You don’t have to be a math whiz or use fancy spreadsheets to understand many parts of your personal finances. Sometimes it’s just a matter of elementary school math: basic addition and subtraction.
Let’s take a look at a few simple formulas you should be familiar with and some financial lessons you can learn from them:
Spending = Income - Savings
You’ve heard the phrase “pay yourself first” but many physicians reverse this equation to look like this:
Savings = Income - Spending
That’s known as “pay yourself last” -- it’s one of the big reasons why so many physicians wonder why they have to continue working full time into their 60s. I’ve said it many times and I’ll say it again: if you’ve practicedmedicine full time for the past 20+ years, and you have not built up a multi-million dollar retirement portfolio, you probably haven’t saved enough.
One reason may be overspending on your home. Here’s how you can apply this equation to figuring out how much you should spend on your home. Take 20% of your gross income -- that should be your savings rate. Then whatever is left over after taxes is what you can spend including your mortgage. You can then calculate out the max value of the home you can buy based on terms of the mortgage.
Net Worth = Assets - Liabilities
I’ve met many asset-rich physicians who are actually poor. This usually means they’re carrying a ton of debt. Here’s an example: you buy a $1 million home and carry $900,000 of mortgage debt. There are physician home loans out there that you can get with very little down payment. I’m not saying those are a good deal, but I’ve seen physicians take the bait -- especially physicians who recently graduated from residency. When you factor in other debt such as student loans, you can see that it’s possible to accumulate a large amount of assets but have a negative net worth. Your goal should be to maximize net worth not assets to build wealth.
Taxable Income = Total Income - Deductions
There’s a misconception that your income tax is based on your total (gross) income. If you look at the federal income tax brackets you’ll see it’s based on the taxable income, which is calculated after a number of deductions and exemptions. How do you maximize your deductions and minimize your taxable income? Here’s a partial list of deductions that may apply to you as an emergency physician:
Health savings account deduction
Deductible part of self employment tax
Self employed, SEP, and qualified plans
State and local income taxes*
Real estate and personal property taxes*
Home mortgage interest*
Gifts to charity*
*on Schedule A of federal income tax return
If you’re an independent contractor, your largest deduction will likely be your retirement plan -- typically a SEP IRA or individual 401k. Depending on your age, income, and type of plan, you can sock away up to $59,000 in 2016 pretax. Assuming you are in the 33% tax bracket (married filing jointly) the contribution lowers your taxable income for tax savings of around $20,000.
Total Return = Capital Gain + Dividends + Interest
You might disagree with me on this one, but hear me out. A popular investment strategy touted by many financial advisors and followed by many investors is to have greater exposure to dividend paying stocks. You might even think that the value of your retirement portfolio you need to build up should be based only on the dividend payouts. The idea is that you don’t touch your principal and instead live off the dividends.
The reality is that the only return that matters for any investment is the total return not just the dividends. Here’s a hypothetical example. Suppose you have two investments A and B. Investment A pays 0% in dividends and has a price gain of 10%. Over the same period of time, Investment B has paid 4% in dividends with a price gain of 5%. Which investment would you rather have? Obviously there are other factors to consider, but the point I’m making is that your investment decisions and your ability to withdraw money during retirement should not just be based on dividends. Money is money whether it comes from price gains or dividends. In the end it’s total return that matters.
After Tax Return = Total Return - Taxes Paid
Taking the previous equation one step further, one of the goals in your investment portfolio should be to maximize after tax returns not necessarily minimize taxes. For example, which would you rather have? Investment A which has a total return of 10% and you pay 2% in taxes or Investment B which has a total return of 6% and you pay 0% in taxes. Don’t let taxes dictate all of your investment decisions, and be especially careful of investment products (usually sold by commission based financial advisors) that entice you with the phrase “tax free.”