I’m sure I’ll leave something off the list, but let me give it a quick try. Here are some of the tax-favored saving opportunities Uncle Sam offers (that might apply to a dentist):
- SEP IRA
- SIMPLE IRA
- Roth IRA
- Roth 401k
- Cash Balance Plan
Let’s talk about just one of these options to illustrate the power of tax-favored status and compound interest in growing wealth: the Roth IRA. The Roth IRA was born in 1997 and was named after the chief legislative sponsor, Senator William Roth of Delaware. (The next time someone talks about how Delaware has never contributed anything to the country you can bring up this factoid.) The Roth IRA is wonderful because money contributed grows tax-free and if money withdrawn meets certain criteria then it comes out tax-free as well. Contributions are not tax deductible, so versus a traditional IRA your marginal tax rate plays a significant role in determining which might be the better tax shelter–but that’s a discussion for another day. Currently an individual may contribute up to $5,500 per year (or $6,500 per year if you are at least 50 years old), but the amount may not be greater than total taxable income for that particular year.
Imagine your 12 year-old earned $3,000 working odd jobs last year (2017). Now imagine he puts that money away into a Roth IRA in a Vanguard total stock market fund and doesn’t touch it again until he turns 70 (conservative guess as to future retirement age). Assuming a rate of return of 8% (and ignoring the ravages of inflation) that paltry 3,000 dollars will have grown into the handsome sum of $305,886.47.
Now imagine he adds another 5,000 dollars per year until age 70. This is not that outlandish of a thought. You could help reimburse him for the money he contributes to the Roth IRA until he is old enough to support himself financially and his own earnings allow him to contribute 5,000 per year. How much will he have if he does this? $6,616,021 dollars. That’s right. He will have contributed only 293,000 dollars over that time frame, but the the miracle of compound interest will have added another 6,323,021 dollars. Incredible. Keep in mind he will have paid very little tax on that money as it went in (depending on his marginal tax bracket) and he will pay no tax when he takes it out in retirement. Retirement planning solved! Of course inflation will eat away at that nearly 7M figure and in today’s dollars it will be worth significantly less. Still, that’s not bad considering we are talking only about funding a basic Roth IRA. Hopefully through his employment in the future he will have access to other tax-favored retirement vehicles such as a 401k, profit sharing plans, cash balance plans and the like. If his income rises such that he no longer qualifies for a direct Roth IRA contribution (income limit is $135,000 for single filers and $199,000 for joint filers) then he can simply do a traditional IRA contribution and convert it to a Roth–the so-called “backdoor” Roth. Also note that $5,500 is the maximum up to age 50 so in our hypothetical example he could have put a little more away from the beginning. Once he hits 50 he can contribute $6,500. These contribution limits should continue to rise over time so again, the hypothetical I described is not unrealistic by any means. Making the effort to actually get going and keep it going is the key. The opportunity is there. How many people make the (relatively small) effort to do it?
Dentistry is the perfect fit for those who wish to maximize contributions to IRA/401k etc
As a dentist and business owner, you can provide gainful employment to your kids. Does your office need a part-time janitor? Can your teenager do landscaping work around the building? In order for a minor to contribute to a Roth IRA they only need to have earned income equal or greater than the amount of money they contribute to the Roth IRA (up to the $5,500 limit). This money can come in the form of babysitting (for other families, not your own), doing odd jobs around town or in the form of W2 wages. If income from non-W2 sources is used to support the contributions then this should be documented. Ideally, this documentation would show the service provided and amount paid along with a date and a signature or initials by the “employer.” Not only is this a wonderful way to give your kids a huge head start on their retirement, but it’s also a fantastic way to teach your kids about the way investing works and the power of time and compounding interest.
As the owner of a small business you are responsible for a lot of different things in terms of running the business day to day. This can lead to some real headaches and stress. The positive side to this, however, is that as the owner of the business you can pick and choose how you want to set up your retirement plan through the office. There are various types of plans (solo 401k, SEP, 401k, Roth 401k, 401k/profit sharing, cash balance plans etc) and each has its pros and cons, depending on your particular situation. If you are an employee then you are stuck with whatever your employer offers. Early on in your career you might want something simple like an SEP IRA or SIMPLE IRA, but later as your income grows and the number of staff in your office increases you might go with a 401k with profit sharing. Toward the end of your career you might look at doing a cash-balance plan to turbo-charge your retirement savings.
They key to investing is to actually do it! As a dentist and business owner you can streamline this process to match your needs better than so many other professionals who are employees of companies, hospitals or government institutions. Maximizing your contributions to tax-favored accounts is one of the key ways you can be financially successful in dentistry.
Have you reviewed your current situation? Are there any acronyms from the list at the beginning of this post that aren’t familiar to you? I’ll cover more of the nitty gritty details in future posts, but I would be happy to help anyone who is getting started with these tax-advantaged entities. Are you maximizing your ability to make the most of these opportunities the government (for the time being) provides? What are you plans to utilize tax-favored vehicles in the next 5 years? 10 years? For retirement?