James R. Pride, DDS, and

Brian C. Hufford, CPA, CFP

The handwriting is on the wall: there are fewer dental graduates this year than 10 years ago and America`s population is increasing. The good news is that there will be fewer dentists and more patients available per dentist in the near future. But the bad news is that the decrease in new dentists will mean a shrinking market of buyers for older dentists wanting to sell their practices.

The increasing patient population will make it easier for the new dentist to start a practice from scratch. (Statistics from one dental school already are showing a marked increase in the percentage of graduates starting practices from scratch.) Thus, in 10 years, the value of a dental practice could fall to an estimated 50 percent of its current market price of approximately 55 to 60 percent of adjusted production. Looking at the demographics of graduates vs. population, some experts predict that, in 10 years, the average dental practice could sell for as little as 20 to 25 percent of its adjusted gross income. This may sound like doom and gloom, but it does not have to be.

We are constantly asked the question: "Should I sell my practice when its value is at its peak, even though I`m not ready to retire?" The question we ask back is: "Are you prepared to work as an associate or employee after selling your practice?" We need to challenge the premise that the only way the dentist can retire is to sell early and then work for another 10 or more years as the second in command. We have seen this scenario fail more often than it succeeds. The reason is that the senior doctor, who has built the practice and made all the decisions, usually does not take well to a loss of autonomy.

The young doctor buys the practice and begins to make changes. The senior doctor may not like these changes. Staff members frequently disapproves, as well. They complain to the older doctor about the changes. The senior doctor does not know how to handle this situation, but tends to support the staff. Therefore, communication does not occur along proper channels. Thus, the young owner begins to resent the former owner for not relinquishing control of the practice and for meddling in the new order. This can lead to an unhappy termination of the purchase contract or of the senior dentist and the staff.

These problems have occurred even between family members in the same practice. When you have been at the helm for a long time, it is difficult to give up the wheel. Having an unhappy relationship with your successor is no way to end a career.

If selling your practice early and working as an associate is no walk in the park, then when is the best time to sell a dental practice? We can provide a few guidelines.

First: The right time to sell the practice is when your pension is fully funded. When you sell your practice and terminate your professional income, your pension needs to pay for your lifestyle. It also needs to continue growing to support your financial needs until at least age 90.

If your pension is not properly funded - no matter how much you can get for the sale of your practice - it is not the right time to sell. This is because proceeds from the sale of the practice will likely fall short of the lump sum of $1.5 million or more needed to retire. (Keep reading. We`ll explain how to get there.)

Second: The right time to sell is when you are tired of practicing dentistry. Of course, this is precisely the time many dentists want to sell. However, if you are tired of practicing dentistry and your pension is not fully funded, it is not the time to attempt to sell the practice. Interestingly, many dentists discover that, once they get the business end of dentistry in order and have funded their pension, they love practicing again and have no intention of selling for many years.

"How much money do I need for retirement?" This probably is the second most common question we hear. Since you cannot count on the sale of your practice to support you for what could be a 20- to 30-year retirement, as we discuss later in this article, the question of how much money you need becomes: how much do you need to fully fund your pension?

We know literally hundreds of retired dentists, along with the intimate financial details and challenges of their retirement (both the humorous and the sad). One client in his early sixties was beginning to phase into retirement by working for nine months and spending the three winter months in Florida. He would complain about the many times that he was forced to pick up the tab when having lunch with his retired golf buddies, who apparently felt it was O.K. to lean on the one member of the group still working. The restaurant conversation frequently turned to the same topic: how to live like a king on $50,000 per year of retirement income. Every time the client returned from Florida, he shared with us the latest schemes to make $50,000 per year seem like $150,000. Part of the secret, apparently, was leaning on golf buddies for the lunch tab.

In some respects, these individuals may seem fortunate to live reasonably well and have the option of playing golf regularly. However, real hardships exist. There is nothing as sad as meeting a 65-year-old dentist who has earned the equivalent of $150,000 per year in today`s dollars for the previous 35 working years and now only has $85,000 saved in IRA accounts. Whether you wish to retire at 50 or to work until you die, the mathematics of calculating how much you need are fairly simple.

These retirement amounts appear huge. The factors that are creating seemingly large numbers are inflation, even though the assumption is only 3 percent per year, and investment risk. We have lived through one of the best 20-year investment periods in the last 200 years. Had you retired in 1967, you would have lived through periods of raging inflation along with a Dow Industrials that dropped from 1000 to 750 over a 15-year period, ending in 1982. So remember, you can have more risk than you`re experiencing now.

We asked Ned Davis Research, Inc. to calculate average growth for the previous 70 years in stocks, bonds, real estate, treasury bills, and inflation. These annual numbers are: stocks, 10.4 percent; bonds, 5.4 percent; real estate, 4.3 percent; treasury bills, 3.9 percent; and inflation, 3.3 percent. We don`t know what your returns will be; it all depends on market conditions and cycles through your working and retirement years. You may retire at the start of a raging depression (as forecast by some for baby boomers) or at the start of a booming economic prosperity. Perhaps the average of the previous 70 years of investment returns is the best guess of your returns in the future.

If you are retired for as long as 30 years - say from age 60 to age 90 - your investments will most probably need to survive at least one major economic recession, along with the resulting loss of investment capital. Once again, we asked Ned Davis Research, Inc. to do this calculation, beginning in the year 1926 and going forward one year at a time for 30-year retirement periods. The objective was to find out the percentage of retirement capital that could be spent each year (with the assurance of not running out of money) with a million dollars of retirement savings.

The answer was a shock.! To be absolutely sure a retiree wouldn`t run out of funds, the maximum percentage withdrawn from a retirement portfolio of stocks and bonds was only 4 percent per year, adjusted for inflation. With a 60 percent-stocks and 40 percent-bonds mix, withdrawing 5 percent per year causes the retiree to run out of money 20.5 percent of the time! Taking 6 percent per year increases the risk of running out of money to 56.9 percent. Therefore, to be safe with a million dollars in retirement savings, you would need to live on only 4 percent or $40,000 per year during 30 years of retirement because of inflation and economic recessions. Not a pleasant prospect!

But there is hope. The solution is to invest in stock and bond returns during good economic times and move your money into treasury-bill-like investments during bad economic times to avoid losses, thus allowing you to withdraw as much as 8 to 10 percent per year during retirement. We have found money managers able to do this in real time and with historical back testing. Will it work in the future? Ask our grandchildren.

Funding retirement from sale

Finally, the third question we are asked is: "Won`t the sale of my dental practice fund my retirement?"

Let`s look next at where the value of the dental practice fits into the retirement equation. Let`s assume that a practice has a current production of $500,000. How much will the doctor realize after income taxes from a practice sale 15 years from now? Step 2 of our formula is an inflation calculation. So, we could merely multiply $500,000 times the 15-year factor of 1.56 to guess at what the doctor`s production would be 15 years from now. ($500,000 times 1.56 equals $780,000)

One frequently used indicator of practice value is 60 percent of annual production. Applying this factor, the practice in question could be worth 0.6 x $780,000, or $468,000 in 15 years. As discussed above, there is reason for skepticism about the future value of dental practices and about using these values in retirement calculations.

But perhaps it is worthwhile to assume the practice will retain today`s value 15 years from now, just to see the best percentage that the dental practice can bring to the table. Therefore, let`s assume the practice sells 15 years from now for $468,000, with the assistance of a practice broker who charges a 10 percent commission. With the broker receiving $46,800, the proceeds net of commission would be $421,200.

As part of the agreement, the seller and buyer will determine the allocation of the sales price among equipment, furnishings, supplies, patient charts, leasehold improvements, noncompetition covenants and goodwill. Typically, only the goodwill component generates favorable capital-gains treatment.

Other components generate ordinary income or less favorably taxed gains. If we assume in the best case that 50 percent of the sales price will receive capital gains treatment and 50 percent will receive ordinary-income treatment, this would create $210,600 of capital gains and $210,600 of ordinary income.

We might assume a 25 percent combined federal- and state-capital gains tax rate and a 40 percent combined ordinary-income tax rate. This would mean that a further income tax amount of $136,890 would be subtracted from the sales proceeds.

In this example, the dentist would receive gross sales proceeds of $468,000 minus the brokerage commission of $46,800, and minus income taxes of $136,890, for a net amount of $284,310. This net amount is just a little over 10 percent of the $2,674,932 of retirement capital that is needed.

Yes, there are many ways to reduce income taxes on the practice sale. Perhaps with good tax-planning, the net-practice proceeds could be increased to $350,000 after taxes. But, this still is less than 15 percent of the retirement capital needed. This is why we say that a dentist should not count on the sale of his or her practice to fund retirement.

Determine retirement needs

What do the above calculations mean? First, they demonstrate that there is a necessary amount to predetermine and then to accumulate in your pension for retirement. For most dentists, that amount is between two and three million dollars in the account at the time of the practice sale or retirement. This amount will vary based on geographical location and individual needs.

There is an old tale that when you retire, your living expenses are reduced. Frankly, we don`t find this to be true. Retired dentists with time to do what they have always wanted to do - which can include travel, leisure activities, condominiums, second homes, and continued support of their children`s and grandchildren`s education - need a tremendous amount of money. This, coupled with the fact that the average life span is increasing, means that you need substantial money for your retirement. For these reasons, retirement is not cheap.

At first glance, it may seem prudent to attempt to sell the practice while its value is at its peak. However, since the practice sale is going to net only 10 to 20 percent of the amount needed to retire, it makes more sense to sell only when the pension has been fully funded or a plan is in place for catching up on pension funding.

The extent to which you can fund your pension is a direct result of the way you operate your dental business. Some dentists are finding it necessary to establish defined-benefit plans and put between $60,000 and $90,000 a year into these pension plans to make up for prior years of nonfunding. To do this, they are needing to find the cash flow from the practice. Regardless of geographics or demographics, we`ve seen dentists from all parts of the country that have not been able to accomplish this.

The right time to sell your practice is when the pension has been fully funded and you find dentistry no longer enjoyable or you have other avocations or experiences you wish to enjoy. The bottom-line is that with the proper knowledge and planning, you can enjoy financial independence and your accustomed lifestyle for the rest of your days.

The retirement calculation

Here are three easy steps to calculate the retirement dollars you need. Before you begin, calculate how many years are remaining until your retirement. For instance, if you are 45 and wish to retire at 60, you have 15 years remaining until retirement.

The assumptions we are using are: 1) a 3 percent annual inflation rate until retirement, dropping to a 1.5 percent inflation rate at retirement (half of the inflation index is housing inflation); and 2) 30 years of retirement.

Step 1. Account for Tax Multiply your annual retirement budget by 1.3 to determine your before-tax retirement need. (Example: a $100,000 retirement budget times 1.3 equals $130,000 of before-tax investment income needed.)

Step 2. Account for Inflation Project the annual before-tax investment income from Step 1 forward until your planned retirement by using the following table: for 5 years, use a (compounding) inflation factor of 1.16; 10 years, 1.34; 15 years, 1.56; 20 years, 1.81; 25 years, 2.09. (Example: $130,000 needed 15 years from now at retirement equals $130,000 times 1.56 or $202,800.)

Step 3. Calculate the Total Lump Sum Dollars Needed at Retirement. Determine the percentage you may safely withdraw from your retirement capital each year. If you are a buy-and-hold investor, you may wish to use 4 percent. If you have a system to protect capital, as we believe we have, use 8 percent. For 4 percent, use a factor of 21.03; 5 percent, use 18.51; 6 percent, use 16.42; 7 percent, use 14.67; 8 percent, use 13.19. Multiply Step 2 by this factor. (Example: $202,800 times 13.19 equals $2,674,932.)

This means that to live on an annual $100,000 of after-tax retirement income for 30 years - and accounting for inflation - you`ll need to have $2,674,932 in your pension when you retire at age 60.