by Brian Hufford, CPA, CFP®
I've recently been working with several dentists who have a familiar pattern that leads to severe wealth destruction, especially under the new Obama tax law. The pattern goes something like this -- the dentist is in his 40s to 60s, owns an office building, and is in a hurry to eliminate debt, both for his practice and the office building.
The new tax math presents some major problems in eliminating nondeductible principal. The dentist must earn $2 to have $1 left after tax to pay principal (39.6% federal, 6% state, and 3.8% surtax on rent income). Part of the pattern that accompanies this debt elimination mindset is typically a small retirement savings. With large principal payments and large taxes, there is little remaining to save.
Here is a pattern I encountered recently. A 45-year-old dentist was committing about $12,500 per month to rapidly repay an office mortgage and a small amount of remaining office debt. The rent from the practice to his building LLC was quite high to allow for eliminating the mortgage in seven years. The building entity was generating about $50,000 per year of passive taxable income because of the higher rent, which in 2013 would be subject to the new Medicare Surtax of 3.8% as passive income in addition to his income taxes.
When I asked the dentist if he was aware of this problem, he said that he needed the higher rent to amortize the mortgage faster (building rentals should be set at market rental values to avoid IRS audit problems). In this case, the dentist was planning on funding his 401(k) and safe harbor match at approximately $31,000 per year. He at least was saving for retirement. His debt, tax, and savings priorities were aligned as follows -- debt repayment $150,000, taxes $90,000, and savings $31,000 per year. Because of the priority to eliminate debt, this dentist had only recently begun a 401(k) plan, and had accumulated only $200,000 in savings.
With the "new normal" of lower expected investment returns, retirement math is scary. Many dentists believe that, by beginning to save 10% of income at age 40, they can achieve an adequate retirement. The number is actually more like 20% of income.
Even though this dentist was saving and hoping to sell his practice and building at retirement, we discovered that the amount he should be saving to retire at age 65 was $85,000 per year, not $31,000 per year. Yes, his debt would be eliminated in his early 50s. But he had college expenses for children ahead, and was under the belief that additional saving would not be possible until he reached age 55. This is the wealth destruction potential of high taxes and high debt elimination.
In this case, a simple combination of a different debt strategy and the implementation of a paired 401(k)/cash balance plan could create dramatically different results for the anticipated retirement outcome. By restructuring all of the dentist's debt into one 20-year office mortgage (he had sufficient equity), we were able to drop debt payments from $12,500 per month to $6,500 per month, thus freeing $72,000 per year of after-tax cash flow.
We used the extra cash flow to fund a deductible $143,000 per year in the paired-retirement-plan arrangement. This additional deduction and the lowering of overall rent payments to a more reasonable level lowered overall taxes by $40,000 per year. His new debt, tax, and savings priorities were aligned much differently than before.
The new priorities were as follows: debt repayment, $78,000; taxes, $50,000; and savings, 143,000 per year. He had been saving $31,000 per year for retirement. Now he was saving $143,000. The additional savings would create additional wealth creation potential of approximately $4.3 million at age 65 at 6.5% annual compounding.
You may not own an office building and may not have the dramatic results that I'm illustrating in this case study. From my experience, though, even without building ownership, the average dentist forfeits $50,000 per year of savings potential through improper alignment of debt, taxes, and savings.
Even for dentists without any debt, savings results can be dramatically improved through proper planning of large purchases such as dental equipment, children's tuition, and large home-related expenditures. Wealth creation is always about savings first.
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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