Money Meets Medicine Podcast

Pre-tax vs Roth Investments: Which Is Right For You?

Maybe you’re starting your intern year and you’re considering investing as one of your steps in that journey. As July approaches, maybe you’re transitioning as a trainee from an institution or to a new job, you might be asking yourself, “Should I be investing in pre-tax vs Roth?” 

Physician Disability Insurance

It’s a really interesting topic and an important question, especially as interest rates and inflation changes. 

When someone slides that 401k or that 403b form in front of you, it often gives you the option to choose whether you want to invest in a traditional pre-tax method where the money is taken out of your paycheck before it ever gets taxed. Or do you want it to get taxed immediately, and then get invested knowing that it’ll never get taxed again in the future? 

As it’s been a couple of years since we tackled pre-tax versus Roth IRA, that’s what we’re diving into here. We’ll help you figure out the answers to these questions, or at least help you to make a more informed decision. 

Pre-tax vs Roth investments: what’s the difference?

Pre-tax is when your investment money gets deducted before you get taxed (hence pre-tax) and a Roth is a post-tax investment.

There’s another kind of post-tax investment that you can put inside a taxable or brokerage account that also uses money after tax has been taken out. In either case, you can invest, for example, $1000 of post-tax funds and let it grow.

The difference between a Roth investment and one of these post-tax brokerage account investments is that in the brokerage account, the money you put in has already been taxed and it’ll never get taxed again. But the gains you receive on those funds are subject to what’s called capital gains tax. So when the $1000 becomes $1,100, the $100 is subject to tax.

In a Roth account, however, when it turns into $1,100, neither the thousand dollars nor the $100 that it has gained will get taxed.

But in all honesty, what it really comes down to is when you want to pay taxes on the money, because the government is going to get its due at one time or another.

Really the question of pre-tax vs Roth investments is when you want to pay the tax

As a trainee, resident or fellow, oftentimes we’ve heard of a Roth IRA and those are good accounts. But once you become an attending and your income increases, you’ve got to decide when you want to pay the tax – now or later?

Here’s where many of us think: why would I not want to delay paying taxes?

We remember being in training and how every dollar counted. We didn’t really care about taxes in the same way that we care about them now. Back then we just wanted to bring home enough money to be able to enjoy life. We were just trying to make it.

A lot of people in this same position now are thinking through the pre-tax vs Roth question, and what they’re really trying to figure out is how they can save the most money on taxes. So the question becomes about the tax rate and when the tax will apply.

And unfortunately, we don’t know the future.

Historically there’s data out there about tax rates. The highest income tax bracket that’s ever existed in the US? It was 94% in 1945 during World War II.

During the Reagan era in the eighties it was around 60%, and for the last 30-odd years, it’s been more around 35 to 40%. In the future, taxes could be much higher. They could go lower.

We don’t know.

So the question becomes: is my tax situation now going to be higher or lower in retirement? 

If you think it’s going to be higher now and lower in retirement, most people would take the pre-tax or traditional savings. Take that money out of your paycheck before it gets taxed right now, because your tax rate in retirement will be lower. 

If you think your tax rate will be higher, maybe you’re training and your tax rate is 15% or 20% and you think it’s going to be 35% in retirement, then take the tax out now, use a Roth investment, pay the tax now, and invest the money because you’re expecting to save taxes by paying it now and having a higher tax rate later when you don’t get taxed again.

Traditionally speaking, the advice is that in your peak earning years, pre-tax (a handy way to remember it is P goes with P, R goes with R), and Roth for your lowest earning years, which is typically residency.

Remembering the human factor when it comes to investing

Pre-tax for peak earning and Roth for residency is probably the mathematically correct answer, but human behavior can sometimes be different than simple number-crunching.

Lisha prioritized pre-tax as an intern because she ”was broke.”

She wanted every dollar. And her thought was, “If I can pay less in taxes right now as a broke intern, then that’s what I’m going to do. It may only save me 50 bucks in taxes, but hey, that’s 50 bucks that I can go out with my friends, go to happy hour, or that I can put towards my vacation fund.” 

If she could go back, she would choose Roth.

The many benefits of using a Roth IRA

When you’re talking about a Roth IRA specifically, which a lot of younger doctors have heard of, one of the things that we really love about it is that it provides maximum flexibility, because you can take out your contributions from a Roth IRA at any time. For Lisha, it served as a backup emergency fund.

If your fear is that you’ll start investing and something urgent will come up (like your laptop dies) where you need money, you don’t want to have all your money in an investment account you can’t access. One of the great things about a Roth IRA is that you can get the money back out. 

With a Roth IRA, because you’ve already paid taxes on that money, you can take out your contributions at any time with no penalty.

The only time we’d favor something else is if you have a match at your employer. Unfortunately, a lot of residents don’t have matching employers, but if you do and you’re going to get 100% return on your dollar (you put in a dollar, they give you a dollar inside the 403b or 401k), absolutely take that. 

Let’s say you’re an attending physician and you’re at 37% tax federally, and with a 5% state tax, it’s 42%, meaning you make $100, and you get to keep $58.

If you put $22,500 into your 401k or 403b and maxed it out as of 2023, that would lower your adjusted gross income (AGI) by almost $10,000. Meaning, if you invested in a Roth, you’re going to have to pay an extra $10,000 in taxes.

That’s a big difference.

It’s substantially less tax savings as a resident using a pre-tax method. If you’re not in your peak earning years, you put that same $22,500 away (just to make apples to apples comparisons here, because I recognize as a resident, you’re probably not putting away $22,500) and it would only save you $3,800 in taxes because your tax rate is probably 12 to 15%.

A few Roth IRA account distinctions:

  • The money you invest never gets taxed again.
  • The gains you earn will never get taxed.
  • Your funds can live in your account forever with no tax, making Roth money a great inheritance fund.
  • No required minimum distributions (RMD) in your later years (age 72), meaning the government can never force you to withdraw it or give them a portion.
  • You can qualify for an income-based tax credit as a reward for investing.

Is there a benefit to placing money in pre-tax? 

In your non-peak earning years, should you even place money in pre-tax?

One thing to consider is that student loan payments and income-driven repayment programs are based on your AGI, so if you invest pre-tax, you actually lower your AGI and thereby lower your payment. 

Not only do you get more money back because you put it in pre-tax, but you also lower your student loan payment, and so you get even more money back.

As a third or fourth year trainee, we still think young physicians should prioritize their Roth IRA just because of the flexibility. It really isn’t about the tax savings.

We find that when you’re in training and you’re making $50, 60, 70,000, once you pay taxes and rent’s $2,000 a month, you could care less about how much you’ll save in taxes 10-20 years. You’re just trying to maximize the amount of money that you get from your paycheck.

When to use pre-tax vs Roth in your healthcare career: there’s a place for both accounts

If you’re a newer attending and you know you’re making $400,000 a year (if not more), then one of the first things you may want to set up is a pre-tax account like a 403b or a pre-tax 401k to save significantly in taxes. Once you’re maxed out there, then start a backdoor Roth IRA so that you can get at least some money in a Roth account. 

Because the goal in retirement is to have money in both accounts.

This is because all of the money that’s in the pre-tax account will have taxes due. So having some money in Roth accounts that you can withdraw without having any taxes due will be extremely beneficial to you, especially if you’re someone who’s thinking about retiring early. 

Essentially: trainees should prioritize that Roth IRA. If you’re an attending, consider starting with a pre-tax 403b and move into a backdoor Roth IRA. 

Roth accounts will also be valuable for you closer to retirement age, because investing in a pre-tax account means you’ll have a RMD in less than 10 years. But if you invest that money in a Roth account, you won’t.

If you’re even asking the question of pre-tax vs Roth, you’re ahead of the game

It’s worth mentioning that if you’re even asking this question, you’re winning. If you’re asking, “Should I invest pre-tax or should I invest in a Roth?”, because you’re investing either way, just the fact that you’ve gotten to the point where you’re asking this question and want it to be answered, you’re winning.


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