The Traditional vs. Roth Decision for Medical Residents

Many residents are eager to begin saving for retirement during residency. Often, they will have a choice between traditional and Roth retirement accounts. Deciding which account to use is confusing to many residents. In this post, I will explain the major considerations when deciding between traditional and Roth retirement accounts.

Basics of Roth and Traditional Retirement Accounts

The most important benefits of either traditional or Roth retirement accounts are its tax benefits compared to taxable accounts. There are major differences between the taxes associated with taxable investment accounts, traditional retirement (e.g. 401(k)), and Roth retirement accounts, and the IRS has three opportunities to tax you:

1. When you earn and contribute the money: Like your regular salary, the IRS can tax the income that you contribute to the investment account.
2. As the portfolio grows: The IRS can tax any earnings on the investments in your account (capital gains tax).
3. When you withdraw the money: When you take money out of the account, the IRS may tax this withdrawal.

For each investment account, which of the three taxes above apply?

1. Taxable: You contribute to the account with after-tax money, and any investment profits are taxed as capital gains. Withdrawals are not taxed. (#1 and #2)
2. Traditional: In a traditional retirement account, you receive a tax deduction on contributions. Earnings on your investments will not be taxed. You will have to pay taxes on withdrawals from the account. (#3 only)
3. Roth: In a Roth retirement account, you contribute to the account with after-tax money. However, you do not pay taxes on capital gains or on eligible withdrawals from the account. (#1 only)

The benefits of a traditional or Roth retirement account over a taxable account are now clear: you only pay taxes once with these accounts, while you pay taxes twice with taxable accounts.

There actually exists an account where you are able to avoid all three taxes (“triple-tax free”); this is called a health savings account, or HSA. Contributions are tax-deductible, investment gains are tax-free, and withdrawals are not taxed if used on eligible health expenses.

Deciding between Traditional and Roth Accounts

The primary consideration when deciding between a traditional or Roth account is the difference between your tax rate as a resident and your tax rate in retirement. With Traditional or Roth accounts, you pay taxes only once (#1 for Roth and #3 for traditional in the example above), so you should choose the account with the lower tax rate.

Resident A: Tax Rate as Resident < Tax Rate in Retirement

Resident A wants to contribute $1,000 of her salary through the retirement account. Let’s assume her investment will double over the course of her career and she will withdraw it immediately at retirement. She is in the 15% tax bracket during residency and the 25% tax bracket during retirement.

Scenario 1: Traditional retirement account

Resident A does not have to pay taxes on the initial $1,000 contribution, which will grow to $2,000, after which she will have to pay 25% in taxes on the withdrawal, leaving her with $1,500.

Scenario 2: Roth retirement account

Resident A would have to pay 25% in taxes on the $1,000 in salary he wants to contribute, which means he can only contribute $850 to the Roth, which will double to $1,700, which he can withdraw tax-free. He ends up with $1,700.

When the tax rate during residency is less than the tax rate during retirement, it is beneficial to put the money in a Roth over a traditional account. Verdict: Roth.

Resident B: Tax Rate as Resident > Tax Rate in Retirement

Resident B also wants to contribute $1,000. His investment will also double over the course of his career and he will withdraw it immediately at retirement. However, Resident B is in the 35% tax bracket during residency because his wife is an attending physician. He will be in the 25% tax bracket during retirement.

Scenario 1: Traditional retirement account

Resident B does not have to pay taxes on the initial $1,000 contribution, which will grow to $2,000, after which he will have to pay 25% in taxes on the withdrawal, leaving him with $1,500.

Scenario 2: Roth retirement account

Resident B would have to pay 35% in taxes on the $1,000 in salary he wants to contribute, which means he can only contribute $650 to the Roth, which will double to $1,300, which he can withdraw tax-free. He ends up with only $1,300.

In this case when the resident has a high-income spouse, the resident should contribute to a traditional account, as he will get a larger tax deduction upfront than he would in retirement. Verdict: Traditional.

Resident C: Tax Rate as Resident = Tax Rate in Retirement

Like the other residents, Resident C also wants to contribute $1,000. His investment will also double over the course of his career and he will withdraw it immediately at retirement. However, Resident C is in the 25% tax bracket during residency and during retirement.

Scenario 1: Traditional retirement account

Resident C does not have to pay taxes on the initial $1,000 contribution, which will grow to $2,000, after which he will have to pay 25% in taxes on the withdrawal, leaving him with $1,500.

Scenario 2: Roth retirement account

The resident would have to pay 25% in taxes on the $1,000 in salary he wants to contribute, which means he can only contribute $750 to the Roth. This will double to $1,500, which he can withdraw tax-free. He ends up with the same $1,500.

For Resident C, there is no difference between a Roth or Traditional IRA if he only chooses to contribute $1,000, because the tax rates in residency and retirement would be identical. However, I would favor contributing to a Roth, especially if you plan on maxing out your retirement accounts. For example, if you are able to contribute the maximum $5,500 (post-tax) in a Roth during residency, you get more tax benefits than you would with a maximum $5,500 (pre-tax) contribution to a traditional account, because you will be taxed on withdrawals in the traditional account in retirement. Therefore, if you plan to max out your accounts, the Roth IRA contribution is more valuable than the traditional IRA contribution.

In addition, when you are an attending, you most likely will be in a high tax bracket and want to use a traditional retirement account (like Resident B). Limiting traditional account withdrawals and using funds from both traditional and Roth accounts lowers your tax rate in retirement.

Verdict: Roth

Conclusion

In most cases, I recommend residents contribute to a Roth retirement account over a traditional retirement account. The only exceptions are residents who have a high-income spouse, for whom traditional retirement accounts are preferred.

What do you think? Did you contribute to a traditional or Roth account as a resident?