Saving ahead of time for retirement and other future goals is critically important. Building wealth and being able to retire is accomplished by systematically saving and investing over time, not by dumping your life savings into penny stocks.
The discipline of saving today for retirement later can be hard. High student loan debt, mortgages, insurance, not to mention groceries, children’s activities and nearly everything all cost money! It can be easy to think you don’t have enough money leftover to put toward your retirement. But the best time to start funding your retirement is NOW. When it comes to saving for retirement, time is your best friend. Warren Buffet once said ‘Someone is sitting in the shade today because someone planted a tree a long time ago”. Growing up in the hot Georgia summers, I can appreciate this quote.
Even though you understand the importance of saving for retirement, it can be confusing. Which account should I save into? How much? How does this affect my taxes both now and when I retire? My practice doesn’t offer a retirement plan, am I out of luck? I’m a relief veterinarian, what options are available to me? Hopefully this article will help answer these questions and more to increase your confidence as you save for retirement.
Employer-Sponsored Retirement Plans
Probably the most common and well-known retirement account is the 401(k), or 403(b) if you work for a non-profit organization. Offered by employers, 401(k) & 403(b) contributions are made through payroll deductions, typically on a percentage basis. One of the best benefits of participating in these plans is the ability to take advantage of employer matching, which is basically free money contributed by your employer to encourage you to save for retirement. The match percentage will vary by employer, but at a minimum, you should contribute enough to your account to get the full employer match. If you choose not to contribute, you are leaving money on the table.
Traditional vs. Roth Plans
Within your 401(k) or 403(b), you may have the option to choose either traditional or Roth contributions. Which account you use will affect your current year tax liability as well as the taxation of your savings when you begin to withdraw, so it’s important to understand how you are saving.
Traditional 401(k) or 403(b) Contributions
Contributions made to a traditional 401(k) or 403(b) are done on a pre-tax basis. This means that every dollar you contribute is not taxed and actually lowers your taxable income. For example, if you make $100,000 a year and contribute 10% of your salary to a traditional 401k, this would lower your income by $10,000. If you are in a 22% marginal tax bracket, this $10,000 contribution would save you $2,200 in taxes every year ($10,000 x 22%). The match you receive will also go into your pre-tax account, as employers want the tax deduction today for their contributions as well.
While you don’t pay taxes on the money you or your employer contribute to your pre-tax account today, you will owe tax when you withdraw the funds. Most likely at this time you will be retired, working less or not at all, and your income will be much lower. It is common that retirees are in a much lower tax bracket.
Not in a position to save 10% of your income? That’s ok! Start with the minimum to get your full employer match (if available) and increase your contribution amount by 1% every year. Odds are you won’t even notice the increase in contributions when you receive your paycheck, and this 1% increase every year will be a huge boost to your retirement savings.
For tax year 2021, the maximum you can contribute is $19,500 (with an additional $6500 for those age 50 or over). This maximum amount increases over time. Because contributing to a 401(k) or 403(b) is designed for long-term goals such as retirement, you will want to avoid withdrawals before age 59 ½. With the exception of some exclusions, distributions made before age 59 ½ are subject to ordinary income taxes as well as a 10% penalty. Review your summary plan description when considering withdrawals from your 401(k) or 403(b) while you are still working.
Roth 401(k) or 403(b) Contributions
Roth 401(k) & Roth 403(b) accounts are very similar to traditional accounts, though how these accounts are taxed is different.
Contributions made to a Roth 401(k) or Roth 403(b) are done on an after-tax basis, meaning you receive no tax deduction today for any contributions made. The benefit comes when you withdraw the money in retirement, as all of your contributions and earnings can be withdrawn tax-free, assuming certain requirements are met. Employer matches, however, regardless of whether you elect traditional vs. Roth deferrals will always be considered pre-tax and will be taxed upon withdrawal. This is because your employer wants the tax deduction today, they don’t want to wait.
Just like traditional accounts, the maximum employee Roth 401k contribution for 2021 is $19,500 (with an additional $6500 for those age 50 or over), and distributions before age 59 ½ should be avoided as well. Review your summary plan description when considering withdrawals from your Roth 401(k) or 403(b) while still working.
Traditional vs. Roth – Which is better?
When it comes to retirement savings, having flexibility in the types of accounts you have is beneficial. Having both pre-tax and tax-free buckets to pull money from in retirement can allow you to coordinate a strategy to pay the least amount of taxes.
For example, assume a married couple is currently in retirement. For tax year 2021, they can have up to $81,050 in taxable income and still remain in the 12% tax bracket. Every dollar in income above this $81,050 level will be taxed at the next tax bracket, which is 22%. By having diversification in savings, they can first withdraw from their pre-tax savings (after also accounting for any pension income, part-time income, or social security income) up to the 12% bracket limit of $81,050, and if any additional funds are needed during that year they can withdraw the excess from their Roth accounts. Because Roth distributions are tax-free, they can avoid having to pay 22% tax on any distributions to fund their retirement. Having too much in either a pre-tax or Roth 401(k) or 403(b) can limit your withdrawal flexibility in retirement.
Typically, for those in higher tax brackets a traditional 401(k) or 403(b) is going to be more advantageous. The higher your tax bracket, the more you save. For those in lower tax brackets, a Roth 401(k) or Roth 403(b) may make more sense to take advantage of the tax-free growth and distributions.
This decision should be looked at based on many factors, including but not limited to your potential to increase your income, your ability to qualify for and contribute to outside accounts such as Roth IRA’s, and your short and long term goals.
After-tax 401(k) or 403(b) Contributions
More uncommon than a traditional or Roth, after-tax 401(k) or 403(b) options can be another source of savings for high income earners. Like a Roth, contributions made to an after-tax 401(k) or 403(b) will be tax-free when withdrawn (restrictions apply). Unlike a Roth, earnings on after-tax contributions are considered pre-tax and will grow tax-deferred, but will be fully taxable when distributed.
Some plans may offer what are referred to as in-plan conversions. In-plan conversions allow you to convert after-tax contributions into your Roth 401k, which allows the earnings on your after-tax contributions to grow tax-free as well, avoiding taxable distributions in the future.
The annual maximum that can be contributed to any 401(k) or 403(b) plan is $58,000 in 2021, which includes contributions from all sources (employee deferrals, employer matches, after-tax contributions). Contributing to an after-tax 401(k) or 403(b) is a great option for those who are looking for additional ways to save. Most individuals should solidify their cash reserves, ensure the proper insurances are in place, and max out their 401(k)/403(b) deferrals and IRA/Roth IRA’s before contributing to an after-tax 401(k)/403(b).
Solo 401(k) Plans
Solo 401(k) plans are designed for the self-employed. This alternative provides an option for people who work by themselves (such as 1099 employees) to reap the benefits of 401(k) contributions. If you have full-time employees, you can’t utilize this type of account. An important distinction is that if your spouse is employed in the practice and earns money from this business, they can be a participant in this 401(k) plan as well.
Because you are both the employee and the employer, you can contribute the maximum amount of $58,000 for tax year 2021 (plus an additional $6,500 if age 50 or over) to a Solo 401(k). As the employee, you contribute the maximum of $19,500 (plus $6,500 catch up if over age 50), just like a traditional or Roth 401(k). However, because you are also the employer you are able to contribute up to 25% of your compensation* up to $285,000, up to the maximum of $58,000 (or $64,500 for those age 50 or over).
Solo 401(k) plans can be made with either pre-tax or Roth deferrals, and are a fantastic option for self-employed veterinarians and relief vets.
Most non-corporate owned veterinary practices use a SIMPLE IRA plan. SIMPLE IRA’s, as the name implies, are easy to set up and administer and require much less administrative and compliance follow up than 401(k) plans.
Contribution limits differ for SIMPLE IRA’s as well. The maximum employee contribution is $13,500 in 2021 (with a $3,000 catch for those age 50 and over), limited to 100% of your net earnings from self-employment. Employers have 2 options when it comes to matching, elective or non-elective. Non-elective contributions mean the employer will contribute 2% of every eligible employee’s salary, regardless if they contribute or not. Employers can also use elective contributions, meaning they will contribute up to 3% of an employee’s salary deferrals, but only for those who make contributions.
SIMPLE IRA plans currently only offer pre-tax contributions, so there is no Roth option. SIMPLE IRA’s provide a great starting point for offering a retirement plan for smaller practices. Determining eligibility, employer requirements, and distribution rules can be confusing, and it is advised to review IRS guidelines or work with a qualified advisor to answer your questions.
SIMPLE IRA’s, while available to small business owners and relief vets, are many times a better option for those practices with employees.
SEP-IRA (Simplified Employee Pension)
SEP-IRA’s are also very easy to set up and administer. SEP-IRA’s are fully and solely funded by the employer; employees are unable to make deferral contributions into a SEP-IRA.
Employer contributions are made on the same percentage of compensation for every eligible employee, and contributions are limited to the smaller of $58,000 (for tax year 2021) or 25% of compensation.
SEP-IRA’s are popular due to their flexibility of when contributions need to be made, and for how much and can also be a great retirement tool for self-employed veterinarians and relief vets.
Similar to SIMPLE IRA’s, there are many rules regarding SEP-IRA’s so be sure to understand the IRS guidelines when contributing to or implementing this plan.
Individual Retirement Accounts
Individual retirement accounts are available to all individuals who earn income whether or not their employers offer a plan. They are a tool to save additional funds for retirement and can be used in conjunction with any savings to an employer plan. For tax year 2021, the maximum contribution to either an IRA or Roth IRA is $6,000/year, with an additional $1,000 catch-up for those age 50 or over.
Traditional/Rollover IRA’s are pre-tax retirement savings plans, much like a traditional 401(k). Every dollar you contribute reduces your taxable income, saving you in tax liability. The funds grow tax-deferred but because you have yet to pay any tax on this money. When you begin withdrawing in retirement, the full amount you take out will be taxed as ordinary income.
Deductible contributions to IRA’s are subject to income limitations, however. For married couples who file jointly, if your adjusted gross income is over $125,000 in 2021 you are unable to make a deductible contribution to an IRA if you are both covered by a retirement plan at work. If, however, one or both of you is not covered by a retirement plan at work, these income limits increase. Please visit the IRS website for more information on determining the deductibility of IRA contributions. Any individual who has earned income can make an IRA contribution, including spousal IRA contributions in situations where only one spouse has earned income.
Roth IRA’s have become a very popular retirement account due to their tax-free growth and withdrawals. You receive no tax deduction today for any contributions made, but the funds in the Roth IRA continue to grow tax-free and distributions—the money you take out—is tax-free in retirement.
Roth IRA’s are also not subject to required minimum distributions (RMD). RMD’s require that holders of pre-tax accounts, such as 401(k), 403(b), or IRA’s begin withdrawing a minimum distribution from these accounts starting at age 72. These distributions are required whether you need the funds or not. Because Roth IRA’s are not subject to RMD’s, these accounts can continue to grow and be a valuable estate planning tool to pass tax-free assets to heirs.
Roth IRA’s are also subject to income limitations. For married couples if your adjusted gross income is below $208,000 in 2021 you can make a contribution to a Roth IRA, or under $140,000 for single filers. An individual must have earned income to be able to contribute to a Roth IRA. Please visit the IRS website for more information on Roth IRA contributions and distributions.
For those with income exceeding the limits to qualify to contribute to a deductible IRA or Roth IRA, a non-deductible IRA is an option. There are no income limitations to be able to contribute, though you still need to have earned income.
Similar to contributing to a Roth IRA, you contribute after-tax funds to a non-deductible IRA . The earnings are considered pre-tax and thus subject to taxation when withdrawn.
Backdoor Roth IRA
Non-deductible IRA’s are popular for their ability to make backdoor Roth IRA contributions. Essentially for those with incomes too high to make traditional Roth IRA contributions, making a contribution to a non-deductible IRA and converting to a Roth IRA allows for the funds to grow tax-free and be distributed tax-free as they are now housed in a Roth IRA account.
Because contributions to a non-deductible IRA are made with after-tax funds, converting to a Roth IRA should not trigger any additional tax when done correctly. It is highly advised to speak with a qualified financial professional when considering the backdoor Roth IRA strategy as it can be highly complex.
Other Types of Accounts
Qualified accounts and retirement plans are helpful tools when saving for retirement. But whether you are saving for shorter-term goals and/or are looking for additional ways to save outside of your employer plans and IRA/Roth IRA, you may be wondering where else you can put your money to work.
A brokerage account is an account opened through a traditional custodian such as Schwab, Fidelity, Vanguard, or E*Trade. What brokerage accounts lack in tax efficiencies they make up for in flexibility.
Brokerage accounts, which can be titled individually, jointly, or even in a revocable trust, are funded with after-tax funds. Unlike 401(k)s or IRA’s, any interest, dividends, or capital gains received will be taxable in the year received. When making trades or distributions from these accounts, you may also be subject to capital gains tax.
For example, say you buy a mutual fund in a brokerage account with an initial $10,000 investment. 5 years later you decide to sell this fund to purchase a new car, and your investment is now worth $20,000. When you sell this fund, you have a $10,000 gain ($20,000 minus $10,000) and depending on your adjusted gross income you may owe 15% capital gains tax, or $1500 in tax liability.
This is where the flexibility of the brokerage account comes into play. There are no income limitations to contribute, no contribution limits, and no restrictions on when you can withdraw funds. For veterinarians who may be saving for a practice purchase or preparing for the tax bomb if using a student loan forgiveness program, a brokerage account is most likely a better alternative to a 401(k) or IRA which come with penalties if you take out money before retirement.
Health Savings Accounts
Health Savings Accounts, or HSA’s, are offered as an employee benefit to those who are fortunate enough to have health insurance benefits. You need to be enrolled in a high-deductible plan to be eligible to contribute to an HSA. HSA’s offer triple tax benefits in that contributions are made pre-tax, funds can be invested and grow tax-free, and funds withdrawn, if used for qualified medical expenses distributions, are tax-free.
Ideally, if cash flow allows, the best way to utilize an HSA is to contribute the maximum amount ($7200 for a family and $3600 for self-only in 2021), use your current income to pay for any medical expenses, and invest your HSA funds to allow for tax-deferred growth. This strategy could provide for sufficient tax-free funds which can be used for medical expenses in the future, possibly helping bridge the gap before Medicare for those considering retiring before age 65.
529 College Savings Plan
Veterinarians know better than most that education is expensive and seems to only be getting worse. Providing support for your children to attend college with minimal loans is a desire of many parents. However, before funding college ,make sure your own financial house is in order and you are on track to achieve your own goals. Remember, you can always borrow money for college, but you can’t borrow money for retirement.
When considering options to fund college, there is no better choice than a 529 college savings plan. These plans are funded with after-tax funds, and the invested money grows tax-deferred and, if used for qualified higher education expenses, this money can be withdrawn tax-free as well. Many states also offer a state-tax deduction for contributions into their plan, so confirm with your state of residence to see if they offer this benefit.
Qualified education expenses include:
- Room and Board
- Technology items (computer, printer, laptop, etc)
- Books and Supplies (only those that are required)
- Student loan repayment- Up to $10,000 per child, and may be state-specific
- Up to $10,000 can be used for K-12 expenses
529 college savings plans are also transferable, so if your child does not use all funds available to them either for undergraduate or graduate studies, you can use any excess funds for your other children, immediate family members, or even future grandchildren.
Distributions not used for qualified education expenses are subject to income tax on the earnings portion as well as a 10% penalty, so be careful when making non-qualified distributions.
UGMA (Uniformed Gift to Minors Act)/ UTMA (Uniform Transfers to Minors Act) Accounts
These accounts were more popular before the introduction of the 529 college savings plan, but they still serve a purpose today. UGMA and UTMA accounts are brokerage accounts that are titled in the name of a custodian (parent or trusted individual) for the benefit of a minor child. While the custodian has the ability to make changes to the account, they are required to act in a fiduciary manner and use the funds in the account for the benefit of the minor child.
More flexible than 529 plans, these funds can be used for sporting activities, medical expenses, or simply to be used as an investment account for the child. Be aware though that once the minor reaches the age of majority (18 for UGMA accounts and 21 for UTMA for most states) they have full access to the funds. Some 18-year-olds may not be responsible enough to acquire such funds, so be sure this is considered when using these accounts.
Taxation of these accounts is also complicated, as the first $1050 in income is tax-free, the next $1050 is taxed at the child’s rate, and any income above $2100 is taxed at the parents’ tax rate. This is to prevent parents from putting money in their child’s name for the sole purpose of tax avoidance.
As you can see, there are multiple factors to consider when determining how to best save for retirement and other goals. Every situation is unique, and it’s ok to recognize you may need help. If you’re unsure of how you should be saving, consider working with a fiduciary financial planner to create a cohesive strategy for your financial goals.
So now that you understand WHERE to put your savings, HOW should you invest those savings?
How to Invest Your Savings
Understanding what accounts you should be saving your funds into is very important for achieving your financial goals. But once you have made the contributions, how do you actually invest those savings?
On a high-level, there are five main places to invest your savings;
- Equities (Stocks)
- Fixed Income (Bonds)
- Real Estate
- Cash & Cash Alternatives
Investing in Equities (Stocks)
When you own shares of stock, you essentially own equity in a public company. For example, by purchasing even one share of Apple stock, you are now a shareholder, or owner, of Apple.
If you’ve ever watched Shark Tank, you’ve seen good examples of how equity works. Individuals come on the show and offer a percentage of ownership in their business in exchange for an investment of funds. Of course when you purchase one share of Apple, you will not be a majority shareholder, but on a smaller scale, The Shark Tank example is what happens when you invest in stocks.
The shares you purchase become more or less valuable based on how the company performs. This makes stock ownership, particularly individual company ownership, very volatile. You can diversify your equity position through mutual funds and exchange-traded funds, discussed later in this article.
Investing in Fixed Income (Bonds)
Bonds are different than stocks in that when you purchase bonds, you are not actually buying any shares of the organization, but you are actually making a loan. You agree to loan the organization money in exchange for an agreed upon interest rate and period of time, at which point the organization will repay your principal back.
Depending on the type of bond, these are usually much less volatile than stocks. This lower volatility comes with lower expected returns. Companies are not the only ones who offer this kind of debt; governments do, too. US Treasury bonds and bills are offered through the federal government, and because the federal government can raise revenue through taxes, these fixed income instruments are considered one of the safest investments in terms of protecting your principal (the amount of money you invested).
Real Estate Investments
Outside of traditional stocks and bonds, you can also invest in real estate. You can do this through owning tangible property, such as your primary residence, rental property, or commercial real estate if you are a practice owner, or through intangible means such as a REIT (Real Estate Investment Trust).
Owning tangible property can provide tax incentives, such as the ability to deduct mortgage interest or achieve tax-free growth in the case of a personal residence. A personal residence is also one of the few, if not the only, investments you can also use for personal enjoyment.
For veterinary practice owners, owning the real estate for your practice also provides another source of revenue for the owner, as rent payments can be made through the practice itself. When negotiating a practice purchase, be sure to inquire about buying the real estate as well. This can help lengthen the loan terms from 10 to 25 years along with increased revenue and tax benefits.
Owning rental properties is oftentimes more glamorized than the potential rewards, but can be a way to increase your monthly income while also building equity in the properties. Depending on tenants, economic conditions, and your level of activity, rental properties may or not may not be a valuable investment.
If you have a desire to invest in real estate but are not sure about owning physical properties, real estate investment trusts (REITs) offer this opportunity. REITs pool together different real estate properties across a range of sectors which investors can use to diversify their investments. REITs can be either publicly traded or privately traded. Publicly traded REITs typically offer more flexibility while private traded REITS may limit your liquidity and ability to get your money back without penalties.
Cash and Cash Alternatives
Cash and cash equivalents include liquid assets such as money in your checking, savings, or online high-yield savings accounts. CD’s, money market accounts, and treasury bills would be included here as well. These funds make up your emergency cash reserve. Your Emergency reserve should equal around 3-6 months’ living expenses to be able to cover a need without having to withdraw funds from your retirement or other investment accounts.
Because cash and cash equivalents are currently not outpacing inflation, it may not be best to keep more than 6 months expenses in cash, particularly for those more than 10 years away from retirement. Every situation differs, however, and so ensure your liquidity is incorporated into your overall financial plan.
Investing in Your Business
Not a traditional form of investing, I wanted to include this here as private practice ownership is still very popular within veterinary medicine. Reinvesting money back into your practice to improve your processes, boost the well-being of your staff and patients, and increase your practice’s value is another way to utilize your savings.
A trap I have seen practice owners fall into is to not diversify your investments, placing all additional cash flow back into the business. Diversifying your investment approach allows you to take advantage of the other forms of investments available and makes you less reliant on any one investment.
Mutual Funds & Exchange-Traded Funds (ETF)
Individual stock and bond investing may not be the best approach to investing for most veterinarians. Mutual funds and ETF’s offer diversified portfolios that pool together holdings of different stocks, bonds, or other assets. These can help reduce your concentration risk (relying too heavily on a few investments) by investing in a lot of different companies.
Whether to use mutual funds or ETF’s depends on many factors. Mutual funds are not traded on the open market and traditionally are much less tax efficient than ETF’s, but currently there are more mutual funds in the market and thus more strategies. The right fit is dependent on your situation.
Target date funds are mutual funds or ETF’s which invest in both stocks and bonds, with the goal of reallocating (that is, shifting to more conservative investing) over time until it reaches its’ target date, which is designed to be close to the date the investor begins to withdraw.
For example, a 35-year old veterinarian looking at their available options in their 401k sees target date funds available. They select a target date 2050 fund, which coincides with their expected retirement age of 65 in 2055. Today, this target date fund is pretty aggressive, probably close to 80% in stocks and 20% in bonds. But as the fund gets closer to its’ target date of 2055, it slowly begins to reallocate to a more conservative allocation, eventually reaching an approximate 50% stock/50% bond allocation in year 2055. The reason the fund becomes more conservative as it approaches 2055 is the higher allocation to bonds makes the fund less volatile, which will be very beneficial when you begin to make distributions from the account.
Target date funds are not customized to any individual’s goals, but are a great option for long-term savings such as retirement savings and those looking for a one-stop shop with their investments.
Different Asset Classes
Within both equities and fixed income, there are multiple types of asset classes.
Equity Asset Classes
- US Large Cap
- Companies with a market capitalization of more than $10 billion. Think Apple, Google, Delta, Home Depot. These are considered the more ‘conservative’ types of stock, with lower risk but also lower expected returns than their mid-cap or small-cap counterparts
- US Mid-Cap
- Market capitalization between $2 billion and $10 billion. These companies are growing and could become large-cap soon. Their risk and return level is between large-cap and small-cap.
- US Small-Cap
- Market capitalization of below $2 billion. Small-cap companies offer the potential for high returns, but also have the most volatility.
- International Developed
- Stocks from developed international countries, such as Japan, Australia, and European countries.
- Emerging Markets
- Companies from countries such as China, Russia, Brazil, and India, emerging markets offer opportunities for high returns but with high risk as well.
Fixed Income Asset Classes
- Corporate Bonds
- Offered through corporate entities, these bonds typically offer higher yields than government or municipal bonds. The yield may depend upon the company’s risk rating, with a rating of BBB and above being considered investment grade (higher quality bonds).
- High-Yield Bonds
- Also referred to as junk bonds, high-yield bonds are those issued by companies or government entities that are below investment grade. This increases the risk of default, or ability of the issuer to pay back the debt. Because of this risk yields on these bonds are typically higher.
- Government Bonds
- Federally issued bonds, such as treasury bills and bonds, are one of the safest investments due their low risk of default. Investors may sacrifice some yield (expected return) by using these vs. corporate bonds, but the safety for many is worth the trade-off. Treasury bonds are also exempt from state and local taxes.
- Municipal Bonds
- Muni bonds are offered through local municipalities. The benefit of these bonds is they are federally tax-free, meaning any interest earned is not taxed at the federal level. If the issuer resides in the state in which they purchase the bonds, they may also be state-tax free.
The chart below shows the difference of returns by asset classes by investing $1 since 1926. This highlights the need for diversification to allow for growth but also stability by utilizing multiple asset classes. As you can see, $1 invested in U.S. Small Cap stocks in 1926 was worth $32,817 in 2020, whereas $1 invested in U.S. Treasury bills was only worth $22. You will also notice the difference in volatility, with small cap stocks experiencing many ups and downs while U.S. treasuries maintain a more steady growth. This highlights the need for diversification to allow for growth but also stability by utilizing multiple asset classes.
Exhibit 4: In USD. US Small Cap is the CRSP 6–10 Index. US Large Cap is the S&P 500 Index. US Long-Term Government Bonds is the IA SBBI US LT Govt TR USD. US Treasury Bills is the IA SBBI US 30 Day TBill TR USD. US Inflation is measured as changes in the US Consumer Price Index. CRSP data is provided by the Center for Research in Security Prices, University of Chicago. S&P data © 2021 S&P Dow Jones Indices LLC, a division of S&P Global. All rights reserved. US long-term government bonds and Treasury bills data provided by Ibbotson Associates via Morningstar Direct. US Consumer Price Index data is provided by the US Department of Labor Bureau of Labor Statistics.
How to allocate your portfolio
There is no single answer to how to allocate your portfolio. What works for one person may not work for another. If you are 15+ years from retirement, you have time to weather the ups and downs of the market and should most likely be more aggressive than someone less than 5 years from retirement. The important thing is to diversify and understand how you are invested. If you have questions about how your investments should be allocated, I encourage you to speak with a fiduciary, fee-only financial planner who can provide objective advice on how to best manage your portfolio.
As important as asset allocation, asset location refers to the accounts in which your money is invested. Remembering back to the difference between tax-deferred, tax-free, and taxable accounts, where you place different investments can have a profound impact on your tax liability.
Ideally, you would want to invest as follows:
Roth & After-tax Accounts
Because the contributions to these accounts have already been taxed and they grow tax-free with qualified distributions also being tax-free, you should place assets poised for the greatest growth in the Roth IRA. Currently, I place both my small cap equity and emerging markets funds into my Roth IRA. While small cap and emerging markets are also the most volatile, my intention is to not use these funds any time in the near future, which allows for swings in the market. And if these funds achieve huge growth, they won’t be taxed when withdrawn either.
With your pre-tax 401(k) or IRA, you would want to hold your most tax-inefficient holdings. These typically will include mutual funds and individual bonds or bond funds. The thought process here is mutual funds and bonds produce interest, dividends, and capital gains every year. Your pre-tax accounts are not taxed until you begin to withdraw, thus whatever income produced by these investments will not be taxed in the current year.
Brokerage accounts are subject to taxation every year, and any time a trade is made you are subject to capital gains tax. You will want to place your most tax-efficient investments in your brokerage accounts. These will include equity exchange-traded funds (ETF) and individual stocks. ETF’s and individual stocks are very tax efficient, typically not incurring much income while invested. You will be subject to capital gains when you sell the funds, but because of veterinarians’ high incomes, this could outweigh the potential annual tax on inefficient investments.
** CAVEAT: The strategies explained here can vary depending on where your assets are currently located. If you do not have any Roth savings, for example, your asset location strategy will differ. Also, funds designated for shorter-term goals, such as practice purchase or home down payment, may not want to follow these rules as time horizon can affect your strategy. For example, if saving for a practice purchase in 5 years, you may want to reduce your exposure to stocks as a significant stock market decline may cause a drop in value when you need the money.
Other Types of Investments
Popularized recently in media, cryptocurrencies such as Bitcoin, Dogecoin, or Ethereum are becoming increasingly popular among individual investors.
Cryptocurrency is a digital currency which aims to bypass an intermediary, such as a bank, to be able to transfer funds instantly. Whether or not cryptos are a formidable investment is a polarizing topic among many in the financial industry.
Proponents point to the ability of cryptocurrency to be made available to more people through the absence of banks, the scarcity and perceived hedge against inflation, and ease of transactions as reasons behind why to invest.
Opponents liken current cryptocurrencies to a fad and media frenzy. They point to the cybersecurity issues, data losses, price volatility, and regulatory issues as reasons why not to invest in cryptocurrency.
Whether or not you decide to invest your money into these types of investments, consider limiting the amount you invest to 5% or 10% of your overall portfolio.
Annuities get a bad rap, though that is primarily due to the salespeople of annuities rather than the products themselves. Designed to protect you from the risk of outliving your income in retirement, annuities are offered through insurance companies.
Annuities come in two forms: Variable and fixed. Variable annuities are tax-deferred products that are invested in different sub-accounts. They serve as an investment account with insurance features, such as the ability to use your account for income in retirement. The value of the variable annuity fluctuates based on the performance of the sub-accounts, and should you use the annuity for income payments the monthly payment may fluctuate based on the value of the account, i.e. the payment is rarely guaranteed. In my experience, variable annuities are rarely a good option for most. Given the exorbitant fees charged, it is highly likely you are better off utilizing other investment accounts.
Fixed annuities are also tax-deferred insurance products but differing from variable annuities that are invested in sub-accounts, fixed annuities offer a fixed rate of return. If the annuity is used for a stream of income in retirement, the payment is typically fixed as well and not subject to market fluctuations. Fixed annuities can be good options for those looking for tax-deferred growth and safety of principal.
All annuities come with a surrender period, which states you are unable to withdraw funds without penalty for a certain period of time. Be sure you have enough liquidity in other accounts like your bank before considering an annuity as you may not be able to access the annuity without penalty.
Permanent Life Insurance
Veterinary students are often the target of life insurance salespeople who recommend buying a permanent life insurance policy. They will highlight the insurance and investment component of the policy, the ability for tax-free growth and loans, and protection against loss. Don’t be fooled, permanent life insurance is only designed for a select few.
Insurance serves one purpose, to protect against a loss. Insurance should not be used as an investment vehicle and 99% of the time, a term life insurance policy is the better option for veterinarians. Term policies can cover the same loss of income but at a fraction of the cost of permanent policies, allowing you to use the savings to invest elsewhere.
If you currently own a permanent life insurance policy or have been approached to purchase one, consult with a fiduciary, fee-only financial planner who can provide objective advice that is in your best interest.
Time Is Your Friend
When it comes to saving, regardless of the goal, time is your best friend. Albert Einstein referred to compounding interest as ‘the 8th wonder of the world’. The sooner you allow your savings to work for you, the better off you will be down the road.
Work With Us!
I understand this is a lot of information to digest, and it can be difficult to know if you are making the best decisions for you and your family. If you are curious about your current savings goals, investment strategies, or overall financial situation we invite you to schedule a time to speak with us. At VetWorth we offer financial guidance specifically to veterinarians and their families, and it would be our pleasure to see how our services could benefit you.
Andrew Langdon is a CERTIFIED FINANCIAL PLANNER™ and the founder of VetWorth, a fiduciary fee-only financial planning firm dedicated to serving the unique needs of veterinarians and their families.
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Andrew Langdon, and all rights are reserved. Read the full Disclaimer.