Times have changed. There are dozens of reasons that dentists are fed up. They’re fed up with the last decade returning zero % in the market – highs and lows like a roller coaster – with the result being a retirement delayed once again. They’re fed up with being sold whole life insurance as a great investment vehicle despite the commission and expense that cling to it like sucker-fish. Good for some but not for most. They’re fed up with great practice management consulting growing practice revenue and seeing savings for retirement stay the same year over year.
My previous blogs speak of a Financial Revolution in Dentistry, a turning back to a pragmatic time where saving a lot of money was cooler than how you spent it. Living off half your current income in retirement should not be normal, as the ADA Survey on Retirement suggests, yet most dentists believe it is their destiny. The average dentist saves $28k per year, 17% of net income, and it’s not enough. The more you save, the less you chase high returns in the stock market. You want to save more money but don’t know how? Start with getting incorporated.
1. Structure, structure, structure. I know it sounds simple but saving is a lot tougher when there is no W-2 income. For those sole proprietors that missed this lecture in dental school, let’s re-visit the basic principals of corporate structure. Let me start by acknowledging a few advantages some might point out with sole props. Most small businesses default to the sole prop because it’s easy, cheap, and simple. There are some nice tax deductible fringe benefits of a sole prop related to medical premiums, dependent day care, and such but let’s focus on what I call the “big kahuna goal” – your ability to save a lot for retirement and retire when you want. Tell me what trumps that?
A dentist in an incorporated business technically has security from seizure of his personal assets. Only corporate assets may be attached to satisfy a lawsuit. I said “technically” because this security – called the “corporate veil”- is being “pierced” more and more often, so don’t opt for a corporate set-up just because you think it offers 100% protection for your personal assets. We’ll focus on the benefit of structure that incorporating brings rather than security. There are some sticky points when it comes to sole props allowing the owner, in this case a dentist, to easily save money for retirement. When you incorporate, you can take income two ways: one as W-2 salary income, since you are the President and also an employee. The second way is through ‘distribution income’ or also called ‘dividend income’ by some. Just like a big corporation might pay a dividend per share of a company, you can also pay yourself a dividend, or “distribution” as additional income from the corporation on top of your salary.
One of the big challenges many dentists have is where to set that salary income vs. the distributions. Often, distribution income is too heavily weighted in an attempt to save a 2.7% in Medicare tax – which is not deducted from distribution income. The problem with this, from a retirement planning perspective, is that weakened W-2 income often inhibits great retirement and tax savings that result from a well-crafted 401k. When a W-2 employee takes income, the corporation takes out taxes (fed, state, local, Medicare) and social security contributions. Because a sole prop is not taking w-2 income, they have a great big ball of cash that handed to them and they’re expected to place in all in the appropriate buckets – take home income, payables, taxes, etc. No tax withheld = big tax surprises. It never fails, autumn falls upon us and dentists get the call about “good news, bad news” from their CPA. The good news is your production is up. The bad news is you didn’t adjust your tax with-holdings and you owe an additional $30,000. Ouch. Pay the small expense to get incorporated and benefit from great structure AND the ability to super-charge your qualified plan and profit share – hopefully a non-commissioned 401k with a fee-only advisor that doesn’t charge commission.
2. Cash-Hoarding. Sole-proprietor dentists begin to “hoard cash” – like storing acorns for a foreboding winter. That might sound like a good thing but it’s not. Because of the tax surprises the dentist wants to avoid, they begin to hoard cash in their business accounts. They don’t know what to expect in the fall so they choose to over-compensate. The irony is that this is not good cash management since large reserves are trapped in the business checking account and can’t reap the value of being invested and managed properly. Not ideal cash management. Once you understand what a consistent amount to have on hand for payables over 45-60 days, keep no more and no less. A business line of credit really helps here but I find most dentists don’t have one or have too little credit on the line. A little technique we use is to communicate with the CPA when monthly monitoring suggests two things: overhead is the same or better AND productivity is up. That means more tax will be paid and an adjustment should be made NOW to withholdings and/or income.
For example, “Dr. S-Corporation” pays quarterly taxes and has a good idea of his tax situation and income structure because of the reliability of W-2 income versus random distributions. “Dr. Sole Prop” has her business account, personal account, and tax accounts blurred and often they are all fed from the same account. The tax situation is much more unclear because taxes are not actively withheld on an ongoing basis. As a result, she sits on a huge amount of cash just in case the tax situation turns sour. The end result is that there could have been significant cash-flow capitalized on throughout the year but fear of a tax surprise prevents that. The domino effect that results is a major frustration at home that occurs when a spouse sees money is in account but they cannot take income. Though there may be tax surprises with an s-corp., it is drastically limited by actively saving throughout the year and easily being able to decipher how much is yours versus what is going to the IRS.
3. No 401k in place. Not just any 401k but one that is NOT commissioned-based, one that has a generous matching contribution and profit share component, and one that is not expensive to administer. Sole props generally don’t have a 401k in place and opt for a Simple IRA. Simple IRA has lower limits to maximize contributions. A 401k in 2010 allowed for $16,500 for under 50 yrs old (50 and over is $22,000). Simple IRA limits are $11,500 and $14,000 respectively. Additionally, a Simple IRA can only match up to 3% max. With a proper 401k, we insert a 6% match to contribution – plus a profit share analyzed each year.
These limit differences can be seen on an example of Dr. Joe who makes the max income limit for retirement plans ($245,000). If Joe had a simple, he can only contribute $21,350 in max match and deferrals. With a 401k (excluding a profit share), the number jumps to $36,700. That is an additional $15,350/yr that is tax deductible—this would lower the taxes another $6,140 (assuming 40% tax bracket). A lot of folks are advised that a 401k is messier to run and requires a little more expense to manage, although that expense is deductible through the business. A Simple IRA can be done “in-house and is easier to pass the government-required test; however, with an affordable TPA (third party administrator), the plan is easily managed by them with little headache for the dentist.
So you made the changes and, oh so quietly, the income falls into the correct bucket each month, savings becomes automated and the staff loves a 6% match. Your commission-free 401k is maxed now, you save tax as a result, and you escalate contributions to a non-qualified brokerage account in addition to balance your tax burden in retirement. Then, you set up the monthly draft for the kid’s college UTMA (NOT 529 accounts, but that is another blog altogether). You’ll look back at the end of the year and just might be astonished at how much you saved – and it was easy. Won’t work for you? Take the Wealth Workup and find out for yourself.