By Brian Hufford, CPA, CFP®
Are your financial outcomes proportionate to your income? When I speak with a dentist who is frustrated about money, the issue is always a lack of alignment of needs, wants, and savings, although rarely does the dentist understand the source of frustration.
The frustration may be expressed as, “I had an unexpected $25,000 tax bill,” or “I can’t fund my pension with these college tuition bills for my kids.” The whole income/outcome equation has fascinated me throughout my journey with money.
One author I have read defines the “correct” view of prosperity as a deep consciousness of how our ongoing decisions about money align with our important life goals. With this definition, one can be prosperous or not, regardless of the amount of income. A large amount of income can actually move us away from important life goals, such as when too much office time takes away from parenting our children.
How does one align needs, wants, and savings? Let’s start with aligning cash flow from your practice. My theories about financial outcomes are based on the belief that income is not the issue. Regardless of your income, there should be a formula that properly aligns financial outcomes. This formula should apply whether your income is $100,000 per year or $1 million per year.
Start with your cash flow that needs to be aligned. In general dentistry, the cash flow or POP — practice operating profit — is approximately 40% of your production. If your production is $800,000, your POP is likely to be 40%, or $320,000. This is before items such as practice loan payments and lifestyle needs that are deductible in the practice (medical insurance, relatives on payroll, your deductible auto expense, etc.).
It is also before your personal 401(k) plan deductions. The key to aligning needs, wants, and savings is knowing where to start. The cash flow from the practice that you need to properly align starts with POP. Estimate yours.
Next comes savings. You should be saving 20% of POP. The key to creating a financial legacy, whether it is saving for retirement or college, is savings. It is also the key to understanding how well you’re doing in pursuing larger financial outcomes in alignment with longer-term goals to eliminate frustrations about money.
Savings includes your personal 401(k) plan savings, as well as your spouse’s savings. Saving 20% of POP is a basic target or template. To truly be in alignment with your goals, your actual savings need to be the percentage that will adequately fund your retirement, college savings, and other legacy amounts. For instance, it may be 30% if you’re lagging in retirement savings.
Needs are only two things — loan payments and levies, or taxes. Needs should be no more than 50% of POP. Loan payments include all of your monthly payments for practice and personal debt.
In our example, we’re working with $320,000 of POP. Needs, or loan payments and taxes, should be no more than 50% of $320,000, or $160,000. By adding all monthly loan payments (exclude office mortgages for your building) and federal, state, and Social Security taxes, you can calculate whether needs are out of alignment. If needs are out of alignment, your debt is likely to be improperly structured, or basic tax planning has not been properly conducted.
Finally, you should calculate whether your wants are sabotaging wealth creation. Wants should be no more than 30% of POP. Wants are only two things — lifestyle spending and large purchases.
Lifestyle spending includes items paid in the practice, such as medical insurance and spending at home. Large purchases are payments in cash for anything that is more than $3,000 total in a given year, and can include items such as paying cash for office equipment or a home auto. It can also include payments for college tuition, private schools, or weddings. Are wants making it impossible for you to save?
Perhaps the best definition of prosperity is a deep consciousness of how financial behavior supports longer-term goals or legacy. With this consciousness, we could have minimized the effects of the debt bubble in housing.
In dentistry, this means aligning needs, wants, and savings in the 50%/30%/20% ratio. Regardless of a dentist’s income, the appropriate outcome can be assured by forcing a legacy with the proper alignment of needs, wants, and savings.
Brian Hufford, CPA, CFP®, is CEO of Hufford Financial Advisors, LLC, an independent, fee-only planning firm that helps dentists achieve financial peace of mind. Contact Hufford at (888) 470-3064 or [email protected].
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