A reader is an independent contractor in emergency medicine. He is married with young kids, looking to buy a house in the next 1-2 years in a high cost of living (HCOL) area in a high income tax state.
He still has student loans under $200k, but they are refinanced at a low rate where the math favors paying the loan on schedule and investing remaining income elsewhere.
He graduated residency fewer than five years ago and is on an accelerated learning program toward financial literacy, devouring books on my list of the Fantastic Four of Physician Personal Finance.
The SEP IRA that he has been using up until this point suddenly feels inadequate - he'd like to augment his savings, and he'd like to know what additional savings vehicles he can use in the process, and whether it makes sense for him to incorporate.
Ready, Set, Supersaver?
You've cleverly hidden your cape and mask in the doctors' lounge, and you are already sporting the brightly-colored tights under your white coat - all set to morph into a supersaver, right?
Easy, tiger: You are considering buying a house in a HCOL area. You need a large downpayment held in a low risk, liquid account. This might be in a high yield CD at a bank or in a money market fund in your taxable brokerage account.
Assuming you meet WCI's criteria for buying a home (both your work situation and your relationship are stable and long-term), you want to sock away as much of a downpayment as you can to minimize the debt to take on to buy your home.
The first hazard is that since homes cost a ton where you plan to buy, you could become debt numb and end up a house poor wage slave. Don't undermine your path to financial independence with this common rookie mistake.
The second danger is your newfound zealotry: Reading Bernstein and Dahle makes you feel like you missed out on saving and investing by not having fully funded a Roth IRA your first year of internship. The truth is you are at a fine starting point and ahead of >90% of your peers.
Also, don't let your newfound financial literacy and your desire to make up for lost time push you into rash decisions you'll be paying for down the road.
For example, the perceived benefits of incorporation may not make sense for a newbie about to buy a home, since that home will immediately become the major diversion for your income.
Those benefits of incorporation tend to accrue to docs who have maxed out the usual tax-protected accounts and find themselves with additional income beyond expenses they are looking to place into less conventional tax-protected or tax-deferred accounts. Folks like this guy.
Despite commendable enthusiasm, most newbies are not facing the problem of too much income with too few tax-protected venues in which to invest it.
What To Do About An Existing SEP IRA
Having read about backdoor Roth IRAs, you are dying to start one for you and your spouse, and I want to help you get there. You can rollover your SEP IRA into an individual 401k (i401k). The latter requires more paperwork than the former, but it will allow you to make backdoor Roth contributions.
For Vanguard die-hards, it can be disappointing to learn that unfortunately Vanguard will not allow rollovers from a SEP IRA into an i401k. (Even Prince Charming has a wart or two, and this is Vanguard's.)
Fidelity does allow this, so Vanguard loyalists can easily buy Vanguard ETFs (or consider Fidelity's new zero expense ratio index funds such as FZROX) in your Fidelity i401k. There are threads on the WCI Forum addressing this very question. My advice is to call Fidelity and ask the representative which path would be easier:
- Open a SEP IRA at Fidelity, rollover your outside SEP IRA to Fidelity, then convert it to a Fidelity i401k
- Open a Fidelity i401k and then rollover your outside SEP IRA to the Fidelity i401k
- After doing either of the above steps, if you are a Vanguard die-hard and feel so compelled, you could next open an i401k at Vanguard and roll your Fidelity i401k back over to Vanguard to repatriate your investments to Jack Bogle's loving embrace
The White Coat Investor has a post from 2014 comparing places to open an i401k, where e-trade came out ahead for offering a cash signup bonus depending on the amount transferred, so depending on your tolerance for hassle, you might eke out a profit of a few hundred bucks in the process.
Maximum SEP IRA contribution for 2019 is 25% of compensation up to $56k. This means to max out your SEP IRA you need to demonstrate income of $224k.
Maximum i401k contribution for 2019 is $19k employee contribution plus up to $37k employer contribution for a maximum of $56k. Employer contribution is calculated as 20% of net income for a sole proprietorship, so to max out your i401k you need to demonstrate income of $280k.
Before switching from SEP IRA to i401k, ensure you can document sufficient income at the higher level to continue to max out the i401k.
Max Out Other Preferred Savings Vehicles That Don't Require Incorporation
Assuming you go through with the i401k rollover, you will now be eligible for backdoor Roth contributions to your account and your spouse's account. In 2019 you will be able to contribute $6k to your backdoor Roth ($7k if you are 50 or over) and an additional $6k to your spouse's backdoor Roth (ditto if your old lady is actually an old lady). Recall that Roth contributions are after tax contributions, so there's no tax break, but the money you invest grows and will never be taxed again - a valuable cumulative benefit over time.
Another favored vehicle for families fortunate enough not to have chronic illnesses is the Health Savings Account (HSA). If your family is healthy without known recurring medical costs, you could select a high deductible health insurance plan which would make you eligible to contribute $7k for a family in 2019.
This money should be invested consistent with your investor policy statement as part of your portfolio. Used as an adjunct to your other investments, the HSA has certain advantages that have garnered it the nickname Stealth IRA by folks smarter than me.
This concludes the first of this 2 part series. Look out for the sequel!