CHAPTER 9
Retirement Planning
If I’d known I was going to live so long, I’d have taken better care of myself.
Leon Eldred
Most dentists realize that they will not be able (or want) to practice their entire lives. Private dental practitioners do not have pensions or retirement income plans funded by a large employer. Instead, they are responsible for funding their retirement savings. When they retire, they draw down their retirement savings as they withdraw funds for living expenses. The obvious fear is that retirement will last longer than the retirement funds. Retirement planning then becomes a critical personal financial planning task. Fortunately, dentists are relatively highly paid professionals. This makes it easier than for many other vocations to set aside money for retirement planning. For the more straightforward plans described in this chapter, a dentist can work with the office accountant or financial planner to select and carry out a plan. For the more complex plans, practitioners will need to use a specialist in retirement plans. Fortunately, if a dentist starts a plan early and funds the simpler plans with the maximum amount permitted, they should not need the more complex (and more expensive) plans. A dental practice owner might use several types of retirement plans. Congress and the Internal Revenue Service (IRS) change the tax implications of these plans frequently. Practice owners must check with an accountant or tax advisor for the current tax laws before establishing or contributing to a plan.
This chapter describes the principles of retirement planning for dental practitioners (Box 9.1). For many, retirement implies a gold watch and a porch swing. But people are living longer and healthier lives than in the past. Many dentists are retiring at a younger age than in years past. Some of them leave work entirely. Some pursue a hobby or a second career. This leads to more years of retirement and a more active (and expensive) retirement. Others continue to work well into their later years, working part‐time. For these reasons, many financial planners prefer to call this process planning for financial independence rather than for retirement. Financial independence is the time in life when someone can work or not. They have adequate resources to support themselves and their family in their chosen lifestyle.
Retiring from dental practice involves significant personal self‐examination and planning. Many private practitioners have so much of their self‐esteem committed to their practice that it becomes difficult for them to walk away. This, after all, has been a large part of their professional and personal identity. Successful retirees develop projects and interests that extend well into retirement. These tasks provide emotional and intellectual challenges that lead to high self‐esteem. Playing golf every day sounds wonderful when someone works every day. After playing every day for a month, golfing may lose some of its luster. Sometimes people think only about the financial aspects of retirement planning. Personal emotional preparation is as essential and often inadequately addressed. However, this chapter examines only the financial bases of retirement planning.
COMPONENTS OF A RETIREMENT PLAN
Retirement planning for dentists is like a three‐legged stool: each component is necessary for the system to work, but none of them can work alone. The three components of retirement plans are Social Security, private savings and assets, and retirement savings and pensions.
SOCIAL SECURITY
Self‐employed dentists pay into the Social Security system through the SETA self‐employment tax. If a dentist is employed by someone else or their own corporation, then the employer pays half the Federal Insurance Contributions Act (FICA) Social Security payments. (If dentists own their corporation, they pay both halves.) Given the aging of the US population, Congress continually grapples with the problem of funding Social Security. Social Security retirement payments are not large to begin with. In the future, higher‐income earners will pay more (both while working and in retirement) to help keep the system solvent. This effectively decreases their return. So, although Social Security will probably not end in the future, most dentists should not plan for Social Security to be a significant part of their retirement income. They need to plan as if Social Security will not exist. Any payments received from Social Security will then be a bonus. Practitioners ought to keep up with the news and the changes that Congress makes in the Social Security system.
Everyone should regularly check their Social Security status and benefits on the Social Security website (www.ssa.gov). The Social Security Administration provides an online “Personal Earnings History and Benefits Statement.” This is a history of reported earnings (throughout a person’s lifetime) and an estimate of benefits at retirement. (The statement also shows estimated benefits for disability and for a surviving spouse and children.) It shows benefits in today’s dollars, although actual benefits are indexed for inflation so that the amount will be higher.
PRIVATE SAVINGS AND ASSETS
Private savings are those made with after‐tax money. Examples include a dental practice, a home, and most investments. Financial assets (investments) are a valuable component of the total retirement asset base. Someone can turn these assets into immediate income by selling them (stock, etc.) or using any income (such as dividends) for personal income. Private savings and investments are generally used for non‐retirement purposes. Some assets, such as a home or an automobile, should not be included as a component of a retirement plan because they will be needed in retirement.
Many dental practice owners plan on selling their practice to fund their retirement plans. This is a risky strategy. They may be unable to sell the practice when they want to sell or at the price they hoped to get. Taxes then eat up a sizable portion of the proceeds, which may leave them with too small a remaining asset base to fund retirement adequately. Many practitioners then find that they cannot afford to sell the practice and retire.
RETIREMENT SAVINGS AND PENSIONS
The essential component of most dentists’ retirement plans is their retirement plan savings. These are funds specifically earmarked for retirement savings purposes and are designed to be a retirement savings method, not a personal savings plan. If someone withdraws money from retirement plan savings for other uses (e.g. to buy a boat), they will face significant taxes and penalties. “Qualified” plans receive favorable tax treatment for both employer and employee because they comply with specific IRS code requirements. Overall, these requirements protect employees through non‐discrimination and fiduciary responsibility rules. Retirement savings are good investments because people fund them with pretax money, and they grow tax free until withdrawn (possibly in a lower tax bracket). However, this advantage only comes with specific stipulations, the largest of which is that the dental practice owner (the employer) must also fund their employees’ retirement plans. As a rule, a practice owner funding their tax‐advantaged retirement plan to the maximum amount permitted is still advantageous. (Details about retirement plans are found later in this chapter.)
Some dentists will have a pension to provide retirement income. A pension is a set income that the retiree receives each month. This may be indexed for inflation, and it may be for their life and the life of their spouse. Large corporations and government organizations more commonly provide pensions. A dentist generally only sees a pension if they have been employed by the military or other branch of government for many years. They are being phased out as a business retirement plan in favor of one of the Individual Retirement Account (IRA) or defined contribution types of plans described later.
Retirement plans allow someone to save money with many tax advantages. When they retire, they live off these savings. If they have adequate savings, they live off the investment increase (interest and gain), leaving the principal intact. If the savings are inadequate for this strategy, they must gradually erode the principal or lower their retirement income expectations (Box 9.2).
PRINCIPLES OF RETIREMENT SAVINGS
The following principles apply to all investments, especially tax‐advantaged retirement plans.
TIME
The longer the time until retirement, the more the investment will grow. The rule of 72 is an excellent method for determining how quickly an investment will double (see Box 9.3). This rule says that the time for an investment to double equals 72 divided by the investment rate of return. For example, if someone earns 6% on an investment, it will double in about 12 years (72/6). This can also estimate any compounding value. For example, a person may expect inflation to be 3%. Prices for goods and services then will double in approximately 24 (72/3) years. A financial advisor has calculators that are more exact, but the rule of 72 is a good estimator for how quickly an investment can grow.
COMPOUNDING
Compounding is one of the most powerful concepts to understand in retirement planning. Compounding occurs when someone earns interest on the interest they have already earned. The value of an investment then mushrooms as the portion they contributed decreases. Compounding needs time (many years) to work, which is another reason to begin retirement plan contributions as early in a career as possible (Box 9.4). The sooner someone begins retirement plan contributions, the more compounding helps, and the healthier the retirement plan will be.
TAX SHELTERING
Retirement savings gain their advantage because they are sheltered from taxes. Tax sheltering means that a person gains an immediate tax deduction for the contribution (tax deductible), and the investment grows tax free until they draw it out of the fund (tax deferred). This allows for a higher return (the money grows tax free) and a possibly lower tax rate when they withdraw the money. Note that these plans defer taxes until retirement; they do not altogether avoid or eliminate income taxes.
Tax Deductibility
Qualified retirement plans use pretax money for funding. If someone is in the 33% marginal tax bracket, that means that for each $1000 they contribute, they get a total of $1000 going toward retirement savings. A posttax (taxable) contribution means that for each $1000, the person must first pay 33% in taxes ($333) and then invest the remainder ($667). The total return will be less. Box 9.5 shows the difference between using a tax‐deductible retirement plan and not using one.
Tax Deferral
Qualified retirement plans also grow with tax deferred. That means the owner does not pay income tax on the earnings until they withdraw them at retirement. Assume someone is in a 25% marginal tax bracket and earns 8% on an investment (i.e. a $10 000 investment yields $800 per year). If the investment is in a tax‐advantaged retirement plan, they keep the entire $800. Next year, that person earns 8% of $10 800 (the initial $10 000 plus $800 earned last year) and so on (i.e. compounding). The same investment in a taxable account would only yield a $60 return. A person would earn the same $800 but pay 25% ($200) in taxes. Compounding is slowed significantly under this later scenario. Box 9.6 shows the power of adding tax deferral to tax deductibility.
RISK–RETURN RELATIONSHIP
A general rule of investing is that the higher the risk, the higher the return required to get people to invest in the project. Risk is a measure of the variability of the return on investment. Figure 9.1a shows that lower‐risk investments tend to have lower total returns and lower swings from high to low. Higher‐risk investments (Figure 9.1b) have greater long‐term returns and “ups and downs.” The timing of when the person needs the investment plays a key role. The practical effect of this principle is that early in a career (and a retirement plan), someone can tolerate more risk (and gain a higher return) than later in the plan. At this later point, people generally want to preserve their gains as they begin to draw money from their funds.
FACTORS THAT DETERMINE PEOPLE’S ABILITY TO REACH RETIREMENT GOALS
As a rule, a person will need 75–80% of their preretirement income as a level for their retirement income. This can vary depending on the situation. Most retirees have lower monthly costs due to not buying work clothes, traveling to work, or other costs (such as meals) resulting from work. At this time in their careers, most people have also paid off their house mortgage and other loans. They have fewer purchases as the children grow and leave home. On the other hand, they may have higher expenses in some categories, such as travel and entertainment, as they act on their retirement dreams.
Several factors determine whether someone can meet their retirement income goal.
FIGURE 9.1 Risk and reward. (a) Low‐risk investment. (b) High‐risk investment.
INCOME LEVEL DESIRED
The higher the income someone requires in retirement, the more retirement savings they require. This makes intuitive sense. The tricky part is to quantify how much is enough. As with all investment decisions, estimating based on expected returns and inflation is the best thing to do. One significant problem early in a career is estimating what inflation will be by the end of that career. An income level of $20 000 per month today may be paltry when the effects of 25 years of inflation are considered.
ESTIMATED LENGTH OF TIME IN RETIREMENT
How long a person will be in retirement depends on their age at retirement and an estimate of the longevity of that person and their spouse. If they retire when they are 55 years old, they need to plan for a longer retirement than if they retire at age 80, all things being equal. The longer the time in retirement, the longer that person needs to be concerned about inflation eroding the buying power of their retirement income. Each person needs to look realistically at their family history, personal health, and habits when estimating life expectancy. (An honest appraisal of an expected lifetime is an important exercise.) If someone has a family history of heart disease and does little to address it, they can plan to have a shorter time in retirement than otherwise. They must also plan for their spouse’s lifetime income in retirement if that spouse depends on them for income. As a rule, everyone needs to plan on living until the age of 90 if they have no significant health problems. This allows for a complete retirement for about 90% of Americans.
PRESENT RETIREMENT SAVINGS PATTERN
A person who only saves $1 per year will not realize their retirement goals. Although saying that people should increase their retirement plan contributions is easy, each person must evaluate their personal budget to identify areas of possible savings. To do this, they must first have a budget and know where they spend money. They must rank retirement savings along with other long‐ and short‐term goals. (Once they earn money, it can only be saved or spent.) These priorities will change as stages of life and family circumstances change.
COMPOSITION OF NET WORTH
Two people may have the same net worth but have different income‐generating potential from their assets. In Box 9.7, both dentists have the same net worth. However, Dentist 2 has more assets in their home, which does not produce retirement income. Dentist 1 has a more significant value in their retirement plan and, therefore, a more considerable monthly income in retirement.
INVESTMENT RATE OF RETURN
Risk is a measure of the variability of an investment. There is always some risk that the underlying company, country, or other entity will become insolvent. Then investors will lose their entire investment. That occurrence is rare with mainstream US Wall Street investments. Instead, the greater risk is from the normal fluctuations of the economy. The primary risk is that the value of an investment will decline just when someone needs the investment. How assets are allocated within the retirement plan becomes essential for an adequate return.
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