Residency to Retirement: Part One
Key financial success factors for ophthalmologists at every career stage… starting with fellowships
David B. Mandell, Carole C. Foos | | Longer Read
At a Glance
- Rising education costs mean it is not unusual for young ophthalmologists to begin their careers with six-figure debt
- There are three things residents can do for a more financially secure future: manage student loan debt, protect a multi-million-dollar asset and begin a financial plan
- Physicians in their early career can reduce tax by maximizing contributions to qualified retirement plans and considering non-qualified plans (if they work in private practice) and using both pre-tax qualified retirement plans and after-tax IRAs (if they are employed)
- It is also useful to employ a financial advisor to avoid any potential pitfalls and secure the best chance of a comfortable retirement.
In writing this two-part article, we faced a significant challenge: how to select a handful of key success factors to building and protecting an ophthalmologist’s finances. As advisors to physicians for decades, we know that there are many other important planning areas, including retirement modeling, asset protection and estate planning, that we simply did not have the space to discuss. In this article, we will focus on selected topics for young physicians, namely managing student loan debt, protecting a multi-million-dollar asset and beginning a financial plan.
Residency and fellowship
1. Manage Student Loan Debt
Given the rising costs of medical education and the expenses of living during residency and fellowship, it is not unusual for young ophthalmologists to be staring at six-figure debt loads as they embark on their careers. Unless addressed properly, such debt burdens may dramatically affect real savings, retirement planning and even credit worthiness later in life.
Try to Avoid Capitalization
Although sometimes unavoidable, student loan costs typically balloon the highest during residency due to a process called capitalization; the addition of unpaid interest to the principal balance of your loan. The principal balance of a loan increases when payments are postponed during periods of deferment or forbearance and unpaid interest is capitalized.
Sometimes, it is difficult to avoid capitalization during residency due to a high cost of living. However, if possible, paying some or all of the interest during residency will allow the young physician to significantly slow runaway capitalization of their debt burden. Income-driven repayment plans have recently become a solution for allowing repayment of student loan interest during residency with much more affordable monthly payments. One such example is the Revised Pay As You Earn (REPAYE) program offered through the Department of Education. With REPAYE, the federal government covers 50 percent of all interest above the monthly payment amount during repayment. To illustrate, a resident making $55,000 a year has a student loan of $164,000 at 6 percent interest. If the loan is deferred until completion of residency and fellowship, the monthly payment just to cover interest would be $824, under a typical 10-year repayment plan. Under REPAYE, the resident would only have to pay $300 per month while the Federal government would cover $262 of the monthly interest. Although some interest will still capitalize, the amount is much more tolerable.
Next step, refinance
One of the simplest methods for reducing the burden of student loan debt is refinancing through a private lender when starting practice. Refinancing is a relatively easy way to not only consolidate student loans into one lump sum, but also lower the interest rate considerably. Although the physician may give up certain loan protections inherent to federal student loans and income-based repayment models, the upside of refinancing is typically a dramatic reduction in student loan interest rate. It is not uncommon to see interest rates lowered by two or three percent, an amount that may significantly reduce the cost of debt over a ten-year span. For example, a $268,000 loan paid back over 10 years at 6 percent interest would require a monthly payment of $2975.35, with $89,042 in total interest. The same loan at a 4 percent rate would cost $2713.37 per month, with $57,604 in total interest.
2. Protect a million-dollar asset
While student loans are generally a depressing topic for young ophthalmologists, the prospect of already owning a million-dollar asset is exciting, if not astonishing. Many of them, with little savings, may ask: “What million-dollar asset? I am in severe debt!” The answer is that they have actually built a significant asset that needs protecting – the value of their future incomes. It should not be surprising that the present value of an ophthalmologist’s future income is substantial. Let’s assume that an ophthalmologist is offered a starting salary of $300,000, including benefits. Assuming this physician plans on practicing for 30 years (and 3.5 percent inflation), the present value of this annual income is $5,517,613, even if that doctor never makes more than $300,000 per year, including inflation. Most people would think an asset this valuable is worth protecting.
The Need for Disability Insurance
Disability income insurance is essential for two reasons. One, because of the physical nature of their work, ophthalmologists who perform surgeries and other procedures have a relatively higher risk of disability than other professionals like attorneys or CPAs; and two, the disability of the physician income-earner can be more financially devastating to a family than premature death. In the case of death, the deceased earner is no longer an expense to the family.
Yet, if the breadwinner suddenly becomes disabled, he or she still needs to be fed, clothed and cared for by medical professionals or family members. Thus, with a disability, income is reduced or eliminated and expenses increase. And that is why disability income insurance is so important – and is the number one tool for young ophthalmologists to implement. Further, young ophthalmologists with financial dependents – typically, children, spouses or other family members – need to focus on protecting their future income value, not only against disability, but also against death. For this reason, life insurance is the second most important tool we recommend for young physicians.
3. Begin a financial plan
Student loan repayment tactics and disability and life insurance are simple tools. While implementing them independently can be effective, it is best to create a longer-term financial plan that considers these two areas and several others, including tax reduction, retirement planning, education planning and budgeting. Within a multidisciplinary financial plan, different tools and tactics fit together in a holistic manner and encourage the physician to visualize long-term financial goals. This focus is crucial because it provides motivation for systematic saving, allowing the young ophthalmologist to capitalize on the powerful benefits of compounding interest. As Albert Einstein said: “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.”
The following two key success factors are applicable to all physicians, but it behooves every young ophthalmologist to focus on them early in their careers.
Tactics to reduce taxes for ophthalmologists in private practice
- Maximize contributions to qualified retirement plans (“QRPs”). A QRP for a private practice may be in the form of a defined benefit plan, profit sharing plan, money purchase plan or 401(k). Properly structured plans offer a variety of benefits: tax deductions for contributions to a traditional QRP, tax-deferred growth of funds within the QRP and (if non-owner employees participate) the funds within a QRP enjoy superior asset protection.
- Consider non-qualified plans (“Non-Q Plans”). Many private practice physicians want to save significantly for retirement but are limited by the funding rules of QRPs and the employee costs. Non-qualified plans can be the solution for many doctors. Because these plans are not subject to QRP rules, Non-Q Plans do not have to be offered to any employees. Further, even among the physician-owners, there is total flexibility. For example, one doctor can contribute a maximum amount, the next partner could contribute much less, and a third physician could opt out completely. The main drawback to Non-Q Plans is that contributions are not tax deductible. However, they can be structured for tax-free growth and tax-free access in retirement, like a Roth IRA. In fact, a Non-Q Plan can be an ideal long-term tax hedge against a QRP.
Tactics to Reduce Taxes for Employed Ophthalmologists
- Maximize contributions to employer’s QRP. Physicians who are W-2 employees can often participate in their employer’s QRP, which allows them to defer income by contributing to the plan. As employees themselves, these physicians are not negatively impacted by the costs for employees, as are owners in private practices. Further, they may receive some type of contribution match from their employer, making the plan even more attractive.
- Use after-tax IRAs, when possible. Under the 2019 limits, doctors can defer up to $6,000 per year ($7,000 per year if they are 50 or older) into a traditional IRA. Ophthalmologists who are not covered by a workplace retirement plan may deduct pretax contributions; those who are can make non-deductible or partially deductible contributions (depending on their earned income and filing status). While Roth IRA contribution limits are the same as traditional IRA limits, most ophthalmologists earn income that exceeds the adjusted gross income limits for Roth IRAs and are therefore not allowed to contribute directly to a Roth IRA. Doctors can often implement a “backdoor Roth IRA” by contributing to a traditional IRA and then converting the traditional IRA to a Roth IRA. (Note: This tactic requires careful planning to avoid unnecessary taxation. The help of an experienced advisor is crucial.) Roth IRAs can be very beneficial to long-term retirement planning because funds in a Roth IRA grow tax free and can be withdrawn tax free during retirement.
- Use life insurance as a retirement plan, when appropriate.As above, Roth IRA contributions are after-tax, but the balance grows tax-free and can be accessed tax-free in the future. Many physicians are surprised to learn that, if managed properly, a permanent life insurance policy behaves the same way. “Permanent” life insurance includes whole life, universal life, variable life and equity-indexed life insurance policies. Regardless of the product type, the cash value of such policies grows tax free and can be accessed tax free during the insured’s life – a tax treatment that has remained stable for over 100 years. For many ophthalmologists, this type of tax planning tool makes sense in their overall financial plan.
Choose an investment adviser wisely
All physicians, including ophthalmologists, want to invest well for their retirement and avoid potential pitfalls. However, the topic of investing (in general) and working with financial advisors (specifically) is a complex one. One fundamental question for an ophthalmologist to ask: does a particular investment professional, or do they not, owe the physician-investor a fiduciary duty? If they do, this factor alone does not guarantee the achievement of one’s investment goals. But, if they do not, the advisor is simply not required to work in the doctor’s best interests. Despite this simple fact, the unfortunate truth is that many ophthalmologists work with financial professionals who can legally put their own interests above their physician clients. Here are two key questions that physicians should ask a prospective or current financial advisor to determine where they stand on this fundamental issue:
Question #1. As an advisor, do you owe me a fiduciary duty as a client, or are you held only to a “suitability” standard?
Per above, this may be the most important question of all. For those not in the industry, this may seem like a subtle difference; however, the result can have a substantial impact on the client.
Example: Client A contacts his broker and expresses an interest in investing $50,000 in US growth stocks. The broker invests the client assets in Fund XYZ, which charges a sales load of 5.75 percent with operating expenses of 0.68 percent annually. The client will immediately pay a one-time fee of $2875 on the trade on top of the recurring fund-management fee. In this case, the suitability standard has been met. Client B contacts his Registered Investment Advisor (RIA) with the same request. The investment advisor purchases an exchange-traded fund (ETF) with a gross expense ratio of 0.18 percent and pays a commission of $8.95 on the trade. This client pays his RIA a management fee of 1 percent of the assets, which equates to $500 per year on $50,000. The advisor has met the fiduciary standard. In our very realistic example, the front-loaded fees paid by client A are significant enough that it would require a commitment of approximately nine years to this fund family before that commission is equal to the sum of advisory fees paid by client B.
Question #2: Can you provide me a detailed explanation of all the ways you are compensated?
Does an ophthalmologist’s advisor receive commissions on any of the investments they recommend? Beyond commissions, compensation can come from sales charges on mutual funds or from a higher operating expense on a specific class of funds. Further, private equities, structured notes, hedge funds, and non-traded real estate investment trust (REIT) can offer various fee arrangements that may not be transparent. A RIA operating under the fiduciary standard may be able to offer the same investment at a lower cost simply because they are not taking a cut before your money goes to work for you.
Example: Client A is approached by his broker to invest in a non-publicly traded REIT. The client sends in a check for $100,000, and the security is priced at $10 per share, so the client receives 10,000 shares. The broker receives a 7 percent commission from the REIT sponsor. Client B is approached by his RIA to invest $100,000 in the same privately held REIT. The advisor charges a 1 percent management fee and does not accept compensation from the REIT sponsor. In this scenario, the commission is returned to the RIA client in the form of a reduced purchase price for the shares. Client B receives a discounted price of $9.30 from the sponsor and is able to purchase 10,752 shares of the same REIT with his $100,000 investment. Client A would have to hold the investment for approximately seven years before his 7 percent commission matches the sum of fees paid by client B to his advisor.
These success factors are crucial for young ophthalmologists in residency and fellowship, and later, as they continue on in their careers. The points we have listed are just a few of the many components of a comprehensive wealth management plan – one that can play a significant role in helping physicians achieve their long-term financial goals. In part two of this article, we will discuss success factors for ophthalmologists further along in practice and those approaching retirement.
To receive free copies of our book – print or digital – “For Doctors Only: A Guide to Working Less and Building More” and “Wealth Management Made Simple”, text OPHTH to 555-888 or visit www.ojmbookstore.com and enter promotional code OPHTH at the checkout.
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