Bad News: Single-Step Financial Solutions Can Sabotage Your Retirement Savings
What would you need to do differently to double your annual retirement savings? Does it really seem possible to accomplish that goal in just one fell swoop?
I have learned over the years that most financial advice is based upon single-step solutions: Get out of debt. Operate on a budget. Lower your taxes. The problem with single-step solutions, however, is that they rarely achieve significant outcomes (like doubling savings for retirement) well.
In fact, most of the time single-step solutions simply result in more feelings of guilt, thanks to their inability to actually improve financial outcomes in a meaningful way. The truth is that financial issues are complicated, especially when personal finances are paired with owning a small business, such as a dental practice. All your financial decisions affect one another. You want to buy new technology for your practice? That affects how you save for a child’s college education. You want to get out of debt? That affects how you save for retirement.
Needs, wants, and savings
Great financial complexity requires a simple organizing process that can be used to align financial priorities and pursue important goals. The most significant breakthrough in my career has been the discovery of a process for properly aligning needs, wants, and savings. I call it the “financial balance guide.” This guide outlines four, and only four, financial priorities that must be aligned to further retirement savings: debt payments, tax payments, large purchases payments, and lifestyle spending. Needs are defined as debt payments and tax payments. Wants are defined as large purchases and lifestyle spending. To double retirement savings, dental practice owners need to properly align their needs and wants.
A dentist I worked with recently was saving $35,000 per year for retirement. She needed to save at least $70,000 per year to generate the retirement income she desired at her chosen retirement age. She could have accomplished this goal by never purchasing new equipment for her practice, suspending college savings for her children and operating on a very restrictive budget at home. No expensive vacations. No new cars. No home improvements-for the rest of her career.
Instead of those less-than-optimal strategies, we looked at properly aligning her needs, wants, and savings. In her case, personal- and practice-related debt payments totaled $80,000 per year. Federal and state income tax payments totaled $60,000 per year. Her needs (debt payments plus tax payments) were $140,000 per year, which was 65% of her cash flow. Needs shouldn’t exceed 50% of cash flow.
She restructured her existing debt with longer terms and, in her case, slightly lower interest rates. Debt payments dropped from $80,000 per year to $50,000 per year following the restructure. She would be paying off debt more slowly, which does violate the single-step principle of getting out of debt. The upside, though, was that she recouped $30,000 to fund her retirement plan. With the resulting tax savings, she was able to put aside $85,000 per year for retirement compared to her previous savings of $35,000. Her debt payments now were only $50,000 and her tax payments fell from $60,000 to $40,000 annually. Her needs dropped from $140,000 per year to $90,000, resulting in additional retirement savings of $50,000 per year.
What about the issue of paying off debt more slowly? Doesn’t everyone want to get out of debt as quickly as possible? In our dentist’s case, her increased savings resulted in an additional $1.5 million of retirement savings by the end of her career. Even though she would be paying off debt more slowly, her plan would still allow her to be out of debt by the end of her career. The trade-off is that while she will pay more loan interest over her career (longer terms), she will also increase her retirement savings by $1.5 million and achieve a greater degree of financial security. The greater security results from locking in a much lower cash flow requirement following the change in the terms of her loans. If the economy shrinks, her practice will be more likely to survive with lower required debt payments.
Single-step financial solutions feel right. After all, who doesn’t want to pay off debt more rapidly or achieve disciplined spending through a budget? Good feelings, however, won’t necessarily result in better financial outcomes.
This commentary originally appeared February 11 on DentalEconomics.com
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