Should You Convert Your 401(k) To A Roth IRA After Residency/Fellowship?

July 30th, 2022
8

Many residents and fellows will contribute to a 401(k) or 403(b) over the course of their medical training. They should be commended for saving for retirement on just a resident’s income.

Often, newly-minted attendings wonder what to do with these 401(k)s or 403(b)s from their training hospitals. In particular, they wonder whether they should convert their 401(k) to a Roth IRA.

Four Options – Some Better Than Others

In general, there are four things you can do with your old 401(k) from residency:

1. Keep it at your old hospital

There’s no requirement to rollover your 401(k) from residency. You can keep the account at your old hospital indefinitely. If your old hospital’s 401(k) has excellent investment options with low fees and you don’t want to convert your 401(k) to a Roth IRA, then this is a great option.

2. Move it to your new hospital

You can also rollover your old 401(k) to the 401(k) program at your new hospital. Some people might do this because the new hospital’s 401(k) has better investment options with lower fees, or for simplicity (you have fewer investment accounts to deal with).

3. Convert it to a traditional IRA (not a good idea)

You could convert your 401(k) to a traditional IRA, but I would advise against this for physicians or other high-income professionals because it limits your ability to do backdoor Roth IRAs.

4. Convert it to a Roth IRA

This is the focus of this article, as many graduating residents and fellows wonder whether it makes sense to convert their old 401(k)s to Roth IRAs.

The short window of opportunity to convert the 401(k) to a Roth IRA

Because 401(k)s use pre-tax contributions and Roth IRAs use post-tax contributions, you have to pay ordinary income taxes on the rollover when converting a 401(k) to a Roth IRA. If you plan to do this, you should make the conversion in the calendar year when you finish your training and start your first job.

This is because most graduating residents will have a “half-attending” salary in the year of graduation, when they are paid as a resident for 6 months and as an attending for 6 months. Your salary (and therefore marginal tax rate) during this “transitional year” will be the lowest it will likely be until retirement.

In fact, I would advise most physicians against converting the 401(k) into a Roth IRA once you are making a full attending salary, as it will likely be beneficial to keep it in a pre-tax account.

Should you convert your 401(k) to a Roth IRA?

It isn’t necessarily a no-brainer to convert your 401(k) into a Roth IRA during your transition year from residency/fellowship to practice.

In general, the decision to convert your 401(k) to a Roth IRA is based on your current and expected retirement marginal tax rates.

Because you didn’t pay taxes on the initial 401(k) contribution, you will pay taxes either when you roll it over to a Roth IRA or when you withdraw it in retirement. The goal is to pay the lowest tax rate on this money, so you need to compare your current marginal tax rate with your expected marginal tax rate in retirement.

Most married physicians (except those whose spouses also have a high salary) will be in the 24% federal income tax bracket during the transitional year between residency and your first job. For single residents, your tax rate is at least 24%, and often can be 32% or even 35%.

It’s actually fairly likely that your tax rate in retirement will be lower than these numbers. In retirement, you won’t be making any money from your job. You will still have to pay taxes, because you are collecting taxable income from certain retirement accounts, Social Security benefits, and dividends / capital gains from taxable accounts.

And if you are single when you finish residency but married in retirement, your tax rate could be significantly higher now than in retirement.

Any Other Considerations?

However, there are many benefits of Roth IRAs outside of its direct tax benefits that might make it beneficial to convert your 401(k) to a Roth IRA:

  1. No required minimum distributions — unlike 401(k)s, Roth IRAs do not have required minimum distributions, so you are better able to control your retirement income by selectively withdrawing from your Roth IRA as needed.
  2. Estate planning – If you pass on your Roth IRA to your children, the distributions are tax-free (although there are required minimum distributions once the Roth IRA is passed to your children)
  3. Protection against future tax rate increases – the current tax rates are a result of the Tax Cuts and Jobs Act of 2017. A future Democratic administration could increase taxes to Obama-era rates, or even higher.

So even if your tax rate is slightly lower in retirement than in your transition year, it might still be beneficial to make the conversion.

Case Studies from the Internet

Let’s look at two case studies I found on discussion boards around the Internet to illustrate the principles of this article:

1. Student Doctor Network: Single taxpayer with a trust fund

Question: Neopsych12 finished residency in June and was wondering if he should convert the $65,000 in his 403(b) to a Roth IRA, a taxable investment account, or neither (leave it in a 403(b)).

He is 29, single, has no student loans, and has $500,000 in a taxable account from a trust. His salary will be approximately $150,000 in his transition year (half-resident, half-attending).

WSP’s Take: This patient is single, so the money would likely be converted at a tax rate of 32% in 2018. Assuming he eventually gets married, his tax rate will likely be lower in retirement. I would generally advise against converting the money to a Roth IRA for a physician in this situation. He should just keep the money in the 403(b).

2. White Coat Investor: Regretting Converting 401(k) to Roth IRA

Question: WCI reader “Not So Good With Numbers” has $21,000 in a 403(b), of which $7,000 is already post-tax. The 403(b) has an expense ratio of 0.11%. By his calculation, he would have to pay $5,300 in taxes to convert his 403(b) into a Roth IRA.

Based on what he has read, he believes that converting to a Roth IRA is a no-brainer and was wondering whether other physicians have regretted not converting their residency 401(k) into Roth IRAs during their transition year into attending-hood.

WSP’s Take: If I understand his situation correctly, if $21,000 is in the 403(b) and 1/3 of it is already post-tax, then only $14,000 would be subject to taxes. Assuming he is paying $5,300 in taxes in a Roth conversion, that would be a tax rate of 37.8%.

If that’s the case, it would be likely better to keep the money in the 403(b) rather than convert it to a Roth IRA. His tax rate in retirement will likely be much lower than 37.8%.

Conclusion

Many new attendings are eager to convert their residency 401(k)s or 403(b)s into Roth IRAs following training. The decision to do this should be based mostly on whether your current marginal tax rate is higher or lower than your expected marginal tax rate in retirement.

In many cases, it is beneficial for the physician to keep her money in the 401(k), or do a rollover to her new hospital’s 401(k). However, there are many additional benefits to a Roth IRA, such as tax diversification, that might lead a physician to convert their 401(k) to a Roth IRA even if their current tax rate is higher than her expected retirement tax rate. It is usually a mistake for a physician to convert a 401(k) to a traditional IRA, as it limits their ability to perform backdoor Roth IRAs in the future.

What do you think? Did you rollover your residency 401(k) into a Roth IRA when you finished training? Do you think it was a good idea or a bad idea?

8 COMMENTS

    • i think it’s a false assumption. In general, Republican administrations want to cut taxes and Democratic administrations want to raise taxes. But even Democratic administrations only want to increase taxes on the wealthy, while also giving middle-class Americans a tax cut. In my opinion, most physicians won’t be generating taxable income in retirement at the level to be hit by Democratic tax increases (e.g. the $250,000 barrier).

      Of course, I could be wrong about future tax policy, and converting to a Roth IRA does protect against possible future tax increases.

      -WSP

  1. I find that if you really do a good job with saving and investing you will have more “passive’ income than you might think. After 30 years of saving and investing my dividends and interest were about $160k last year. At 70 you add in social security and RMDs you can easily hit that $250k barrier. Every situation is different but I would have a low threshold to Roth convert the money. Your 70 year old self would thank you.

    • That’s great insight about what the realities of retirement income might be for someone who crushed retirement planning. If that is a physician’s retirement income just based on interest, dividends, RMDs, and SS, then that’s a good problem to have and the mistake of not converting a residency 401k likely won’t make a huge difference in your retirement lifestyle.

  2. Nice overview. Most of what you read on converting traditional 403b to roth after residency is in the affirmative. I’m glad you outlined when that might be a bad idea. This topic in general seems like a relatively small point for most people. It’s a little bit of tax arbitrage but isn’t going to make or break a financial independence plan. As you know, it is the behavior after residency that is the key driver!

  3. I agree with Hatton on this. Although it is a good problem to have, passive income plus RMD later on can certainly push you into the top tax brackets which then get Social security taxed, etc. It starts a chain of event. And if you are a couple and 1 dies, the surviving spouse can be pushed way up the tax bracket chain.

    I was fortunate (I think) that the place I trained at didn’t do a 401k but rather a state pension which required a 4 year employed requirement (so a lot of the residencies didn’t qualify unless stayed and did fellowship or stayed on as an attending. Radiology met the limit so I was vested.

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