Avoid These Costly 401k Rollover Mistakes

Question: “I recently left my medical group for a new job. Should I rollover my old 401k or keep it where it is?”

While practicing medicine can be frustrating and challenging (that’s an understatement!) -- think lawsuits, nightshifts, patient satisfaction scores, and EMRs -- some specialties such as emergency medicine have the flexibility to move to a different job fairly easily.

One tricky aspect of changing jobs is figuring out what to do with your old 401k from your previous employer.  The laziest option -- just keeping it where it is -- might not be your best option and could cost you dearly. Here are some big 401k rollover mistakes you should avoid:

Mistake #1: Not doing a direct rollover

There are two ways to transfer your old 401k to another retirement plan account. The first is a 60 day rollover and the second is a direct rollover. With a 60 day rollover, the employer is required by IRS rules to withhold 20% of the amount as taxes and the 80% remainder is paid directly to you. Within 60 days you must fund the new retirement plan account. Otherwise you’ll be hit with taxes on the entire amount you should have rolled over plus possibly a 10% penalty.

As an example suppose you have $100,000 in a 401k that you do a 60 day rollover with. The employer will withhold $20,000 as taxes and send you a check for $80,000. You have 60 days to fund the new retirement account -- but here’s the kicker. You have to fund $100,000 not $80,000 even though the check you received was for $80,000. This means you must come up with the $20,000 from your own funds. If you send a check for $80,000 instead of $100,000, you’ll be taxed on $20,000 and additional 10% penalty if under age 59.5. So your best option is to do a direct rollover and have your previous employer make the funds payable to your new retirement account not to you.

Mistake #2: Paying higher fees

You should consider the internal expenses (called the expense ratio) of the funds offered in your old 401k with the funds offered in the new retirement account. If you are thinking of rolling over your old 401k to another 401k with your new employer, make a list of all the funds in both plans and compare the expense ratios of funds in the same asset class. Generally you should choose the plan with the lower overall costs. However you also have to consider which plan offers better diversification and weigh that against the cost. What if one plan has higher costs but access to multiple asset classes but the second plan has lower costs but lacks access to certain asset classes?

If you’re rolling over to an IRA with almost unlimited investment options, compare the funds you would use in the IRA versus the current 401k. Sometimes it’s better to keep the old 401k.

On the other hand a problem with 401k plans is that investment choices can change and you usually have no say in it.  So even if the current lineup looks good, next year’s lineup may not. If you rollover your old 401k to your new employer 401k because the new 401k has better funds and then the new 401k replaces the lower cost funds with higher cost funds, you’re stuck because you usually can’t rollover the new 401k until you leave the new employer.

Mistake #3: Loading up your financial advisor with commissions

This is a hot topic right now because of the new fiduciary rules coming next year for retirement plans. If you’ve hired a financial advisor and he’s urgingyou to rollover your old 401k to an IRA that he wants to manage, be very careful. In my opinion the right way a financial advisor should be managing your portfolio is to manage all of it -- including your 401k accounts no matter where they are located. The fee he’s charging you should already factor in the 401k accounts. Otherwise you don’t have an investment plan. If your advisor is not managing your old 401k and therefore not charging you a fee for that account, and now he wants you to rollover your 401k to an IRA he manages, make sure you understand the reasons for his recommendation. Is it because he’ll sell you high cost commission loaded funds in the IRA and make more money for himself? Or is it because you’ll have lower cost options in the IRA and a better investment plan?

Mistake #4: Getting dinged with penalties

Usually if you withdraw money from an IRA before age 59.5, you’l have to pay taxes on the withdrawal plus an additional 10% early withdrawal penalty (with some exceptions). A little known rule you may not know is that if you leave your employer after age 55, the 10% withdrawal penalty does not apply to 401k accounts. So let’s say you are age 56 right now and you leave your employer. If you keep your old 401k where it is, you can withdraw money from it now and pay the tax but avoid the 10% penalty. Realize that it’s the age at which you separate from the employer that makes this work. If instead you rollover your old 401k to an IRA, and you withdraw money from the IRA at age 56, you will have to pay the 10% penalty. This is important because if you’re thinking of early retirement, leaving the money in your old 401k might be the way to go.

Mistake #5: Gambling with your money

It’s tempting to rollover your old 401k to an IRA with almost unlimited investment choices. But what if you start buying penny stocks and lose everything? The chance of getting burned goes way up if you don’t know how to manage a portfolio. In this case it might be better to keep the old 401k even if that plan has poor investment choices. I’d rather pay high fees in the old 401k and at least get some diversification then to pay no fees in my IRA because my balance went to $0.

As you can see the decision to rollover of your old 401k -- like many financial decisions -- is multifactorial and depends your specific situation. Make sure you consider all pros and cons before signing off on the paperwork.

So You Want To Send Your Kid To An Ivy League School?

This month thousands of high school seniors will graduate and in a few months thousands of freshman will enter college, and many parents -- including you -- may be footing the ever snowballing bill. Like retirement planning I’ve met many physicians that vastly underestimate what it takes to send their kids to college. Their “plan” is to pay for college through current cash flow. But with physician income stagnant, the math just doesn’t work out especially if you send your kids to a private university or an out of state public university (usually these charge out of state prices almost as high as private universities).

Let’s take an example. If you live in Georgia and send your kid to the University of Georgia (a fine public university) the published 2015-2016 total cost is $25,134 (source:  https://www.admissions.uga.edu/prospective-students/tuition-fees).

2015-2016 Total One Year Cost of Two Colleges (Publlc vs. Private)

*Public = University of Georgia, Private = Yale

Instead if you send your kid to Yale you’ll shell out $65,725 (source: http://www.yale.edu/tuba/finaid/new-students/index.html) -- a whopping $40,000 difference.

Suppose you are physician making $300,000 in annual income and pay about 30% of that in taxes (federal, state, and payroll which are the big ones).  You would be left with about $210,000 in after tax income.  Assuming you want some sort of decent lifestyle and you spend $10,000 per month ($120,000 annually), that only leaves you with $90,000 to pay for college and fund your retirement.  

How’s that private university looking now? How many extra days and shifts are you willing to work to make it happen?

But wait there’s more.

That cost is only for one child. Suppose you have two kids that are 4 years apart. You’ll now have almost a decade long commitment of tuition payments, and this will happen when you’re around 45-50 years old. Either that or you’ll mire your kids in a mountain of debt.

If that doesn’t concern you, then this will:

Total 4 Year College Cost For Newborn Child (Public vs. Private)

*Public = University of Georgia, Private = Yale

Here are the estimated 4 year total college costs for a new born child if he goes to the above institutions assuming that the annual college inflation rate is 5% (see bar chart on right):

You may think those numbers sound crazy, but consider this. When I graduated from college at Johns Hopkins over 20 years ago, the total cost was under $20,000 annually and now it's over $65,000 -- it's gone up faster than the general inflation rate. That's true for most colleges.

I’m not suggesting that you don’t send your kids to college, nor am I questioning the value of a college education (OK, maybe I am -- hey I'm sure those sociology and philosophy classes have some value in life I guess). The point I’m making is that just like funding your future retirement, if one of your goals is to pick up your kids’ college tab, then relying on your future income isn’t going to cut it. You’ll have to plan far ahead for that obligation and coordinate your own retirement and current lifestyle into a well thought out financial plan.

The decision to go to a public in state school versus a private one boils down to a personal preference in many cases. Just realize that the financial pressure you'll be placing on yourself or your kids may be far higher than you think. Many physicians I meet don't realize this until they actually start paying the bills.

This is why keeping track of your finances on a micro level (cash flows, income, spending, savings, taxes) and a macro level (how that relates to your goals) is so important. Every expense affects other expenses. Every goal affects other goals. Looking at those relationships gives you a better picture of what to expect and how to plan for it.

5 Simple Financial Equations You Should Know

You don’t have to be a math whiz or use fancy spreadsheets to understand many parts of your personal finances. Sometimes it’s just a matter of elementary school math: basic addition and subtraction.

Let’s take a look at a few simple formulas you should be familiar with and some financial lessons you can learn from them:

Spending = Income - Savings

You’ve heard the phrase “pay yourself first” but many physicians reverse this equation to look like this:

Savings = Income - Spending

That’s known as “pay yourself last” -- it’s one of the big reasons why so many physicians wonder why they have to continue working full time into their 60s. I’ve said it many times and I’ll say it again: if you’ve practicedmedicine full time for the past 20+ years, and you have not built up a multi-million dollar retirement portfolio, you probably haven’t saved enough.

One reason may be overspending on your home. Here’s how you can apply this equation to figuring out how much you should spend on your home. Take 20% of your gross income -- that should be your savings rate. Then whatever is left over after taxes is what you can spend including your mortgage. You can then calculate out the max value of the home you can buy based on terms of the mortgage.

Net Worth = Assets - Liabilities

I’ve met many asset-rich physicians who are actually poor. This usually means they’re carrying a ton of debt. Here’s an example: you buy a $1 million home and carry $900,000 of mortgage debt. There are physician home loans out there that you can get with very little down payment. I’m not saying those are a good deal, but I’ve seen physicians take the bait -- especially physicians who recently graduated from residency. When you factor in other debt such as student loans, you can see that it’s possible to accumulate a large amount of assets but have a negative net worth. Your goal should be to maximize net worth not assets to build wealth.

Taxable Income = Total Income - Deductions

There’s a misconception that your income tax is based on your total (gross) income. If you look at the federal income tax brackets you’ll see it’s based on the taxable income, which is calculated after a number of deductions and exemptions. How do you maximize your deductions and minimize your taxable income? Here’s a partial list of deductions that may apply to you as an emergency physician:

Health savings account deduction

Deductible part of self employment tax

Self employed, SEP, and qualified plans

Medical expenses*

State and local income taxes*

Real estate and personal property taxes*

Home mortgage interest*

Gifts to charity*

*on Schedule A of federal income tax return

If you’re an independent contractor, your largest deduction will likely be your retirement plan -- typically a SEP IRA or individual 401k. Depending on your age, income, and type of plan, you can sock away up to $59,000 in 2016 pretax. Assuming you are in the 33% tax bracket (married filing jointly) the contribution lowers your taxable income for tax savings of around $20,000.

Total Return = Capital Gain + Dividends + Interest

You might disagree with me on this one, but hear me out. A popular investment strategy touted by many financial advisors and followed by many investors is to have greater exposure to dividend paying stocks. You might even think that the value of your retirement portfolio you need to build up should be based only on the dividend payouts. The idea is that you don’t touch your principal and instead live off the dividends.

The reality is that the only return that matters for any investment is the total return not just the dividends. Here’s a hypothetical example. Suppose you have two investments A and B. Investment A pays 0% in dividends and has a price gain of 10%. Over the same period of time, Investment B has paid 4% in dividends with a price gain of 5%. Which investment would you rather have? Obviously there are other factors to consider, but the point I’m making is that your investment decisions and your ability to withdraw money during retirement should not just be based on dividends. Money is money whether it comes from price gains or dividends. In the end it’s total return that matters.

After Tax Return = Total Return - Taxes Paid

Taking the previous equation one step further, one of the goals in your investment portfolio should be to maximize after tax returns not necessarily minimize taxes. For example, which would you rather have? Investment A which has a total return of 10% and you pay 2% in taxes or Investment B which has a total return of 6% and you pay 0% in taxes. Don’t let taxes dictate all of your investment decisions, and be especially careful of investment products (usually sold by commission based financial advisors) that entice you with the phrase “tax free.”