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Prepare for the future when times are good so it is easier to weather possible storms from a strong financial position.
We all go through ups and downs in life. There are many things out of our control, but one of the things we can control is how we prepare for the future. It is much easier to weather the storms in life if you are in a strong position financially.
Two important items that we have observed over the years in working with physicians are liquidity and adequate disability insurance.
Debt is a wonderful tool. If it was not for debt, it would be hard to buy your first house, a new car, or receive an education.
However, debt used without the proper understanding of risk can cause enormous problems. Many times, this debt is incurred when times are so good - people cannot imagine a scenario when they would get into trouble. Think high-margin debt on a stock portfolio, real estate loans with high debt to equity, and investment products offering attractive yields that are using leverage to generate that return.
Debt also has to be serviced, so if hard times hit, you need adequate liquidity to service your debt for an extended period of time. Six months is the typical rule of thumb for a liquid reserve fund, but that varies and could be longer depending on the expenses and fixed costs that you would need to pay. “What if” analysis and stress testing of your situation is important to identify any areas of weakness and making sure you are putting yourself in the best possible position for success in the future.
The safest way to hold a reserve fund is in cash. If your bank is not paying around 1% interest, consider some of the online banks that pay higher yields that are covered by FDIC insurance. As the Federal Reserve begins to raise interest rates, holding cash will become a little easier. Over and above this, having a diversified non-retirement investment portfolio could also serve as part of your reserve fund. Just keep in mind that you do not want your reserve fund going down at the same time you need it, so be aware of the risk you are trying to protect and the risk you are taking in your portfolio. Many clients will also have an untapped line of credit as an extra reserve. The bank can always decrease or not renew this line, but that would be an extreme circumstance. Ideally, all of the above is a good strategy.
One of the keys I have observed in life is there is a certain peace of mind that comes with living below your means. This leaves margin for things to go wrong and the compounding impact of savings and paying down debt allows for significant financial freedom and peace of mind.
Who likes paying for insurance? I have yet to meet anyone that does.
There are plenty of other goals I would rather fund than pay for insurance premiums. In looking at insurance, you are making several choices. Are you self-insuring the risk, partially insuring, or fully insuring the risk? This may be a different decision depending on the type of insurance. For doctors in their working years, their human capital is most likely their most valuable asset. Take a doctor who will make $200,000 for the next 30 years. At a 5% rate, that is a current present value of $3,075,000. Put in that context, your current earning capacity is definitely something worth insuring and puts some of the cost of disability insurance in the proper context.
A common mistake we see is individuals deducting the premium of their disability insurance. While this gives a small tax deduction now, it can potentially cause significant taxes in the future. Ideally, disability insurance is paid with after-tax dollars. This could mean a doctor pays the premiums individually or pays through an employer; some businesses allow you to impute the premium as income each year. We use this planning opportunity regularly for new clients. One of our clients was able to begin paying the disability premiums on an after-tax basis and had to start taking disability benefits a number of years later. She will receive $10,000 a month tax-free for almost 15 years, rather than having to pay income tax on the $10,000 if she had continued deducting the premiums. At a 30% tax rate, this small adjustment to paying disability premiums will save her over $500,000 in taxes over the next 15 years on the $1,800,000 in disability benefits she will receive.
The time to plan is when times are good. Make sure you are enjoying life as it goes along, while also putting yourself and your family in the best possible position to have long-term financial success.
Bill Cleveland, MBA, CPA, CFP, is a partner and senior adviser for Preston & Cleveland Wealth Management, LLC, with offices in the Southern U.S. Cleveland is a fee-only CFP and a member of the National Association of Personal Financial Advisors (NAPFA), providing comprehensive financial planning and investment management services to individuals and retirement plans across the country. He can be contacted at email@example.com.