Over the past few weeks, we’ve tackled so many of the largest issues including living within your means and your rate of return. Yet, there are a few other key areas that need to be considered before your retire.
- Difference in Ages Between Spouses
- Family Health History
- Dependent Kids (health or addiction issues)
- Kid’s College Expenses
- Cars, Second Homes & Cabins, and Other One-Time Purchases
I find that these areas are often neglected, left flapping in the wind in many financial plans.
Some of these are really scary!
In May 2012, my family and I were blessed with having our second child, Evangeline (Eva). She was born nearly four months ahead of time at a total weight of 12.5 oz- 3.5 oz short of one pound. Our miracle baby! The next seven months were grueling and trying times as we ran back and forth from the hospital. Finally in late September 2012, we brought her home on oxygen and six or seven meds. I’m not sure what the hospital bills were, but I call her our million dollar baby.
One day in August 2012 as I sat holding her, I thought of our first daughter Gabby as well as Eva. I could see the sky-high costs of college as I met with clients. How can I put my kids in the best possible position for financing their college education? I don’t want to shell out 200k or 300k nor have them carrying that kind of crazy debt load, or possibly both! That raises the hair on my neck, yuck!
In the last year, one client and their son were looking at an engineering specific university that cost 65k/year!! They didn’t get all that much in financial aid except in loans and it was evident that these costs could totally sink their financial plan!
That’s $260,000 over 4 years. Unbelievable.
Let me illustrate a few of these examples and how they can change the financial plan.
Scenarios# 1 through 3: 45 year old Orthopedic Surgeon With Current $530,000 Portfolio (433k Income, 110k living expenses, 40k Savings, Has an Employer Pension, Student Debts paid off in a few years, Living Expenses of 110k)
Retires at Age
Living Expenses Age 65
Money At Retirement
Money at Death, Age 90
In scenarios 1 through 3, we can see the impact of inflation. My inflation assumption of 3.71% is the long-term average over the last 4 or 5 decades.
I assume that both wages and living expenses move with inflation. Most physicians and financial advisors may argue that wages for doctors may stagnate while living expenses go up.
Personally, I don’t buy that argument. While it is true in certain practices and niches, overall compensation for physicians has continued to rise close to, if not exceed inflation- particularly for younger physicians.
It is something that we have to keep an eye on and certainly if Medicare reimbursements radically change then we may need to revisit that assumptions.
Anyhow, check out how living expenses differ between the three. This leads to drastic changes in retirement.
In Scenario 3, where the 5% inflation number leads to a higher overall portfolio balance (due to higher $ savings), the 6% draw plus 5% inflation transforms to an inflation-adjusted 11% draw rate.
This kills this portfolio- so much so that there is huge negative number!!
Meanwhile, in scenario 2, there is a 2% inflation rate & a draw rate of slight less than 4%. This leads to an inflation adjusted slightly less than 6% draw rate. This means that you are EARNING more than you are drawing out and the balance grows and grows and grows. You NEVER touch the principal in this scenario.
What does this all means?
Some folks make the argument that inflation is likely to be SUPER HIGH over the next 10 years because of all the printing the Federal Reserve and our government has done.
Yet others argue that we are subject to deflation or low inflation because of the consumer being constrained by debt & the velocity of money slowing down.
In the last 10 years, the low inflation camp has won out and the numbers continue to show this scale is likely to continue.
Overall, for a saver, low inflation isn’t an issue as long as you can earn a medium sized rate of return.
Thus, I still firmly believe that 3.73% is the right number because it will help you make more potentially conservative projections. You can run higher numbers to “stress test” the plan. However, don’t freak out about it.
If we have low inflation, you’ll be made in the shade as in your working years your inflation-adjusted living expenses stay relatively low and you save and save.
I am much more concerned about living expenses and the rate of return that you achieve because those two factors are much more in your control as you are the one who determines what you spend and your overall risk tolerance (i.e. how aggressive or conservative the portfolio is).
If you are living within your means and only drawing earnings, you shouldn’t have to worry about what inflation does.
Scenarios# 4 through 6: 45 year old Orthopedic Surgeon With Current $530,000 Portfolio (433k Income, 40k Savings, Has an Employer Pension, 3.73% Inflation, Student Debts paid off in a few years, Living Expenses of 110k)
Retires at Age
Money At Retirement
Money at Death, Age 90
Meanwhile, taxes are a very interesting subject and a concern that I personally have in the future for virtually any physician.
For the last fifty years, effective tax rates had gotten lower and lower and lower until 2008.
Then, with the passage of the Affordable Care Act (Obamacare), our taxes started to climb for the first time in many years.
In addition, our entitlement programs & overall government spending are out of whack. The government is consistently taking in FAR less than they are spending.
Payroll taxes which consistent of employee and employer contributions totaling about 15% are SUPPOSED to pay-as-we-go.
But, we’ve lived longer and longer and longer yet the entitlement system & tax system hasn’t changed a whole lot.
There are many proposed solutions to this problem:
- Raise eligibility ages for Medicare & Social Security
- Eliminating social security altogether for the “wealthy” (i.e. they pay into the system, but never get anything back out of the system)
- Lowering compensation to physicians through Medicare
- Decreasing the cost of Medicare via malpractice by establishing limits on punitive damages
- Eliminating the cap off of social security (currently only taxed up to $118,500 in 2015)
- Increasing the overall tax rate on payroll taxes (15% to 20%?)
- Eliminating inflation adjustments from Social Security
- Eliminating the maximum that social security can be taxed (currently a maximum of 85% of social security income can have federal income taxes)
- Adding on a payroll tax to ALL income including dividends, capital gains, etc
- Eliminating itemized deductions (including state income tax deductions)
- Raising overall tax brackets, and much more.
The reality is that as a physician nearly ALL of these directly affect you in one way or the other, and almost all of them negatively.
While politicians so far have been scared to touch the “third rail” and get electrocuted and removed from office by the voters, sooner or later (likely at the last possible minute) they will coordinate their efforts and get something done.
Thus, in your financial plan, make sure that you consider the following income-linked taxes that you pay directly out of your pay check:
- Social Security (6.2%, currently capped at $118,500)
- Medicare (0.8%, unlimited)
- Medicaid (1.2%, unlimited)
- Federal Income Taxes (Tiered with deductions- often minimum of 20% for physicians)
- State income taxes (State dependent, most have it, a handful do not, often a minimum of 5% for physicians)
- For all the scenarios we ran, we gave 44% total during the working years which was inclusive of ALL of these taxes. Yours may be more or less, but given the income this physician is making- this is right on the dot.
- Because taxable income drops so much in retirement, we assumed that tax rates went DOWN as I have seen for virtually every single client. I think this is reasonable to continue to assume in the future.
For your own personal situation, pay very close attention to how taxes may effect your working years.
I would STRONGLY suggest making a goal of saving MORE rather than less to the best of your ability. An extra $100/month or $200/month could help to adjust for any changes that may be coming down the road.
Takeaways and Action Steps:
- Consider all the “extras” in your financial plan. For example, how much do you plan on contributing to your kids education? How often do you replace your car?
- Do you have any dependent, special needs children that are going to need financial help after you pass?
- Do you have all of those “extra” expenses increasing with inflation?
- Review over your inflation assumptions. Try using 3.73% as a baseline, but consider 2% as well as 5% to “stress test” your plan.
- Consider how much you currently pay in ALL the different kinds of income-linked taxes. Add it all up. Test your plan to see what would happen if those taxes increased by 1%, 2%, and 5%.
- Make sure to consider taxes in retirement- that should be substantially lower than in your working years.
- Work to save as much as you can- consider bumping up your savings $100/month or $200/month to try to adjust for possible future tax increases that may reduce your ability to save later on.
Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation.
Please consult with your accountant or tax advisor for specific guidance.