Mechanics of Money

Dentists, like other professionals, often do not have much confidence when it comes to business and finances. You have had to spend a lot of years in school learning the clinical side of your profession, so you come about your condition naturally. You are often easily swayed by the “experts”. (Do you realize it takes more time, experience and testing to become a licensed plumber than it does to become a stock broker or insurance agent!).

The purpose of this article is to catch you before you get into too much trouble. These are the things that the dentists 30 years your senior wish they had been told, and it is as though they have asked me to report back their experiences from the “far side”. To warn you.

You will want to bring your spouse into this conversation too, because if there is a hole in either end of your boat, you still have a problem.

So, here are just a few of many basic money tips:

? Rule #1: Be aware of the High Cost of Living High.

The good news is that you will do well financially as a dentist. You have to really work to mess that up. (A drug habit, a few divorces, lose your license, etc.) But the bad news is that dentistry will not make you wealthy. Unfortunately the tendency is to spend like you are going to be wealthy. If I told you that you will probably be netting $200,000 a year in 5 years, you would have thought you had died and gone to heaven. The problem is that $200,000 does not buy as much as you think. Take a look at the example below:

The High Cost of Living High
Practice Profit		$200,000
Expenses:
Fed, State and FICA tax	80,000
$400,000 home	50,000
Food, clothes, insur., entertainment	36,000
Two cars (3?)	12,000
Two kids in private school	20,000
Total Expenses		198,000
Left over		$ 2,000

Notice that the list above does not even mention country clubs, 2^nd homes, boat, etc. and it especially omits savings. Be careful when considering the “toys and trinkets” you buy but don’t really need. You have to cut a lot of crown preps to keep paying on some of those things long after the novelty has worn off. (Keep asking yourself, “Why do I spend money I don’t have to buy things I don’t need to impress people I don’t like!”)

? Rule # 2: Recognize that Income Is Not Wealth.

You may be tempted to scoff at a classmate who intends to become a life-long employee in research, teaching or the military rather than go into private practice. Although their path may not appear to be as financially rewarding, they do have one advantage: their employer is going to provide a retirement plan for them. At this age, you are young and immortal, so that does not mean much. But a pension at age 40 is about like having $2 million in the bank. As a private practitioner, some of your big income had better be creating that same nest egg.

I expect this announcement any day: “Due to budget constraints, there is no longer a light at the end of the tunnel. Please bring your own!” Even though you may earn a higher income during your career, if you don’t save any of it, you are not creating any “net worth” or savings to live off of later. I know many dentists who have all the trappings of success (big car, big house, big office), but they don’t have two nickels to rub together. In fact, they are only a few checks from bankruptcy!

? Rule #3: He/She Who Gets To Critical Mass First Wins!

The human mind does not intuitively understand the power of compound interest because it is not “linear”. Instead, it is “geometric”. Let me explain. Suppose you start contributing $3,000 to an IRA as soon as you graduate. Suppose that your bench mate decides to buy a few toys instead and does not begin saving until after 7 years. How much did that delay cost him/her?
The simple answer would appear to be $3,000 x 7 = $21,000, but the real answer is about $250,000! Say what?!? Check out the chart below. The dashed red line only grows to about $280,000 after 30 years. The top blue line grows to about $530,000—$250,000 more! What’s going on here?
After 7 years, due to the compound growth of “interest on interest” the early saver has about $31,000 in the bank. At 10%, the account earns more than $3,000 the next year even if he does not contribute any more! So he is essentially putting in a new $3,000 PLUS the earned $3,000, for a total of $6,000. The late saver can never catch up at just $3,000 per year!
I refer to this $31,000 (that generates as much as you have been investing each year) as the “critical mass”. In fact, due to reaching the critical mass, the early saver could stop investing after 7 years and have the same $280,000 that the late starter has—but the late starter has to save every year for the rest of the time!

? Rule #4: Retirement Requires A Lot of Money!.

So, just how much money do you need to have accumulated when you retire. That depends on how much you need to live on, what rate of return your investments can earn, what inflation is, how long you will need to live off your money, etc. However, a very rough rule of thumb is the following: For every $1,000 per month you want in current purchasing power, you will need about ¼ million dollars if you retired today. That money should last about 30 years and give you a raise equal to inflation each year, assuming about 3% inflation returns.
If you retire 10 years from now, you need about 1/3 million and in 20 years you need about ½ million. Due to inflation, 30 years from now, you will need about $2,500/mo. to buy $1,000 worth of today’s goods! That will require almost 2/3 million dollars! That is a LOT of money, but the good news is that you have 30 years to accumulate it…. Better get started as soon as you can per Rule #3.
By the way, for every 1% of overhead you can save in a $600,000 practice, that amounts to $6,000 per year. Invested at 10% return, that $6,000 will grow to $1 million in 30 years. So don’t say that overhead isn’t important!

? Rule #5: Chasing Hot Investments Is A Fool’s Game.

At some point you are going to wonder why “brains don’t count” when it comes to the stock market. In school, you presume that if you are smart, work hard, etc. you should end up in the upper level of your class. That does not work in the stock market because there are over 10,000 professional money managers that you are competing with. It is futile to try to pick the next “Tiger Woods” of money management because there are too many Tigers out there.

With the easy access to data these days, the market is simply too “efficient” for anybody to consistently pick winners. And just because somebody had a hot hand for a few years, or is awarded stars for good past performance, that does not predict who will be hot next year. Think about it: Money magazine may have had an article a year ago touting “10 Stocks For a Lifetime”. But when they have a similar article this year, the list has 10 different stocks! If the original list was “good for a lifetime”, how come they did not make the list this year? Short lifetime!

This is a complex topic, but, suffice it to say, it is in the financial industry’s best interest to keep you hyped up and making trades. All the action is what keeps selling advertising and magazines. Someone once said that the financial industry is like a bookie—they make money whether you win or lose. For a more complete discussion on this topic, see my article “How To Win the Loser’s Game” in the July, 2003 issue of Dental Economics.

? Rule #6: Income Is Not Cash Flow and Vice Versa.

This distinction is critical, but it will probably boggle your mind forever. Note in the table below that the collections and operating expenses are the same for Year 1 and Year 2 and Net Operating Income is $80,000 for both years . However your CPA only reports $55,000 taxable income on your tax return for Year 1 because you bought some equipment and got a depreciation deduction. The nice thing about depreciation is that you get the full deduction even though you may not have written a check to pay for it—you used borrowed money. Since the depreciation was a “non-cash” expense, we add it back at the bottom to show that you still have $80,000 cash even though you only pay taxes on $55,000. You think your CPA is a hero!

However, let’s compress time and assume that you have to pay back the bank loan in Year 2. The practice feels the same to you, since you grossed the same, had the same normal expenses and your Net Operating Income is the same $80,000. However, your CPA now says that you owe a lot of taxes on taxable income of $80,000 (since you have no more depreciation deduction). To make matters worse, you have less cash than Year 1 because you had to pay back the bank. That bank repayment is not deductible! This is the worst of both worlds.

The lesson is that your taxable income on your tax return rarely matches the cash you have in your checkbook. Don’t assume that having no cash left over means that you don’t have any taxable “accounting” profit. You may well have “paper profit” and have a big tax bill coming!

Cash Flow vs. Taxable Income
	Year 1	Year 2
Fees Collected	$ 200,000	$ 200,000
Supplies, staff, etc.	- 120,000	- 120,000
Net Operating Income	80,000	80,000
Depreciation	- 25,000	-- n/a –
Net Taxable Income	55,000	80,000
Cash Flow Adjustments:
Add back depreciation	+ 25,000	-- n/a –
Less Loan Repayment	-- n/a –	- 25,000
Net Cash Flow	$ 80,000	$ 55,000

? Rule #7: “Tax Deductible” Does Not Mean “Free”.

Many folks mistakenly believe that if something is “tax deductible” that means it is “free”. It usually comes up in a conversation like this. I will tell a doctor that they will owe $10,000 taxes in December. The doctor says he’s darned if that will be so—he will spend $10,000 on a tax deductible ski trip instead. I explain that he will, in fact, reduce his taxable income by $10,000 that way; but not his taxes.

If he is in the 40% tax bracket, reducing his income by $10,000 will only save 40% of that in tax, or $4,000—not the full $10,000. So his tax bill is only $6,000, but he had to spend $10,000 on the trip—for a total of $16,000. He was stuck with a $10,000 tax bill originally, so he is only out an extra $6,000. In effect, the trip only cost $6,000, as though he got a 40% discount. I reminded him he doesn’t even like to ski, and he was out 6 weeks with a broken arm last time he went. So, rather than spend $16,000 on taxes and the trip, it might be best to pay the original $10,000 in taxes, stay home and put the remaining $6,000 in the bank!

Your objective is to increase you net worth/wealth, not necessarily save taxes at all costs. So don’t rush out to buy equipment or anything else for the practice that you might not need, just to save taxes. As the table shows below, it is a no brainer to make something deductible vs. personal that you are going to spend anyway. Remember, if that new BMW is “deductible”, so is a used Ford….

Personal vs. Business

Personal Business

Cost of item $10,000 $10,000

Less tax saved 0 - 4,000

After-tax cost $10,000 $ 6,000

? Rule #8: Not everything that can be counted counts, and

not everything that counts can be counted. (Albert Einstein)

What really matters? When it is all said and done, remember there are 4 other “F’s” besides “finances”.

Faith

Family

Fitness

Friends

Finances

I had a friend who scrimped all his life while he built a sailboat to cruise around the world when he retired. He died of cancer when he was 50 years old…. So don’t just hang all your hopes on the “destination”. Remember: The journey IS the reward!