Practice Management Toolkit

Planning – The Key to Saving and Investing

If you’re like most people, saving for retirement is probably a distance thought or something that may never have truly garnered much of your attention. After all, retirement may be years, if not decades away, so why worry about it now?

For one reason, retirement is like any other long-term goal. To achieve your desired outcome you have to plan for the future. Planning is the key to success. The sooner you get organized, create a saving and investment strategy, and implement that strategy, the more likely you are to reach your financial goals. That is, of course, assuming your goals are realistic and achievable given your income level, spending habits, and ability to save. It is not necessarily how much you set aside and invest, but the time period over which you invest.

Time Is One of Your Best Assets

It may sound trite, but numbers don’t lie. To demonstrate the value and impact of starting to invest at a young age, simply look at the following examples that illustrate why you should start investing as soon as you can.

Assumptions: We’ll take a look at the money management efforts of two dental hygienists. Both individuals are 22 years of age, and they have equal opportunity to set aside $100 per paycheck or $200 per month. (More on exactly how you might achieve this in a moment).

Employee #1 is a conscientious saver, well organized, and able to live on a budget that has the $100 automatically transferred to a bank account each payday. She realizes how important it is to take charge of her personal finances. She also is determined to prepare for her financial future by setting money aside now rather than later. All Employee #1 needs is some help on what to do with that money she has saved.

Employee #2, in contrast, could take that same $100 per paycheck and set it aside for the future. However, she has not gotten around to making any financial decisions, because she is focused on other issues. As a result that $200 slips through her hands each month leaving little to show for it. If asked to itemize her spending, she probably couldn’t tell you what she did with the money. In her mind, she’s too young to think about retiring. Besides, she wants to enjoy her life now rather than later. Frankly, saving for retirement in not foremost in her thoughts.

So What’s The Big Deal?

Does it really make a difference that Employee #1 started to save and invest early in life while Employee #2 did not? To answer that question, you need only look at the following examples. We’ll assume the money is invested in a personal (taxable) account. Then we’ll do the calculations with the understanding that all the contributions go into a tax-deferred account like an individual retirement account (IRA), 401(k), or similar program. Two hundred dollars per month or $2,400 per year is well below the maximum contributions for these retirement plans.

(Note: For the sake of consistency in these examples, it is assumed that both employees are in the 27% federal tax bracket, pay the same amount of state taxes, and inflation remains at 2.0% during the entire investment period.)

What Do The Numbers Tell Us?

As you can see from these examples, two things happen. First, the longer the investment period (40 years versus 30 or 20 years) the greater is the account value. Second, investing in a tax-deferred account proved to be more profitable (more growth) than simply putting cash a personal (taxable) account.

Obviously, there’s a lot to be learned here. For example, postponing the start of any saving and investing plan for a substantial period of time is costly in a very literal sense. There is the potential for money to be made by starting the investment process as early in life as possible. Even in a personal (taxable) account, the difference between a 40-year and a 20-year investment time horizon is $104,045 in our example. That same time difference, 40 years versus 20 years, in a tax-deferred account boosts the potential value of the account to $159,641 resulting in an extra $55,596 for retirement. This is, of course, assuming you are able to average 6% per year over those 40 years. That unto itself may be an accomplishment if current market weakness persists for a protracted period of time. Even if you reduce the average annual rate of return below 6.0%, the dollar amounts are lower but the relative outcome remains the same. Start saving and investing as soon as you can.

Tax Treatment of Personal Versus Retirement Accounts

It is also important to point out the differences in the treatment of distributions between personal (taxable) and tax-deferred (retirement) accounts. Income you receive in a personal account is taxed at the federal and state level in the year in which it is received. One of the many advantages of an individual retirement account (IRA), 401(k) or 403(b) plan or other retirement plan is that interest income from fixed income investments, dividends paid by stocks, and dividends and capital gains paid by mutual funds are not taxed every year. Those taxes on those distributions are deferred until withdrawals are made from the account.

Be advised that not every investments produce distributions. There are a number of individual stocks that do not pay dividends at all. Investors purchase shares of these companies for their potential to appreciate in value over time. In other words, investors purchase stock for $10 per share with the expectation (or hope) that each share will appreciate to $12, $15, $20, or more in value at some point in the future. When a stock doubles in value (on paper), that appreciation is referred to as an “unrealized” capital gain. A gain obtained over a period of more than one year is referred to as a long-term capital gain, and it is taxed at a much lower income rate (15% maximum). Conversely, once you retire any distributions withdrawn from a retirement account are taxed at as ordinary income. Also, if the two employees in the previous examples amass sufficient assets over their working careers, they may remain in the same income tax bracket even in retirement, rather than fall into a lower tax bracket.

When Employee #1 and #2 sell assets in their 401(k) or an IRA for a profit (a capital gain), those sale proceeds are also taxed as ordinary income (27% in our example). They do not get the benefit of the reduced long-term capital gains tax break had they same sale occurred in a personal (taxable) account. That’s the bad news. The good news is they have the potential to see substantial appreciation of the assets in their retirement account from the many years in which taxes were deferred and growth was permitted to compound over time.

So What Can You Do to Help Yourself?

If you’d like to follow the example of Employee #1 but don’t know where to start, don’t worry, it is not all that difficult. You already know how much you make, and you probably have a handle on your monthly spending. But you may not know where all your money goes. The first thing you want to consider is creating a personal budget, so you have a better appreciation of just where your money goes every day.

Establishing a personal budget

Think of a budget as a tool you can use to track your spending, analyze money flow, and then modify to increase your savings. In other words, you should be able to account for how your paycheck is spent from pay period to pay period. If you don’t know if you have enough money to participate in your retirement plan at work or open an IRA, then consider establishing a personal budget.

All you have to do is track your spending. Do this by recording your expenditures in a notebook each day for a period of two to three month. Buy a soft drink from a vending machine, each lunch out, pick up some dry cleaning, put gasoline in your car, pay a school fee, and write it all down. Create a category for every possible expense. Take any annual payments for things like life or health insurance, holiday gift spending, vacation travel, etc. and divide those bills by 12 to arrive at an estimated monthly average cost. Then put those dollar values in your monthly budget.

With two to three months of data in your notebook, average your spending for each category you established. Total all the categories, divide those values by the number of months over which the data were collected, and you have an average of your monthly expenses.

Arriving at an estimate of your “disposable income”

Once you know your average monthly expenses, you can subtract these expenses from this figure. The difference, if it is a positive number, is your monthly “disposable income.” In other words, what you have left over after paying your bills each month is money you can use as you wish. You can spend it on entertainment, take a vacation, establish an emergency fund, or make contributions to a retirement plan at work and even fund an individual retirement account.

The choice is yours. That’s why they call this “disposable” income.

In the event your bills exceed your monthly income, attention probably should first be directed to your spending habits. Sit down and analyze your budget. Are there spending categories you can reduce or even eliminate? Would it help if you “brown bagged” your lunch everyday, brought your own soft drinks or water to work, and otherwise reduced your spending? Scrutinize your budget and be creative. Try to find ways to save money without drastically altering your lifestyle.

If you cut spending but still come up short each month, consider working more, or even getting a second, part-time job. Be creative here as well. Ask yourself what you can do to bring in more money if you’ve done everything you can to reduce outflow in the spending side.

Do You Have an Emergency Fund?

Once your spending is under control, and you know how much “disposable income” you generate each month, consider setting up an emergency fund. Make this your first investment. Pundits will tell you to set aside anywhere from 2 to 6 months of expenses depending on whether you are single, married, married with children, or care for extended family members. Think of it this way. How much money do you want to have in the bank, so you can sleep comfortably each night and not worry about gyrations in the stock market. And what’s your comfort level for risk? Take your personal situation (single or married with or without children), combine that response with your comfort level for risk, and come up with a amount of money you want to have tucked away safe and set aside for emergencies. That will be your emergency fund.

Speak with your local bank, savings and loan, or credit union about the safest and best yielding account to hold the emergency fund dollars. Set up the account and slowly add to it each pay period until you hit that target amount of money.

Obviously, there are a number of alternative ways to cover unexpected expenses. If your monthly cash flow is high, you can always charge an unexpected expense on a credit card. When the bill arrives, you simply pay off the balance in full and avoid costly interest charges. You be the judge. You can approach this matter any way that makes good sense for you personally and brings you comfort.

About the Author

W. Patrick Naylor, D.D.S., M.P.H., M.S. is an adjunct professor at the Loma Linda University School of Dentistry where he lectures on personal finance and investing. He is author of the book, 10 Steps to Financial Success, A Beginner’s Guide to Saving and Investing (John Wiley & Sons, Inc.). Dr. Naylor also wrote a dental text, Introduction to Metal Ceramic Technology (Quintessence Publishing Co.).

Together with Loma Linda University he created a self-paced personal finance CD-ROM entitled “Personal Finance Series for Health Professionals” based on 16 hours of lecture. The CD-ROM consists of four parts: Series #1 - Savings and Investment Basics, Series #2 - Investment Selection I – Mutual Funds, Series #3 - Investment Selection II – Stock Selection and Investment Tracking, and Series #4 - Investing in Tax-Deferred Accounts. The topics in all four of the series are of general interest, but Series #4 contains a section devoted to retirement plans for the dental office.

The personal finance CD-ROM can be purchased from the Loma Linda University School of Dentistry for $35.00 (including shipping in the continental U.S.) by calling (909) 558 - 4685 or sending a check for $35.00 to Continuing Education, Loma Linda University, School of Dentistry, Loma Linda, CA 92350. Loma Linda School of Dentistry also has several dental CD-ROM programs available for sale.

Dr. Naylor’s personal finance book can be obtained from any of the large, online book retailers, such as www.Amazon.com, or ordered by a local bookstore. His dental textbook is available through the Quintessence Publishing (800-621-0387 or 630-682-3223).