done in a 401(k). There is also a thing called a Roth conversion. A Roth conversion is anytime you take money that is not Roth and you move it into a Roth account and you may or may not have to pay taxes on that conversion, depending on how much that money has been taxed previously. A Roth conversion is a step in the Backdoor Roth IRA process. It is also a step in the Mega Backdoor Roth IRA process.
Now, we have the terminology straight. There are three types of contributions that you can make to a qualified plan, like a 401(k) or 403(b), etc. Those types of contributions are a tax-deferred contribution. That's one type. Where the money has not been taxed, you got a big tax deduction. You put $10,000 in there. Your marginal tax rate is 40%. You just saved $4,000 in taxes by putting that money in. It's a great thing. There are also Roth contributions. This is money you pay tax on now. You put it in there, and it never gets taxed again. Then there are after-tax contributions. Note that this is not the same as Roth contributions. After-tax contributions are money on which you will not pay taxes when you withdraw it, but you will pay taxes on any gains. You don't pay them at long-term capital gains rates; you pay them at ordinary income tax rates. If you just made a contribution to a traditional IRA and were not allowed to take a deduction for it, that's what you would have in there. You would have after-tax money. The basis or the money you put in there would come out tax-free but any earnings that were put in there would later come out taxed at your ordinary income tax rates.
Same thing inside a 401(k). If you just put that money in there as after-tax money, because your 401(k) allows you to—and lots of 401(k)s do—then when you take it out, the basis comes out tax-free. All the earnings are taxed just like your tax-deferred contributions. That's not an awesome thing. You don't really want to pay on those earnings at your ordinary income tax rates, especially if there's another option. That other option that is available in many plans is to convert that money to Roth money. The Mega Backdoor Roth IRA process is step 1, contributing to the after-tax portion of a 401(k). Depending on the employer and the plan, you may be able to put a lot of money in there. You may be able to put $37,000 in there a year—$61,000 is the limit this year. I suppose some people might be able to put in $40,500 of after-tax money.
But step 2 is then converting it inside the plan into Roth money. There's no cost to that conversion, no tax cost, because it has already been taxed. Now, the earnings, instead of being taxed at your ordinary income tax rate, are never taxed again. That's an awesome thing. It's just like you put $20,000, $30,000, $40,000 into a Roth IRA. That's why it's called the Mega Backdoor Roth IRA, because you are putting a ton of money in there that is now Roth money and will now grow tax-free going forward. That's what the Mega Backdoor Roth IRA process is. Depending on the plan, you may or may not be able to put any at all in there. How much goes in there may depend on how much of an employer match you get. Because there's this limit, $61,000 limit this year, on how much can go into that account total between all of your contributions and all of your employer's contributions. If you put in $20,000 as your regular contribution, $20,500 is probably what you put in, and then your employer matched another $10,000, and they say, “Well, you can go up to $61,000 total.” So, maybe you chose to put in another $30,000 as an after-tax contribution. If they allow you to do that, that's a great thing. If they also allow you to then convert that money to a Roth account, that's an even better thing, because now you've got a bunch of money in Roth instead of just after-tax and that's much, much better. It's great if you can do that.
Now, what if you have a choice between that and something else? Lots of us do have that choice. We have that choice in The White Coat Investor 401(k). We set it up that way. That is what Katie and I actually do these days. We make all that contribution after-tax; then we immediately convert it to Roth money. The reason why has to do with the 199A deduction. It's not right for everybody, but it is right for us. Those are the contributions we make to our 401(k) these days. If your plan allows it, it might be right for you. Only you can decide. If the other option is $61,000 that's all tax-deferred, that could very well be the right option for you, especially during your peak earnings years. You just have to weigh those factors, and that's going to be different for everybody.
Again, if you're a super saver or you expect a whole bunch of other sources of income in retirement or you expect to be in the exact same bracket or even a higher bracket than you are now in retirement, then you want to lean more toward Roth money. If you're a more typical doc and you're going to retire with just a few million dollars and you're not going to even have enough tax-deferred withdrawals each year to fill up the first three or four brackets, then you're probably going to want to do tax-deferred contributions and not do the Mega Backdoor Roth contributions. You just have to evaluate the plan that you are offered, put it in place with your overall financial plan, and decide on the right thing to do. I hope that's helpful. It's actually a fairly complicated question. A lot goes into answering that question, but I hope that gives you a little bit more clarity to what you're actually dealing with.
More information here:
A New Reason to Use the Mega Backdoor Roth IRA
SIMPLE IRA
“Hi, Dr. Dahle. I'm a new grad and have questions about my Roth IRA. I've been contributing via Backdoor for the last two years, and I put in my $6,000 this year but was actually enrolled in a SIMPLE IRA through work in about June. So, I didn't think about it until I saw a post recently, but I'm wanting to know the best way to move forward. Again, I don't have much, I'm a new grad, but I have around $15,000 in the Roth and only about $2,000 which will probably be closer to $4,000-$5,000 at the end of the year. Would it be best to call Vanguard and recharacterize my Roth back into a traditional IRA to see if I can roll over the SIMPLE IRA into the Roth, if that's possible, or something else? Also, if I were to roll it over, would it not be over the limit of the $6,000 in one year? And then I was reading that it would lead to a 6% excise tax year after year until that was resolved. I didn't fully understand that, but I would appreciate any insight.”
Sorry you have a SIMPLE IRA at work. To those of you who are employers, if you employ docs and your retirement plan at your company is a SIMPLE IRA, you suck. I hate you. Why would you do that for doctors? That's really lame. Now, I get it. If you're in a small dental practice or something, sometimes a SIMPLE IRA makes sense to be what you offer to your employees. If that's the case and you just happen to have one associate dentist or one associate physician or whatever, OK, I get it. It was the best you could do. If you're putting a plan into your business, you ought to get a study of the business and how much employees are likely to contribute and how many of them are highly compensated employees vs. non highly compensated and figure out what the right plan is for the business. It might be a SIMPLE IRA. It might be a SEP IRA. It might be a 401(k). It might be no plan at all. But boy, if you make a SIMPLE IRA, you're not helping your docs very much and you're probably not helping yourself very much. Keep that in mind. The contributions on a SIMPLE IRA, what are they this year? Like $14,000 or something like that? It’s dramatically less than the $61,000 you can put into 401(k). For you and your docs, you are really limiting how much money you can get into a tax-protected and asset-protected account if you're putting a SIMPLE IRA in place.
Aside from that, you're also screwing their ability to do a Backdoor Roth IRA. Remember what I said earlier about Form 8606 line six, right? It asks for the balance at the end of the year of all the money you have in a traditional IRA, a SIMPLE IRA, and a SEP IRA. If you have money on that line in those accounts, your conversion for your Backdoor Roth IRA process is going to be pro-rated. Now being pro-rated isn't the end of the world but it kind of defeats the purpose of doing the Backdoor Roth IRA process. Not only are you not letting people put much into retirement, but you're basically keeping them from being able to do this $6,000 in an effective way.
You didn't know this, John. You've just been plodding along doing the right thing and you got ambushed by an employer that for whatever reason has a SIMPLE IRA in place. What's going to happen this year if you don't do anything is you're going to get your conversion pro-rated. However much money you've got in that SIMPLE IRA plus the $6,000 that you did the conversion on, some portion of that conversion you did is going to be basis, meaning it's not taxable. Some portion of it is going to be SIMPLE IRA money that you got a tax deduction for. There's going to be a cost for your Roth conversion this year. It's not the end of the world, right? Because that money that you're paying to convert is never going to be taxed again. You've still got some basis in that IRA, but it sure does make things more complicated.
As a general rule, if the plan at work is a SIMPLE IRA, you just don't do Backdoor Roth IRAs going forward. If you think you're only going to be there a few years or the employer might change the plan, well, you can keep doing the contribution step of the Backdoor Roth IRA process and just have that money sit in the traditional IRA and then you can do a conversion at a later date. Obviously, you'll have to pay taxes on any gains that you convert, but the original basis can still be converted tax-free down the road. That's not a bad thing to do. But if it looks like you're going to be in this job for 15 years and that this plan is not going to change—this is going to be your retirement plan at the job—well, it may not be worth messing around with the Backdoor Roth IRA at all. You're one of those few people that probably shouldn't be doing a Backdoor Roth IRA each year, because it's just going to get pro-rated. Not only is that not as beneficial as you expected it to be, but it's also a pain tax-wise.
Now, would I go back and try to undo my Backdoor Roth IRA for this year? Probably not. They may not even let you contribute to the SIMPLE IRA this year. That would also solve the problem for this year. You'll just have to use that money for something else to pay off your student loans or beef up your emergency fund or invest in taxable or whatever. That might be an option. Just pull any contribution you've made to the SIMPLE IRA out this year and start using it next year instead of doing a Backdoor Roth IRA. But really I would choose between the two going forward. You're going to have to do the rest of your savings in taxable. Sorry about that. It stinks to have your retirement plan be a SIMPLE IRA.
And no, you can't just convert it every year. You can do that with a SEP IRA, but with a SIMPLE IRA, you have to leave the money there for two years. It's just a really lame retirement account. It's simple to set up. It's cheap to set up. That's why employers use it but it's not a very good account. I hate SIMPLE IRAs.
Why Are So Many Docs Going for FIRE?
“I'm curious for your thoughts of why seemingly more physicians are looking for side hustles or FIRE than before. Is medicine worse now than 20 or 30 years ago? Is it just that options like FIRE are more known now? I'm fascinated why it seems like so many physicians think about these options, and I wonder if it stems from a desire to leave medicine or something else.”
Everybody thinks it was way better in the past, right? The golden age of medicine always seems to be about five years before you entered medical school. Everything's been going downhill ever since. People were saying that in the '80s and the '90s and the 2000s and the 2010s, and they're still saying it in the 2020s, right? That everything used to be really good. If you look at it objectively, that's not necessarily true. There are lots of docs that are doing better now than they ever were. There may not have been a golden age of medicine, and this is regional dependent or specialty dependent.
Are there some unique stresses now? Yes. Is burnout higher than ever before? Yes. Is that just because we're looking for it more? It's hard to say. I think one thing that does make burnout worse these days is docs have a lot less control over their practices. A much larger percentage of doctors are employees now vs. owners of their practice. They don't have the ability to say who works for them. They don't have the ability to pick their own partners. They don't have the ability to hire and fire those they work with, to choose which EMR to use, to determine how many patients per hour they're going to see. All those things that they used to have, or many of them used to have, a lot more control over. I think it's losing control, especially when the person who now has control might be private equity-backed, primarily profit-motivated, and really flogging the whip to get you to move people through as quickly as possible. The radiologists talk about this a lot, that it has just become such a productivity-based business. How many CTs can you read in an hour? They don't care about quality. How many can you pump through?
In that respect, I think medicine is probably worse in a few ways than it used to be. How much of it is simply that people know more about it now? Well, I guess I'm partially responsible for that. I started The White Coat Investor in 2011. I've definitely noticed a change in physician financial literacy over the last decade. More of us are smarter now with our money than we used to be. I think that's a good thing. To know about your options is not a bad thing. Has FIRE been more popularized over the last five or six or seven years? Sure. Do millennials hate to work? They probably have more of a focus on lifestyle than maybe the baby boomers did. I think there are some cultural changes. I think there are some changes in medicine. I think there are some financial literacy changes that have contributed to this, but most likely I think the biggest factor is that you're simply seeing a subset of doctors.
Those who are maybe not as satisfied with their practice, those who are more interested in changing to nonclinical options or some other sort of side hustle or more interested in FIRE, they're concentrated in the places you're hanging out. They're concentrated in the audience of a podcast like this, on the forums of The White Coat Investor, or a subreddit about FIRE. You're just seeing a selection bias there among doctors. I assure you that there are plenty of doctors out there that are planning to work a full career, that aren't saving all that much of their money, that are not going to have an option to FIRE. There are plenty of them out there.
I suspect a big portion of what you're seeing is simply where you're hanging out. If you go hang out somewhere where people aren't talking about finances, you're not going to see nearly as much of that. But I do think burnout is higher now than it's ever been. I think more docs would like to leave medicine now than perhaps in the past. But I also think more docs actually have that option. And because they have that option, they consider it and talk about it.
Moving Away from a Financial Advisor
“Hi, I've just discovered White Coat Investor during my recent quest to become more engaged in investing. I'm a surgical pathologist in upstate New York, and I anticipate working for at least 20 more years. I've had a financial advisor for about 10 years who really helped me get my house in order. I maximized my 403(b) and Roth IRA contributions, and I've been saving about $2,000 a month to a taxable account at Schwab. My hospital also has a pension plan, believe it or not. My advisor designed my portfolio for both my Roth and taxable accounts at Schwab. Now that I've educated myself more about the wisdom of simplicity indexing, I'm looking at it with a more critical eye. In my Roth account, I have about 17 funds. In my taxable account, I have 15 funds. Some funds in both accounts are actively managed with an expense ratio of over 1%.
Two questions. One, does this portfolio sound excessively complex to you? Two, if so, would it be unwise for me to consider eventually managing it on my own to at least avoid my advisor's fee? I've read lots about designing a simple tax-efficient portfolio, but what's a person to do with a portfolio designed by someone else when I was a financial neophyte just out of residency? Wouldn't selling the actively managed funds have a huge tax? In the spirit of the buy and hold, am I better off just staying the course? I realize it may be difficult for you to answer these questions without seeing my portfolio, but I appreciate any advice you have. Thanks so much.”
I get accused a lot of being anti-financial advisor. That's not actually the case. I like financial advisors. I have friends that are financial advisors. I think there are a lot of really good financial advisors out there who give good advice at a fair price. This person that you have engaged to function as your financial advisor is not a good financial advisor. They suck at what they do. I don't know if they are a mutual fund salesman. If that is how they're being paid, if you're paying on commissions, if these are loaded or commissioned mutual funds, that's the mistake you've made. You have basically hired a commissioned sales agent masquerading as an advisor. If that's not the case and this is just a terribly untalented, unknowledgeable, ignorant advisor, I guess the end result is the same. This person needs to be fired. They're terrible. They really are.
If this is your portfolio, if you're this poor doc's advisor, you suck. Why did you do this? Why are you in this profession if this is the kind of work you're going to do? This is basically financial malpractice to set up a portfolio with 15 funds in one, 17 funds in another at 1%+ ER. I mean, come on, you're not doing this person a service. You're ripping them off. Most likely this advisor is not doing it deliberately; they're not a bad person. It's that they're ignorant. They don't know how to construct a portfolio properly. They don't know about index funds. They don't know about the importance of keeping costs low. They don't know about the importance of having a reasonably simple portfolio.
This is an advisor that needs to be fired. So, step No. 1 is to figure out what are you going to do going forward? You have two good options. One is to get a real financial advisor that offers good advice at a fair price. You can find a list of these folks at whitecoatinvestor.com. Go into the recommended tab for financial advisors. We've got a lot of great people. They do charge money. Financial advice isn't cheap. You have to expect to pay a four-figure amount a year, but they give good advice. They're not going to put you into this crappy portfolio. If they do, I want to hear about it because I'm taking them off my list. But we ask them about this sort of stuff when we vet them to put them on that list. Do you use a bunch of actively managed funds? Do you use a bunch of high-expense ratio funds? We ask them these questions. Are you trying to time the market? We actually make that application with those questions available to you. You can read their answers before you hire them. So, that's one option.
The second option is to do what lots of White Coat Investors are doing. That is manage your own money. There are some real advantages to managing your own money. No. 1, you save the fees. Even if you're not exactly quite as good as a professional, talented financial advisor, as long as you are no worse than the amount it costs to hire that person, then you're still coming out ahead. So that's one option. The other thing is you know you're not going to rip yourself off and you don't have to schedule a bunch of time to meet with yourself. There are some advantages to doing it yourself in that way. I've been a do-it-yourself investor for a couple of decades now, and I intend to do that continuing forward. I don't find it complicated. I find the price to hire somebody to do this to be dramatically more than the value I get from having them do it. I think that's a perfectly reasonable option.
Either way, you've got to choose what you're going to do going forward. I wouldn't do anything until you've made that decision. That's step 1. If the plan is to hire a good advisor, you dump this in their lap and have them sort it out. That's their job. That's why you're hiring them. That's perfectly acceptable to do. In fact, you can just hire somebody to help you sort it out, and then going forward, manage it yourself. We have lots of people on that list that specialize in doing that sort of a thing where they just do it on an hourly base or on a flat fee base and help you get your portfolio set up properly.
You sound like you're probably going to be a do-it-yourself investor going forward. Then, you've got to figure out how to do this on your own. Again, don't do anything until you have the plan in place. Get a written financial plan in place. If you need to hire an advisor to do that, hire an advisor to do that. If you need to take our Fire Your Financial Advisor online course to learn how to do that, do that. If you feel like you're now competent to do it, then do it, but get the plan in place first. Then, it's just a question of going from here to there. With the tax-protected accounts, it's very, very easy. There's no tax cost to selling any of that crap. You just sell it all. You put it in the portfolio that you want. In a taxable account, it's a little more complicated and you may end up with some legacy investments. Legacy investments are investments you wouldn't buy now, but you don't want to sell because the tax cost to selling is too high. And you've got some options of what to do with that.
When you look at a taxable account that's in 15 or 17 different funds or whatever the crap that was, the first thing you do is you figure out the cost basis for each of those tax lots. You may find, especially with the performance of the market this year, that you've actually got a bunch of those lots with losses. If you are underwater on any of that, great, sell it and buy what you should actually be investing in in the first place. You're actually in a tax-loss harvest situation at the same time. This is a good thing. If the basis is about the same as what you bought it at, great, no tax cost. You can sell it and buy what you'd rather own. If you were able to pick up a bunch of tax losses in this process, you can now sell some of those things with gains and use the losses to offset the gains. Again, get invested into the sort of stuff that you actually want. Then, if you've got a few things left that have a very low basis compared to their current value, well, you may want to build around those in your portfolio. You may want to say, “Well, these are mostly large cap blend funds. I'll just own a little bit less of the total stock market fund in order to account for the fact that some of my portfolio is going to sit in these at least for a while.”
If you end up gifting something to your children, you can gift those appreciated shares. If you give to charity, those are great things to give to charity. These appreciated shares that you don't actually even want. You can do that with no tax cost. Obviously, don't be reinvesting dividends into those funds. They just become legacy investments for you, and you just have to deal with them in that way. But most people that go into this process that have only been doing this for a couple of years, you're probably going to be able to change 95% of your portfolio to what you actually want to be invested in, no problem. You might have a little bit of legacy investments going forward, and that's not a big deal to deal with going forward. Every time you look at it, it'll remind you of the importance of being financially literate.
More information here:
How to Fire Your Financial Advisor
Achieving Passive Cash Flow Sources – Which to Choose?
“In terms of achieving passive cash flow sources, what are your thoughts on annuity vs. dividend stock investing vs. syndicated real estate? Pros and cons. Also, your thoughts in general of discussing fee structure for syndications and why something like a 2 and 20 fee structure is seen with syndications and thought to be OK while investing in stocks it is too high of a fee.”
Let's answer the first one—passive cash flow sources. Passive is one of those things that is a continuum. Some things are more passive than others. You want something that's really passive? Put your money into a mutual fund, put it into the total stock market mutual fund, and it'll pay you a dividend every quarter for the rest of your life extremely passively. You'll never do a thing with it again. That's really passive. On the other hand, if you write a book, that's also passive income that comes in after that, the royalties, but you had to do a whole bunch of work up front. There are all kinds of other passive opportunities where maybe you're getting paid out of proportion to the amount of work you're putting in. Maybe that's running a direct real estate property. That might be considered passive by lots of people, but obviously, there's some work there. Some of that is kind of active income, if you will.
But anyway, we're comparing annuities vs. dividend stocks vs. syndicated real estate. Well, let's divide this annuity on one side, and dividend stock investing and syndicated real estate on the other. Bear in mind, there are lots of terrible annuities that you should avoid. But when we're talking about an annuity here, I'm assuming you're talking about a good annuity. Something like a SPIA—Single Premium Immediate Annuity. What you're doing with that sort of a thing is you're buying a pension. You're going to an insurance company. You're giving them a lump sum of money. In exchange, they're promising to pay you a certain amount every month, as long as you live. That's obviously very passive, as a passive cash flow source. But really, you should think about that as a way to spend your money, not a way to invest your money. If you're looking for something very safe and a way to spend your money, that's where an annuity comes in.
These other two, stocks and real estate, have much more risk. I would expect higher returns in the long run from both of those than I would from an annuity. The main difference from a cash flow perspective is that with a stock, a relatively small portion of the total return from the investment comes as income. With real estate, a relatively larger percentage of the return comes from income. If the goal is income, then real estate tends to be a better option than stocks. Dividend stocks pay slightly higher dividends than the overall stock market. Instead of getting 2%, maybe you're getting 3% or 4% and the rest of the return. If the return is 8% total, the rest of the return comes as appreciation. Whereas with real estate you might get 3% in appreciation and 5% in income. A larger percentage of the return is coming as income with real estate.
I think they're both great. I own stocks. I own real estate. I own all the dividend stocks. People think I'm anti-dividend stocks. Nope. I own them all. I own all the international ones. I own all the US ones. That's what you get with total market index funds. It's a nice income, but if the goal is more of your return coming in as income, you may prefer to have a little bit more in real estate than in stocks. It's not like you can't declare your own dividend. You can sell stocks anytime you want and declare your own dividend. It's no big deal. In fact, paying dividends is not ideal from a tax perspective. All this time, you're accumulating money and reinvesting it, getting paid dividends, at least in a taxable account, is just creating a tax drag on the growth on that money. So, it's not necessarily a good thing.
Let's talk about fee structures for syndications. Most syndications, most private real estate funds, are set up with fees and they're set up with a waterfall structure. In a typical waterfall, you'll have to pay some sort of fee before you get to the waterfall. Maybe 1%, that's pretty typical. Then what happens is there's usually a preferred return. That's usually something in the 6%-8%, 10% range. Let's say 8%. So, you pay those guys 1% a year. That's pretty typical. That's for running the investment, for running the fund, for running the syndication. Any business has expenses, and that's how they pay the expenses. Then you get your preferred return. You get all your money back, you get all the principal back, and then you're guaranteed the first 8%. That is the preferred return. That goes to the investors preferentially.
But in order to incentivize that manager to do really well, they actually get a promote, which is where most of their money comes from. Most of their income and profit from this deal comes from the promote. The promote is how the money is split up beyond the preferred return. A typical one might be you get the first 8% as the investor and above there, you split it 80/20 percent. That would be if this thing makes, let's say 18%, and does really well. You get the first 8% and then there's another 10% of return. That gets split 80% to you. Another 8% to you and 2% to the manager. They get 2%; you get 16%. It's pretty good, right? Not too bad.
Now some of those have a catch-up, meaning that on the overall return, if it makes enough money, eventually the manager of that fund gets 20%. If there were a catch-up system, whether it catches up 50-50 or it catches up 100% to the manager or it's 80/20 on the catch-up, however the catch-up works, if it makes enough money, eventually they're going to get 20% of the entire return. Let's say again, this one smashes it out of the park. It makes 20%. You're going to get 16%. They're going to get 4%. That's how it works with this sort of promote structure.
Is this the same thing as a hedge fund charging 2 and 20? In some ways it is, and in some ways, it isn't. No. 1, the hedge fund typically isn't giving you a promote. No. 2, the hedge fund is charging 2%. Typically, most of these syndication deals charge a 1% fee. That's one way in which it is different. It's actually lower. Especially if there's no catch-up, then you get 8% where they don't get any of it. If this thing only makes 10%, well, they're not getting 2%; they're only going to be getting like 0.4%. It's significantly lower fees than what you'd see in a hedge fund. No. 2, we're in the real estate space here. It's significantly less liquid. It's significantly less transparent. It's significantly less efficient than the stock market. If your hedge fund manager is just picking stocks and taking 2 and 20, that's a pretty big fee for picking stocks. You can go to an active mutual fund manager at Vanguard to pay 0.25% instead of 2 and 20. If that hedge fund manager is truly talented and is really going to beat the market, it's worth paying them 2 and 20, but there are very few people out there that have that much talent. Certainly, with a 2 and 20 fee structure, a significant portion of whatever talent they may have is going to flow to their pocket, and your returns are going to be much more similar to the market returns you would get in an index fund. Probably more likely is they just had a few really good years. All the investors pile in, are willing to pay 2 and 20, and then the manager ends up underperforming the market anyway. You're paying 2 and 20 to underperform. Now you're really underperforming after paying that high level of fees.
Here's the deal. If you want to keep your fees rock bottom, super cheap, as cheap as you can and that is your primary concern, you probably should not invest in any sort of private real estate. No syndications, no private real estate. If, however, you're willing to take a little bit broader view and say, “OK, this is the cost of doing business in this space. What I really care about is my after-fee return.” Really your after-fee, after-tax, after-inflation return, then that's what you ought to judge it based on. Yes, every dollar you pay in fees is a dollar that has to come out of your return, but you're not going to get someone to run some sort of real estate syndication on a little $20 million syndication deal. They're not going to be willing to do it for 0.03% like Vanguard's willing to run a trillion-dollar index fund. You're going to have to pay more if you want to play in that space.
Your choice is, if you want to have expenses of less than 10 basis points, all you're going to be able to do is invest in publicly traded investments. You know what? I think there's probably a premium for being willing to be a little bit illiquid. There's probably a premium for getting out of that space, and this is how you access it. Pay attention to fees, but realize that comparing a syndication fee to a mutual fund fee is apples and oranges. The syndication has expenses, things that have to be done. Those expenses for the companies in your index fund do not show up in your expense ratio of that mutual fund. They're in the profit loss statements of the underlying companies. Those have to be paid by somebody and when it comes to this syndication, that's where they get paid.
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No Hype Real Estate Investing Course
WCI’s No Hype Real Estate Investing is the best real estate course on the planet and the best way to get started in this exciting (and profitable) asset class. Taught by Dr. Jim Dahle, with cameos from other experts, and packed with more than 200 lectures and more than 27 hours of content, the course finally gives potential investors a home where they can learn about all the different methods of real estate investing. In reality, you’d probably have to buy a half-dozen courses or more to get all of the information available in No Hype Real Estate Investing. If you’re interested in real estate investing, you can’t afford to miss this course! If you purchase this course before September 26, you get $400 off. This course will be $2,199 going forward, but if you get onboard now, it will only be $1,799. As with all of our courses we offer a no-questions, money-back guarantee if you change your mind.
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Milestones to Millionaire Podcast
#82 — Gynecologist Get Back to Broke
This physician had a swing of about $600,000 in net worth in 2.5 years, basically on one attending and one resident income. Have a financial plan. It works. Dedicating a big chunk of your income to building wealth works. It takes time. It isn’t a get-rich-quick scheme. But it will work. You will become rich.
Listen to Episode #82 here.
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Full Transcript
Transcription – WCI – 279
Intro:
This is the White Coat Investor podcast, where we help those who wear the white coat get a fair shake on Wall Street. We've been helping doctors and other high-income professionals stop doing dumb things with their money since 2011.
Dr. Jim Dahle:
This is White Coat Investor podcast number 279 – Roth options and questions.
Dr. Jim Dahle:
Did you know that the White Coat Investor not only has a podcast and a blog but several books that will help you on your way to financial independence. These books cover topics such as asset protection and minimizing your taxes to keep more of your hard earned money. They discuss plans for insurance, housing, spending, student loan elimination, investing and estate planning. You can learn how to become a millionaire within 5-10 years of leaving residency and how to invest in a sensible low cost and effective manner with or without the assistance of a financial advisor. There is even a book geared directly toward medical and dental students so you can start optimizing your finances early in your professional journey. Find the book that is right for you at the WCI store at shop.whitecoatinvestor.com or on Amazon.
You can do this and The White Coat Investor can help.
Dr. Jim Dahle:
Welcome back to the podcast. I just got back from Wyoming. I was in the Wind Rivers backpacking and climbing Gannett Peak. It was quite an experience. You actually get to hear about it if you're a blog reader. I wrote up a blog post about it with some financial lessons it can be applied to our lives from the trip. Watch for that coming out in the next few weeks or months. Great trip though, I’m feeling very relaxed and happy to be back here at work in WCI headquarters.
Dr. Jim Dahle:
Wherever you're working today, if you're on your way in or on your way home, or whether you're relaxing afterward or working out or whatever, listening to this, let me be the person who thanks you today for what you're doing. Your job is not easy. That's why you're a high income professional. And I know you don't get thanked as much for it as maybe ought to be.
Dr. Jim Dahle:
Those of us who go into medicine, we tend to be more people pleasers than the average person. And a lot of us truly are working for the thank yous. So, if you didn't get any today, let me give you one.
Dr. Jim Dahle:
All right, let's talk about Roth. Roth comes from Senator William Roth. I think it was 1997 when they came up with the Roth IRA. In subsequent years, they came up with Roth options in qualified retirement accounts.
Dr. Jim Dahle:
What is a Roth option? Well, it's basically when you put money into an account after it's been taxed. So, then it grows in a tax protected way, just like it would in a tax deferred account. But when the money comes out, typically in retirement after age 55 or 59 and a half, depending on the account, it doesn't get taxed at all. So, it's tax free forever. And if you leave it to your heirs, they don't pay taxes on it either.
Dr. Jim Dahle:
And so, it's cool in that it's been taxed, it's not going to get taxed again. In fact, sometimes if you can get money in there without it being taxed in the first place, it never gets taxed. For example, if you have a business and it's not a corporation, but it's a business where the only owners are their parents and you pay them, that money is typically not taxed, they typically don't earn enough to pay income taxes on it. You don't have to pay payroll taxes on it. And then if they use it to make Roth IRA contributions, it never gets taxed.
Dr. Jim Dahle:
So, everybody's into tax free. Tax free is great. Tax drag is a major expense, perhaps the largest expense when it comes to investing and eliminating that boosts your returns. You simply end up with more money. Your money grows faster by not paying taxes. And so, there are Roth options in all kinds of accounts.
Dr. Jim Dahle:
If you want to contribute to a Roth IRA however, your income has to be below a certain amount. I think if you're married filing separately, it's just over a couple hundred thousand. I think if you're single, I think it's around $135,000.
Dr. Jim Dahle:
These are modified adjusted gross incomes, and those go up each year with inflation, but you can still contribute to a Roth IRA. You just have to do it indirectly a.k.a. via the backdoor Roth IRA process, which is basically a two-step plan.
Dr. Jim Dahle:
First, you contribute the money to a traditional IRA and you probably don't get a tax deduction for that. So, it's kind of non-deductible traditional IRA money. And then the next day you convert it to a Roth IRA. Since you got no deduction, there's no tax cost on the conversion. And in the end, it's just like you had contributed it directly into a Roth IRA.
Dr. Jim Dahle:
Now, obviously there's a few little things to be paying attention to otherwise you wouldn't see so many questions about the process. You got to be aware of the pro-rata rule, which means you can't have money in other IRAs, SEP IRAs or simple IRAs at the end of the year when you do a Roth conversion during that year, or that conversion gets prorated, you don't want that. And that's the main thing to avoid. Of course, you got to make sure you report it right on IRS form 8606 with your tax return. And IRAs are individual. So, there's one of those for each spouse if you're filing a married filing jointly return.
Dr. Jim Dahle:
But other accounts can also have Roth options. You can have a Roth option in your 401(k). You can have a Roth option in your 403(b). You can have a Roth option in your 457(b). All of those can have Roth options. And the nice thing about that is you get the choice. And in fact, even if you don't like the choice you made, many plans will even allow you to do an in-service conversion, meaning you move money from the tax deferred portion of the account into the Roth account, paying the taxes on that.
Dr. Jim Dahle:
And so, look for those options in your plan. It's plan dependent. The IRS lets them do in-service conversions. It lets them do Roth contributions, but the plan may not have that option. So, you got to get the details on that from your HR folks and figure out what your plan allows.
Dr. Jim Dahle:
The nice thing about making Roth contributions as opposed to tax-deferred contributions is the government lets you make a contribution of the exact same size. For example, the employee 401(k), 403(b) contribution, which is precisely the same size as the 457(b) contribution, at least when you don't take catch ups into consideration, is $20,500 this year for those under 50. So, you can put $20,500 into your Roth 401(k), or you can put $20,500 into your tax deferred 401(k).
Dr. Jim Dahle:
But the truth is if you're like me in a relatively high bracket, you're actually putting more money in on an after-tax basis if you're making the Roth contribution. So really what you should be comparing is putting $20,500 into a Roth account or putting something like $13,000 into a tax protected account and investing another $7,000 or so into a taxable account.
Dr. Jim Dahle:
The idea is that you can actually put more money in when you're putting it into a Roth account. And so, that's why if the tax rates are the same upon contribution as upon withdrawal, Roth actually comes out ahead.
Dr. Jim Dahle:
However, that's not actually the case for most docs in their peak earning years. Most docs in their peak earning years are in the 32%, 35%, 37% bracket. And when they take that money out during retirement years, they're going to be able to withdraw it, filling the brackets as they go. If they don't have any other taxable income before they start getting social security or there's no rental property income or some pension or something, basically you take out the standard deduction amount tax free.
Dr. Jim Dahle:
So, if you got a 37% deduction when the money went in and you pull it out at 0%, that's a huge arbitrage. And that's why tax deferred accounts worked really well during your peak earnings years. And then you can take out a certain amount, more $20,000 or so out at 10%, another $50,000 or so out at 12% and another $75,000 out at 22%.
Dr. Jim Dahle:
And so, the idea is you put money in there saving 32%, 35%, 37%, whatever, when the money goes in and then only have to pay 0%, 10%, 12%, 22% when you take the money out. So, that's a huge arbitrage and that's the best argument against using a Roth contribution. It’s just because the tax savings, the additional tax savings aside from having decades of tax protected growth that you get from using a tax deferred account.
Dr. Jim Dahle:
But if for whatever reason you're going to be filling those brackets with other income, a pension from the military, or a bunch of rental property income or social security payments, etc. If you're going to be filling all those low brackets with other income, then Roth starts making a lot more sense.
Dr. Jim Dahle:
It also makes a lot of sense if you're a super saver. If you're going to end up with $20 million in retirement, you're going to have some huge tax deferred IRA eventually. Those sorts of reasons are reasons why you may want to do more Roth now.
Dr. Jim Dahle:
It also can help you save on state taxes because the stupid IRS, they look at a dollar in a Roth account as exactly the same as a dollar in the tax deferred account. So, if you're knocking on the door of the estate tax exemption, doing Roth conversions or preferentially making Roth contributions, can help you avoid estate taxes as well. So, lots of benefits there.
Dr. Jim Dahle:
Those are things to keep in mind when you're trying to decide whether to do Roth contributions or tax deferred contributions. Honestly, these are two good things. You're choosing between two winning ideas here. It's not like one is dramatically better than the other, but in some situations it's better to use one, in some situations it's better to use the other. Keep in mind your employer match is always tax deferred money, even if you make a Roth contribution. All right. I think that's about all I can tell you about Roth options right now. Hopefully that was useful to you.
Dr. Jim Dahle:
Hey, big news this week. I think this drops on September 8th. So, two days ago we launched our newest online course here at the White Coat Investor. And it's awesome. This course is four times as long as our flagship course Fire Your Financial Advisor. As you recall, Fire Your Financial Advisor helps you get a written financial plan in place. It helps you go from zero to hero. And it's a great course. We've been helping White Coat Investors with it now for several years.
Dr. Jim Dahle:
This new course is about real estate. We call it No Hype Real Estate Investing. And it is literally four times as long as Fire Your Financial Advisor. It is packed with information and we've discovered over the years that people are very interested in real estate investing, including White Coat Investors. That ranges everywhere from direct real estate investing, it might be short term rentals, long term rentals, fix and flips, turnkey investing, et cetera, to more passive stuff. Syndications, funds, REITs, even publicly traded REITs.
Dr. Jim Dahle:
People go out and try to get information on it and all they can find is really, really expensive courses or people with real conflicts of interest giving them information, or worse, just a bunch of hype and people making it sound like super easy, there's no risk in it. And that's not the case.
Dr. Jim Dahle:
And so, we wanted to put together a course with “just the facts, ma'am.” A course that's not going to blow any smoke. That's not going to give you all the hype. It'll still get you excited about real estate investing. It's going to give you the information you need, but it's not going to give you false expectations. You're still going to understand there's a lot of work to do here, but that the rewards are probably worth it.
Dr. Jim Dahle:
And we'll talk about each of those different types of real estate investing and give you a framework on which to place additional knowledge you may acquire down the road about real estate investing.
Dr. Jim Dahle:
So, we think it's a really great course. We've been working on it now for like 10 months. We put a ton of effort into this. They're actually 19 instructors. It's not just me behind the camera here. Great slides. We've got a great AV team now. So, it's well thought out and well presented. And it's a great, great course. We think you should check it out.
Dr. Jim Dahle:
If you have any interest whatsoever in real estate investing, if you've been dabbling in it, if you've been doing it for a while, if you're just thinking about getting into it, this is a great course. You can get more information at whitecoatinvestor.com/realestate. If that's too much to remember do whitecoatinvestor.com/nohype. Either one of them works, and you can check out that course.
Dr. Jim Dahle:
Like all of our courses, it comes with a money back guarantee. There is no risk to you. If you buy it and you look at it and you're like, “Ah, I don't really want this.” Shoot us an email, [emailprotected]. We’ll give you all your money back. Hey, you got a week to check it out. As long as you take less than 20% of it, and you bought it less than a week ago, we give you every dollar back. It is literally no risk to you.
Dr. Jim Dahle:
These courses, if you have looked around the physician space, physician real estate space, or even the nonphysician real estate space, you've seen these courses cost thousands of dollars. This course is longer and more detailed than many of the courses out there. Plus, it doesn't include all that hype that you're trying to avoid. And yet we sell it for dramatically less.
Dr. Jim Dahle:
The retail price is $2,200. Okay, $2,199, but we're going to give you $400 off through September 26th. Through September 26th is just $1,799. So, a real discount there. It's basically four times as big as Fire Your Financial Advisor. We're only selling it in two and a half times the price. So, we think it's a great course. We think it's already a discount. We consider this the resident PA military etc price.
Dr. Jim Dahle:
But obviously if you're scraping by and you're having to choose between this course and buying groceries, we want you to go buy the groceries. But if you've got some capital to invest and you're interested in getting into either active or passive real estate investing, we think you should take this course. Again, that's whitecoatinvestor.com/real estate.
Dr. Jim Dahle:
And by the way, if you want to learn more about it, totally free webinar I'm going to do September 20th at 7:00 PM Mountain. And you can sign up for that at whitecoatinvestor.com/nohypewebinar. And I'll answer all your questions about the course. We'll talk to you about what's in it, give you some more information about real estate. That's totally free. And that'll be on September 20th. But the sale goes through September 26th. Then it goes to regular price. It’s still a deal at regular price, quite honestly. And you can check that out.
Dr. Jim Dahle:
All right, let's talk some more about Roth's stuff. We got some questions on the Speak Pipe about Roth accounts, but before we get there, Cindy tells me we're running a little low on Speak Pipe questions. So, if you wanted to get your questions on the White Coat Investor podcast, you can do so. Go to whitecoatinvestor.com/speakpipe and we'll get your questions on the show, get them answered. In the meantime, let's take this one from Raj about a backdoor Roth IRA issue.
Raj:
Hi, Jim. Call me Raj. Hey, my question is my tax guy, he filed my 1040 without knowing that I converted that into Roth. So, he used 4b and he had $6,000 in the 4b, which is taxable. Now I'm trying to file 8606 and an amendment. Maybe a quick help from you to understand. Can I do that? Can I claim it again or what's the right process to do it? Thank you.
Dr. Jim Dahle:
Hey, Raj, sorry you're having to deal with this. I couldn't quite tell if you have an incompetent tax guy or if you didn't actually give him all the information that he needed to do his job. Typically, when you do a Roth conversion, your IRA custodian will send you a 1099 of some type, a 1099-R or whatever that shows the conversion.
Dr. Jim Dahle:
And whether you gave that to him or not, I don't know. Whether it wasn't clear on there, what happened to him or not. Because a lot of those, especially from Vanguard, they don't necessarily tell you how much of that is taxable. So, if you don't know how much is taxable to put into your tax form, you might mistakenly claim it all.
Dr. Jim Dahle:
But what's happened here is that you claimed a Roth conversion and told the IRS that the money had not yet been taxed. If you're doing a backdoor Roth IRA, that's not the case. So basically, you filed your taxes wrong and paid too much in taxes.
Dr. Jim Dahle:
So, what you need to do is file your taxes again. And that is called an amended tax return. You use IRS form 1040-X and you don't have to fill out the whole tax thing. You just fill out what was changed. So basically, you'll change that line 4b and you'll include forms 8606 that you didn't send in earlier, that document, why you shouldn't have to pay taxes on that $6,000 conversion. Your tax guy ought to be doing that. I mean, that's why you're paying a tax guy to do this stuff is you shouldn't have to do it.
Dr. Jim Dahle:
One way or the other, either hire someone to do your taxes or do it yourself, but you shouldn't have to do both.
Dr. Jim Dahle:
So, go ahead and get that cleaned up. It's no big deal. I've filed lots of 1040-Xs over the years because for many years I did my own taxes and make lots of mistakes. And guess what? When my tax preparer does them, she also makes mistakes and has to file 1040-Xs.
Dr. Jim Dahle:
So, this is not a big deal. If you've never filed a 1040-X, consider yourself lucky. Some of us do it almost every year for some little thing like this that gets messed up. It's not a big deal. It doesn't mean they're going to come audit you and knock down your door at night. It's a normal thing when it comes to paying taxes, especially as you get more and more complicated tax returns.
Dr. Jim Dahle:
All right, the next question is via email. “If I partially contribute Roth to a 403 to do 50-50 traditional Roth contributions, this should not affect my ability for the backdoor Roth IRA. Right?”
Dr. Jim Dahle:
Well, here's the deal. Why would somebody do 50-50 contributions? Well, it's because they're not sure. They're not sure of what they should be doing with their contributions. And that's not a bad thing. Lots of people aren't sure because it's not clear, right? In order to know for sure, you have to know a bunch of information that is not only unknown, but is unknowable. Like what tax rates are going to be in the future, what other sources of income you might have, how wealthy you're going to be, how long you work, those sorts of questions affect that decision.
Dr. Jim Dahle:
So, what a lot of people choose to do is they just split the difference. They're like, “Eh, I don't know what's right. I'm going to minimize regret. I'm going to do half traditional and half Roth.” And that's fine. It's a totally reasonable approach. Obviously, you're going to be wrong with half your money, but at least you're going to know for sure you're not wrong with all of it.
Dr. Jim Dahle:
But at any rate, to answer your question, money in a 403(b) or a 401(k) or a 457(b) or a defined contribution cash balance plan or a defined benefit cash balance plan, none of that counts toward the pro-rata calculation for the backdoor Roth IRA process.
Dr. Jim Dahle:
If you look at IRS form 8606 line six, you'll see that it asks for the balance of your traditional IRAs, your SEP IRAs and your simple IRAs. That includes rollover IRAs. It does not include inherited IRAs. It does not include Roth IRAs. And it certainly doesn't include any qualified retirement plans from your employer like 401(k), 403(b), 457(b), 401(a), etc.
Dr. Jim Dahle:
Okay. So, you're fine. You can make Roth contributions. You can make traditional contributions in your 403(b) or your 401(k). It has nothing to do with your backdoor Roth IRA process.
Dr. Jim Dahle:
All right, here comes another question off the Speak Pipe about mega backdoor Roth conversions.
Tom:
Hi, Dr. Dahle. This is Tom from California. I have a question on mega backdoor Roth conversions. I work for an organization that has a 403(b) that allows for both pre-tax and post-tax contributions from the employee as well as the 403(b) plan allows for in plan conversions.
Tom:
Can you please go over in greater detail the strategies behind when one would want to do a mega backdoor Roth conversion? Is it based simply on your marginal tax rate at the time that you are considering to do this? In my case, I'm in the late 50s. Would it make sense to do this or would it make more sense to do it after I retire say at age 63 or 65 when I would have in theory lower marginal tax rates and do the mega backdoor conversion at that point? Question one.
Tom:
And question two. Is it possible for you to specify which portion of the 403(b) plan of the contributions that you would like to have moved over through the mega backdoor Roth? Could you specify to say I only want my Roth contributions to the 403(b) to be converted over to the Roth?
Dr. Jim Dahle:
All right. That got really confusing at the end. I think most listeners would agree. And I think the reason why you've got questions is because you're confused about what's going on here.
Dr. Jim Dahle:
So, let's talk about the mega backdoor Roth IRA in general here. We've talked about the backdoor Roth IRA process. This is something you do with IRAs. You put money in a traditional IRA, then you convert it to a Roth IRA because you didn't get the deduction. There's no tax cost on the conversion. In the end it's as though you put $6,000 or $7,000 if you're 50 plus directly into a Roth IRA. You just got to be aware of that pro-rata rule.
Dr. Jim Dahle:
The mega backdoor Roth IRA has nothing to do with an IRA despite the name. Despite the fact that it shares a backdoor Roth IRA with that other thing, it's different. The mega backdoor Roth IRA is something you do typically in a 401(k). Maybe it can be done in a 403(b) too, but typically it's done in a 401(k). This is a 401(k) thing, despite the fact that it's called the mega backdoor Roth IRA.
Dr. Jim Dahle:
There is also a thing called a Roth conversion. A Roth conversion is anytime you take money that is not Roth and you move it into a Roth account and you may or may not have to pay taxes on that conversion, depending on how much that money has been taxed previously. A Roth conversion is a step in the backdoor Roth IRA process. It is also a step in the mega backdoor Roth IRA process.
Dr. Jim Dahle:
So, now we got the terminology straight. There are three types of contributions that you can make to a qualified plan, like a 401(k) or 403(b), etc. Those types of contributions are a tax deferred contribution. That's one type. Where the money has not been taxed, you got a big tax deduction. You put $10,000 in there. Your marginal tax rate is 40%. You just save $4,000 in taxes by putting that money in. It's a great thing.
Dr. Jim Dahle:
There are also Roth contributions. This is money you pay tax on now. You put in there and it never gets taxed again. And then there are after tax contributions. Note that this is not the same as Roth contributions. After tax contributions are money on which you will not pay taxes when you withdraw it, but you will pay taxes on any gains. And you don't pay them at long term capital gains rates, you pay them at ordinary income tax rates.
Dr. Jim Dahle:
If you just made a contribution to a traditional IRA and were not allowed to take a deduction for it, that's what you would have in there. You would have after tax money. The basis or the money you put in there would come out tax free but any earnings that were put in there would later come out taxed at your ordinary income tax rates.
Dr. Jim Dahle:
Same thing inside a 401(k). If you just put that money in there as after-tax money, because your 401(k) allows you to, and lots of 401(k)s do, then when you take it out, the basis comes out tax free, all the earnings are tax just like your tax deferred contributions.
Dr. Jim Dahle:
And that's not an awesome thing. You don't really want to pay on those earnings at your ordinary income tax rates, especially if there's another option. And that other option that is available in many plans is to convert that money to Roth money. So, the mega backdoor Roth IRA process is step one, contributing to after tax portion of a 401(k). And depending on the employer and the plan, you may be able to put a lot of money in there. You may be able to put $37,000 in there a year. And I guess $61,000 is the limit this year. So, what would that be? $40,500, I suppose some people might be able to put in there of after-tax money.
Dr. Jim Dahle:
But step two is then converting it inside the plan into Roth money. So, there's no cost to that conversion, no tax cost, because it has already been taxed. And now the earnings, instead of being taxed at your ordinary income tax rate are never taxed again. So that's an awesome thing. It's just like you just put $20,000, $30,000, $40,000 into a Roth IRA. That's why it's called the mega backdoor Roth IRA, because you are putting a ton of money in there that is now Roth money and will now grow tax free going forward.
Dr. Jim Dahle:
So that's what the mega backdoor Roth IRA process is. And depending on the plan, you may or may not be able to put any at all in there. And how much goes in there may depend on how much of an employer match you get. Because there's this limit, $61,000 limit this year on how much can go into that account total between all of your contributions and all of your employer's contributions.
Dr. Jim Dahle:
And so, if you put in $20,000 as your regular contribution, $20,500 is probably what you put in, and then your employer matched another $10,000, and they say, “Well, you can go up to $61,000 total.” So maybe you chose to put in another $30,000 as an after-tax contribution. If they allow you to do that, that's a great thing. If they also allow you to then convert that money to a Roth account, that's an even better thing, because now you've got a bunch of money in Roth instead of just after tax and that's much, much better. So that's great if you can do that.
Dr. Jim Dahle:
Now, what if you have a choice between that and something else? Lots of us do have that choice. We have that choice in the White Coat Investor 401(k). We set it up that way. When you get to design your own 401(k), you got to do whatever you want.
Dr. Jim Dahle:
That is what Katie and I actually do these days. We make all that contribution after tax contribution, then we immediately convert it to Roth money. And the reason why has to do with the 199A deduction, etc. It's not right for everybody, but it is right for us.
Dr. Jim Dahle:
And so those are the contributions we make to our 401(k) these days. If your plan allows it, it might be right for you. Only you can decide. If the other option is $61,000 that's all tax deferred, that could very well be the right option for you, especially during your peak earnings years. You just have to weigh those factors. And that's going to be different for everybody.
Dr. Jim Dahle:
Again, if you're a super saver or you expect a whole bunch of other sources of income in retirement, or you expect to be in the exact same bracket or even a higher bracket than you are now in retirement, then you want to lean more toward Roth money.
Dr. Jim Dahle:
If you're more typical doc and you're going to retire with just a few million dollars and you're not going to even have enough tax deferred withdrawals each year to fill up the first three or four brackets, then you're probably going to want to do tax deferred contributions and not do the mega backdoor Roth contributions. You just have to evaluate the plan that you are offered, put it in place with your overall financial plan and decide on the right thing to do.
Dr. Jim Dahle:
I hope that's helpful. It's actually a fairly complicated question. A lot goes into answering that question, but I hope that gives you a little bit more clarity to what you're actually dealing with.
Dr. Jim Dahle:
All right. The next question is about a Roth IRA from John. Let's take a listen to that.
John:
Hi, Dr. Dahle. I'm a new grad and have questions about my Roth IRA. I've been contributing via backdoor for the last two years and I put in my $6,000 this year, but was actually enrolled in a simple IRA through work in about June. So, I didn't think about it until I saw a post recently, but I'm wanting to out the best way to move forward.
John:
Again, I don't have much, I'm a new grad, but I have around $15,000 in the Roth and only about $2,000 which will probably be closer to $4,000 to $5,000 at the end of the year.
John:
Would it be best to call Vanguard and recharacterize my Roth back into a traditional IRA to see if I can roll over the simple IRA into the Roth, if that's possible or something else? Also, if I were to roll it over, would it not be over the limit of the $6,000 in one year? And then I was reading that it would lead to a 6% excise tax year after year until that was resolved. I didn't fully understand that, but I would appreciate any insight.
John:
Thanks again for all you do. I truly appreciate all the work that you've put into making the White Coat Investor as such a great resource for all of us. Thank you for your help.
Dr. Jim Dahle:
All right. Well, sorry you have a simple IRA at work. To those of you who are employers, if you employ docs and your retirement plan at your company is a simple IRA, you suck. I hate you. Why would you do that for doctors? That's really lame.
Dr. Jim Dahle:
Now I get it. If you're in a small dental practice or something, sometimes a simple IRA makes sense to be what you offer to your employees. And if that's the case and you just happen to have one associate dentist or one associate physician or whatever, okay, I get it. It was the best you could do.
Dr. Jim Dahle:
If you're putting in a plan into your business, you ought to get a study of the business and how much employees are likely to contribute and how many of them are highly compensated employees versus non highly compensated and figure out what the right plan is for the business. It might be a simple IRA. It might be a SEP IRA. It might be a 401(k). It might be no plan at all.
Dr. Jim Dahle:
But boy, if you make a simple IRA, you're not helping your docs very much and you're probably not helping yourself very much. So, keep that in mind. The contributions on a simple IRA… What are they this year? Like $14,000 or something like that? It’s dramatically less than the $61,000 you can put into 401(k). So, for you and your docs, you are really limiting how much money you can get into a tax protected and asset protected account if you're putting a simple IRA in place.
Dr. Jim Dahle:
And aside from that, you're also screwing their ability to do a backdoor Roth IRA. Remember what I said earlier about that form 8606 line six, right? It asks for the balance at the end of the year of all the money you have in a traditional IRA, a simple IRA and a SEP IRA. And if you have money on that line in those accounts, your conversion for your backdoor Roth IRA process is going to be prorated.
Dr. Jim Dahle:
Now being prorated isn't the end of the world but it kind of defeats the purpose of doing the backdoor Roth IRA process. And so, it's really lame. Not only are you not letting people put much into retirement, but you're basically keeping them from being able to do this $6,000 in an effective way.
Dr. Jim Dahle:
So, you didn't know this, John. You've just been plotting along doing the right thing and you got ambushed by an employer that for whatever reason has a simple IRA in place. So, what's going to happen this year if you don't do anything is you're going to get your conversion prorated. However much money you got in that simple IRA plus the $6,000 that you did the conversion on, some portion of that conversion you did is going to be basis, meaning it's not taxable. And some portion of it is going to be simple IRA money that you got a tax deduction for.
Dr. Jim Dahle:
And so, there's going to be a cost for your Roth conversion this year. It's not at the end of the world, right? Because that money that you're paying to convert is never going to be taxed again. And you've still got some basis in that IRA, but it sure does make things more complicated.
Dr. Jim Dahle:
As a general rule, if the plan at work is a simple IRA, you just don't do backdoor Roth IRAs going forward. If you think you're only going to be there a few years, or the employer might change the plan, well, you can keep doing the contribution step of the backdoor Roth IRA process and just have that money sit in the traditional IRA and then you can do a conversion at a later date. Obviously, you'll have to pay taxes on any gains that you convert, but the original basis can still be converted tax free down the road. So that's not a bad thing to do.
Dr. Jim Dahle:
But if it looks like you're going to be in this job for 15 years and that this plan is not going to change, this is going to be your retirement plan at the job, well, it may not be worth messing around with the backdoor Roth IRA at all. You're one of those few people that probably shouldn't be doing a backdoor Roth IRA each year, because it's just going to get pro-rated. And not only is that not as beneficial as you expected it to be, but it's also a pain tax wise.
Dr. Jim Dahle:
Now would I go back and try to undo my backdoor Roth IRA for this year, probably not. I probably wouldn't. They may not even let you contribute to the simple IRA this year. And so, that would also solve the problem for this year. You'll just have to use that money for something else to pay off your student loans or beef up your emergency fund or invest in taxable or whatever. That might be an option. Just pull any contribution you've made to the simple IRA out this year and start using it next year instead of doing a backdoor Roth IRA.
Dr. Jim Dahle:
But really probably choosing between the two going forward. And you're supposed to have to do the rest of your savings in taxable. Sorry about that. It stinks to have your retirement plan be a simple IRA.
Dr. Jim Dahle:
And no, you can't just convert it every year. You can do that with a SEP IRA, but with a simple IRA you have to leave the money there for two years. So, it's just a really lame retirement account. It's simple to set up. It's cheap to set up. That's why employers use it but it's not a very good account. So, I hate simple IRAs.
Dr. Jim Dahle:
Okay. Let's take a question via email. “I'm curious for your thoughts of why seemingly more physicians are looking for side hustles or FIRE than before. Is medicine worse now than 20 or 30 years ago? Is it just that options like FIRE are more known now? I'm fascinated why it seems like so many physicians think about these options and I wonder if it stems from a desire to leave medicine or something else.”
Dr. Jim Dahle:
Well, everybody thinks it was way better in the past, right? The golden age of medicine always seems to be about five years before you entered medical school. And everything's been going downhill ever since. People were saying that in the 80s and the 90s and the 2,000s and the 2010s, and they're still saying it in the 2020s, right? That everything used to be really good.
Dr. Jim Dahle:
Well, if you look at it objectively, that's not necessarily true. There are lots of docs that are doing better now than they ever were. And so, there may not have been a golden age of medicine and this is regional dependent, specialty dependent. So, realize that.
Dr. Jim Dahle:
Are there some unique stresses now? Yes. Is burnout higher than ever before? Yes. Is that just because we're looking for it more? It's hard to say. I think one thing that does make burnout worse these days is docs have a lot less control over their practices. Much larger percentage of doctors are employees now versus owners of their practice. They don't have the ability to say who works for them. They don't have the ability to pick their own partners. They don't have the ability to hire and fire those they work with, to choose which EMR to use, to determine how many patients per hour they're going to see. All those things that they used to have, or many of them used to have a lot more control over.
Dr. Jim Dahle:
And I think losing control, especially when the person who now has control might be private equity backed, primarily profit motivated, and really flogging the whip to get you to move people through as quickly as possible. The radiologists talk about this a lot, that it has just become such a productivity-based business. How many CTs can you read in an hour? They don't care about quality. How many can you pump through?
Dr. Jim Dahle:
In that respect, I think medicine is probably worse in a few ways than it used to be. How much of it is simply that people know more about it now? Well, I guess I'm partially responsible for that. I started the White Coat Investor in 2011. I've definitely noticed a change in physician financial literacy over the last decade. More of us are smarter now with our money than we used to be.
Dr. Jim Dahle:
I think that's a good thing. To know about your options is not a bad thing. Has FIRE been more popularized over the last five or six or seven years? Sure. Do millennials hate to work? They probably have more of a focus on lifestyle than maybe the baby boomers did.
Dr. Jim Dahle:
And so, I think there's some cultural changes. I think there's some changes in medicine. I think there's some financial literacy changes that have contributed to this, but most likely I think the biggest factor is that you're simply seeing a subset of doctors.
Dr. Jim Dahle:
Those who are maybe not as satisfied with their practice, those who are more interested in changing to nonclinical options or some other sort of side hustle or more interested in FIRE, they're concentrated in the places you're hanging out.
Dr. Jim Dahle:
They're concentrated in the audience of a podcast like this, on the forums of the White Coat Investor or a subreddit about FIRE. And so, you're just seeing a selection bias there among doctors. I assure you that there are plenty of doctors out there that are planning to work a full career, that aren't saving all that much of their money, that are not going to have an option to FIRE. There are plenty of them out there.
Dr. Jim Dahle:
And so, I suspect a big portion of what you're seeing is simply where you're hanging out. If you go hang out somewhere where people aren't talking about finances, you're not going to see nearly as much of that. But yeah, I think burnout is higher now than it's ever been. I think more docs would like to leave medicine now than perhaps in the past. But I also think more docs actually have that option. And because they have that option, they consider it and talk about it.
Dr. Jim Dahle:
All right. Now let's do our quote of the day. This one is from Alfred Rappaport. “Cash is a fact. Profit is an opinion.” That one gets dragged out every now and then when people are talking about dividend stocks.
Dr. Jim Dahle:
All right, moving away from financial advisor. Let's take a listen to this one on the Speak Pipe.
Speaker:
Hi, I've just discovered White Coat Investor during my recent quest to become more engaged in investing. I'm a surgical pathologist in upstate New York and I anticipate working for at least 20 more years. I've had a financial advisor for about 10 years who really helped me get my house in order.
Speaker:
I maximized my 403(b) and Roth IRA contributions and I've been saving about $2,000 a month to a taxable account at Schwab. My hospital also has a pension plan, believe it or not.
Speaker:
My advisor designed my portfolio for both my Roth and taxable accounts at Schwab. Now that I've educated myself more about the wisdom of simplicity indexing, I'm looking at it with a more critical eye. In my Roth account, I have about 17 funds. In my taxable account I have 15 funds. Some funds in both accounts are actively managed with an expense ratio of over 1%.
Speaker:
Two questions. One, does this portfolio sound excessively complex to you? Two, if so, would it be unwise for me to consider eventually managing it on my own to at least avoid my advisor's fee?
Speaker:
I've read lots about designing a simple tax efficient portfolio, but what's a person to do with a portfolio designed by someone else when I was a financial neophyte just out of residency? Wouldn't selling the actively managed funds have a huge tax? In the spirit of the buy and hold, am better off just staying the course? I realize it may be difficult for you to answer these questions without seeing my portfolio, but I appreciate any advice you have. Thanks so much.
Dr. Jim Dahle:
I get accused a lot of being anti financial advisor. That's not actually the case. I like financial advisors. I have friends that are financial advisors. I think there's a lot of really good financial advisors out there who give good advice at a fair price.
Dr. Jim Dahle:
This person that you have engaged to function as your financial advisor is not a good financial advisor. They suck at what they do. I don't know if they are a mutual fund salesman. If that is how they're being paid, if you're paying on commissions, if these are loaded or commissioned mutual funds, that's the mistake you've made.
Dr. Jim Dahle:
You have basically hired a commissioned sales agent masquerading as an advisor. If that's not the case, and this is just a terribly untalented unknowledgeable ignorant advisor, I guess the end result is the same. This person needs to be fired. They're terrible. They really are.
Dr. Jim Dahle:
And if this is your portfolio, if you're this poor doc advisor, you suck. Why did you do this? Why are you in this profession if this is the kind of work you're going to do? This is basically financial malpractice to set up a portfolio with 15 funds in one, 17 funds in another. 1% plus ER. I mean, come on, you're not doing this person a service. You're ripping them off.
Dr. Jim Dahle:
Most likely this advisor is not doing it deliberately that they're not a bad person. It's that they're ignorant. They don't know how to construct a portfolio properly. They don't know about index funds. They don't know about the importance of keeping costs slow. They don't know about the importance of having a reasonably simple portfolio.
Dr. Jim Dahle:
All right, this is an advisor that needs to be fired. So, step number one is to figure out what are you going to do going forward? And you have two good options. One is to get a real financial advisor that offers good advice at a fair price. You can find a list of these folks at whitecoatinvestor.com. Go into the recommended tab for financial advisors. We got a lot of great people. They do charge money. Financial advice isn't cheap. You got to expect to pay a four figure amount a year, but they give good advice. They're not going to put you into this crappy portfolio. And if they do, I want to hear about it because I'm taking them off my list.
Dr. Jim Dahle:
But we ask them about this sort of stuff when we vet them to put them on that list. Do you use a bunch of actively managed funds? Do you use a bunch of high expense ratio funds? We ask them these questions. Are you trying to time the market? And we actually make that application with those questions available to you. You can read their answers before you hire them. So that's one option.
Dr. Jim Dahle:
The second option is to do what lots of White Coat Investors are doing. That is manage your own money. There are some real advantages to managing your own money. Number one, you save the fees. So even if you're not exactly quite as good as a professional, talented financial advisor, as long as you are no worse than the amount it costs to hire that person then you're still coming out ahead. So that's one option.
Dr. Jim Dahle:
The other thing is you know you're not going to rip yourself off and you don't have to schedule a bunch of time to meet with yourself. And so, there's some advantages to doing it yourself in that way. I've been a do-it-yourself investor for a couple of decades now and I intend to do that continuing forward. I don't find it complicated. I find the price to hire somebody to do this to be dramatically more than the value I get from having them do it. So, I think that's a perfectly reasonable option.
Dr. Jim Dahle:
Either way you've got to choose what you're going to do going forward. And I wouldn't do anything until you've made that decision. So that's step one. If the plan is to hire a good advisor, you dump this in their lap and have them sort it out. That's their job. That's why you're hiring them. And that's perfectly acceptable to do. In fact, you can just hire somebody to help you sort it out and then going forward manage it yourself. We have lots of people on that list that specialize in doing that sort of a thing where they just do it on an hourly base or on a flat fee base and help you get your portfolio set up properly.
Dr. Jim Dahle:
Assuming, and you sound like you're probably going to be a do-it-yourself investor going forward, then you got to figure out how to do this on your own. Again, don't do anything until you have the plan in place. Get a written financial plan in place. If you need to hire an advisor to do that, hire an advisor to do that. If you need to take our Fire Your Financial Advisor online course to learn how to do that, do that. If you feel like you're now competent to do it, then do it, but get the plan in place first. Then it's just a question of going from here to there.
Dr. Jim Dahle:
With the tax protective accounts, it's very, very easy. There's no tax cost to selling any of that crap. You just sell it all. You put it in the portfolio that you want. In a taxable account, it's a little more complicated and you may end up with some legacy investments. Legacy investments are investments you wouldn't buy now, but you don't want to sell because the tax cost to selling is too high. And you got some options of what to do with that.
Dr. Jim Dahle:
But the step one, when you look at a taxable account that's in 15 or 17 different funds or whatever the crap that was, the first thing you do is you figure out the cost basis for each of those tax lots. And you may find, especially with the performance of the market this year, that you've actually got a bunch of those lots with losses. So, if you were underwater on any of that, great, sell it and buy what you should actually be investing in in the first place. You're actually in a tax loss harvest at the same time. This is a good thing.
Dr. Jim Dahle:
If the basis is about the same as what you bought it at, great, no tax cost. You can sell it and buy what you'd rather own. If you were able to pick up a bunch of tax losses in this process, you can now sell some of those things with gains and use the losses to offset the gains. And again, get invested into that sort of stuff that you actually want.
Dr. Jim Dahle:
Then if you've got a few things left that have a very low basis compared to their current value, well, you may want to build around those in your portfolio. You may want to say, “Well, these are mostly large cap blend funds. So, I'll just own a little bit less of the total stock market fund in order to account for the fact that some of my portfolio is going to sit in these at least for a while.”
Dr. Jim Dahle:
If you end up gifting something to your children or something, you can gift those appreciated shares. If you give to charity, those are great things to give to charity. These appreciated shares that you don't actually even want. And you can do that with no tax cost. Obviously, don't be reinvesting dividends into those funds. but they've just become legacy investments for you and you just have to deal with them in that way.
Dr. Jim Dahle:
But most people that go into this process that have only been doing this for a couple of years, you're probably going to be able to change 95% of your portfolio to what you actually want to be invested in no problem. You might have a little bit of legacy investments going forward and that's not a big deal to deal with going forward. Every time you look at it, it'll remind you of the importance of being financially literate.
Dr. Jim Dahle:
All right. The next question comes via email. “In terms of achieving passive cash flow sources, what are your thoughts on annuity versus dividend stock investing versus syndicated real estate? Pros and cons. Also, your thoughts in general of discussing fee structure for syndications and why something like a 2 and 20 fee structure is seen with syndications and thought to be okay while investing in stocks is too high of a fee.”
Dr. Jim Dahle:
All right, let's do the first one. Passive cash flow sources. Passive is one of those things that it's a continuum. Some things are more passive than others. You want something that's really passive? Well, put your money into a mutual fund, put it into the total stock market mutual fund, and it'll pay you a dividend every quarter for the rest of your life extremely passively. You'll never do a thing with it again. That's really passive.
Dr. Jim Dahle:
On the other hand, if you write a book, that's also passive income that comes in after that, the royalties, but you had to do a whole bunch of work up front. And there are all kinds of other passive opportunities where maybe you're getting paid out of proportion to the amount of work you're putting in. Maybe that's running a direct real estate property. That might be considered passive by lots of people, but obviously there's some work there. Some of that is kind of active income if you will.
Dr. Jim Dahle:
But anyway, we're comparing annuities versus dividend stocks versus syndicated real estate. Well, let's divide this annuity on one side and dividend stock investing and syndicated real estate on the other.
Dr. Jim Dahle:
Bear in mind, there are lots of terrible annuities that you should avoid. But when we're talking about an annuity here, I'm assuming you're talking about a good annuity. Something like a SPIA – Single Premium Immediate Annuity. And what you're doing with that sort of a thing is you're buying a pension. You're going to an insurance company. You're giving them a lump sum of money. In exchange they're promising to pay you a certain amount every month, as long as you live. That's obviously very passive, as a passive cash flow source.
Dr. Jim Dahle:
But really, you should think about that as a way to spend your money, not a way to invest your money. So, if you're looking for something very safe and a way to spend your money, that's where an annuity comes in.
Dr. Jim Dahle:
These other two, stocks and real estate have much more risk. I would expect higher returns in the long run from both of those than I would from an annuity. And the main difference from a cash flow perspective is that with a stock, a relatively small portion of the return of the total return from the investment comes as income.
Dr. Jim Dahle:
With real estate, a relatively larger percentage of the return comes from income. So, if the goal is income, then real estate tends to be a better option than stocks. And dividend stocks pay slightly higher dividends than the overall stock market. And so, instead of getting 2%, maybe you're getting 3% or 4% and the rest of the return, if the return is 8% total, the rest of the return comes as appreciation. Whereas with real estate you might get 3% in appreciation and 5% in income. And so, a larger percentage of the return is coming as income with real estate.
Dr. Jim Dahle:
I think they're both great. I own stocks. I own real estate. I own all the dividend stocks. People think I'm anti dividend stocks. Nope. I own them all. I own all the international ones. I own all the US ones. That's what you get with total market index funds. And so, that's great. It's a nice income, but if the goal is more of your return coming in as income, you may prefer to have a little bit more in real estate than in stocks.
Dr. Jim Dahle:
But it's not like you can't declare your own dividend. You can sell stocks anytime you want and declare your own dividend. It's no big deal. In fact, paying dividends is not ideal from a tax perspective. All this time, you're accumulating money and reinvesting it, getting paid dividends, at least in a taxable account, is just creating a tax drag on the growth on that money. So, it's not necessarily a good thing.
Dr. Jim Dahle:
All right. Let's talk about fee structures for syndications. Most syndications, most private real estate funds are set up with fees and they're set up with a waterfall structure. And in a typical waterfall, you'll have to pay some sort of fee before we get to the waterfall. Maybe 1%, that's pretty typical.
Dr. Jim Dahle:
And then what happens is there's usually a preferred return. That's usually something in the 6% to 8%, 10% range. Let's say 8%. So, you pay those guys 1% a year. That's pretty typical. And that's for running the investment, for running the fund, for running the syndication, whatever. Any business has expenses and that's how they pay the expenses. And then you get your preferred return. So, you get all your money back, you get all the principle back, and then you're guaranteed the first 8%. And that is the preferred return. And that goes to the investors preferentially.
Dr. Jim Dahle:
But in order to incentivize that manager to do really well, they actually get a promote, which is where most of their money comes from. Most of their income and profit from this deal comes from the promote. And the promote is how the money is split up beyond the preferred return.
Dr. Jim Dahle:
A typical one might be you get the first 8% as the investor and above there, you split it 80/20 percent. That would be if this thing makes… Let's say it makes 18%. Does really well. You get the first 8% and then there's another 10% of return. And that gets split 80% to you. So, another 8% to you and 2% to the manager. So, they get 2%, you get 16%. It's pretty good, right? Not too bad.
Dr. Jim Dahle:
Now some of those have a catch up, meaning that on the overall return, if it makes enough money, eventually the manager of that fund gets 20%. So, if there were a catch up system, whether it catches up 50-50, or it catches up 100% to the manager, or it's 80/20 on the catch up, however the catch up works, if it makes enough money, eventually they're going to get 20% of the entire return.
Dr. Jim Dahle:
So, let's say again, this one smashes it out of the park. It makes 20%. So, you're going to get 16%. They're going to get 4%. And that's how it works with this sort of promote structure.
Dr. Jim Dahle:
Now, is this the same thing as a hedge fund charging 2 and 20? In some ways it is. And in some ways, it isn't. Number one, the hedge fund typically isn't giving you a promote. Number two, the hedge fund is charging 2%. And typically, most of these syndication deals charge a 1% fee. So that's one way in which it is different. It's actually lower. Especially if there's no catch up, then you get 8% where they don't get any of it. And if this thing only makes 10%, well, they're not getting 2%, they're only going to be getting like 0.4%. So, it's significantly lower fees than what you'd see in a hedge fund.
Dr. Jim Dahle:
Number two, we're in the real estate space here. It's significantly less liquid. It's significantly less transparent. It's significantly less efficient than the stock market. If your hedge fund manager is just picking stocks and taking 2 and 20, that's a pretty big fee for picking stocks. You can go to an active mutual fund manager, a Vanguard to pay 0.25% instead of 2 and 20.
Dr. Jim Dahle:
So, if that hedge fund manager is truly talented and is really going to beat the market, it's worth paying them 2 and 20, but there are very few people out there that have that much talent. And certainly, with a 2 and 20 fee structure, a significant portion of whatever talent they may have is going to flow to their pocket and your returns are going to be much more similar to the market returns you would get in an index fund.
Dr. Jim Dahle:
Probably more likely is they just had a few really good years. All the investors pile in, are willing to pay 2 and 20, and then the manager ends up underperforming the market anyway. And you're paying 2 and 20 to underperform. So now you're really underperforming after paying that high level of fees.
Dr. Jim Dahle:
So, here's the deal. If you want to keep your fees rock bottom, super cheap, as cheap as you can and that is your primary concern, you probably should not invest in any sort of private real estate. No syndications, no private real estate. If however you're willing to take a little bit broader view and say, “Okay, this is the cost of doing business in this space. And what I really care about is my after fee return.” Really your after fee, after tax, after inflation return, then that's what you ought to judge it based on.
Dr. Jim Dahle:
Yes, every dollar you pay in fees is a dollar that has to come out of your return, but you're not going to get someone to run some sort of real estate syndication on a little $20 million syndication deal. They're not going to be willing to do it for 0.03% like Vanguard's willing to run a trillion-dollar index fund. You're going to have to pay more if you want to play in that space.
Dr. Jim Dahle:
So, your choices if you want to have expenses of less than 10 basis points, all you're going to be able to do is invest in publicly traded investments. And you know what? I think there's probably a premium for being willing to be a little bit of liquid. There's probably a premium for getting out of that space and this is how you access it.
Dr. Jim Dahle:
So, pay attention to fees but realize that comparing a syndication fee to a mutual fund fee is apples and oranges. The syndication has expenses, things that have to be done. Those expenses for the companies in your index fund do not show up in your expense ratio of that mutual fund. They're in the profit loss statements of the underlying companies. So those have to be paid by somebody and when it comes to this syndication, that's where they get paid.
Dr. Jim Dahle:
I hope that makes sense. If you're interested in those sorts of private real estate investments, I'd recommend you check out our new course, this brand-new course No Hype Real Estate Investing. You can sign up for that at whitecoatinvestor.com/realestate. You can come to the webinar, whitecoatinvestor.com/nohypewebinar is where you sign up for that, that's on the 20th at 7:00 PM and learn more about it. And then that way you'll know how to evaluate these deals. You'll know how to recognize what's a fair waterfall structure, what is not a fair waterfall structure and you'll be able to make better decisions with respect to private real estate.
Dr. Jim Dahle:
You may decide you'll just stick with publicly traded real estate. Lots of people do. Other people decide, “You know what? I'm not interested in paying syndicators or fund managers. I'm just going to do it myself. I'm going to go buy the property down the street and rent it out and manage it.” And that's fine too, but you just got to match your desires and the amount of work and capital you're willing to put into the deal and how much control you want to have over it and decide where you fit on that real estate spectrum. We'll talk about that more at the webinar.
Dr. Jim Dahle:
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Dr. Jim Dahle:
All right, thanks for those of you leaving us reviews. Our most recent five-star review came in. It said “Exceptional podcast. Jim has wealth of knowledge, and provides us with exceptional guidances with what I call no bias. Your podcast made huge impact on my financial life. It is needed for many high-income professionals. I highly recommend it.” Thank you so much. Jaijav2015, five stars.
Dr. Jim Dahle:
All right, for the rest of you, keep your head up, shoulders back. You can do this and we can help. We'll see you next time on the White Coat Investor podcast.
Disclaimer:
The hosts of the White Coat Investor podcast are not licensed accountants, attorneys, or financial advisors. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.
