118: Dental Financial Planning: Turning Chaos into Financial Freedom - Part 8

Welcome back. Excited to be with you again. We are carrying on our series on financial planning for dental practice owners Turning financial chaos into financial freedom. I just got done with two episodes on the tax side of phase three which is doing a business financial plan to support your. What was phase two? Personal financial plan for independence. So going through the sequence, number one, assemble a great team, have a systematic cadence of meeting with them. Find a management system in my preferred sort of system of team formation of roster building is to meet on a regular cadence. We use EOS over here at practice CFO in the dental space. There's one called deo. I'll give him a little shout out. Dental entrepreneur organization which is sort of a spin off of EOS for dentists. I think they do have a little bit higher fee where an EOS you could essentially self implement that at no cost other than a few books and then also make sure to meet with these. This team regularly use a system, a software, a format of how you run these meetings and the cadence that is phase one or step one is to develop your team. Number two is the personal financial plan. Number three is the business financial plan. Four supporting the personal financial plan. And then number five is monitor, implement, monitor and revise. And all right, so now we are in that phase three, a business financial plan. We talked about your financial reporting, we talked about your breakevens, we've talked about your tax plan. Now I'm going to talk about determining your payroll. Step four within this section, determine your payroll as an S corp practice owner. If you're a sole prop. This doesn't apply it if you are doing more than roughly 800,000 or so in collections you should probably convert to an S corporation from a sole proprietor. Please don't be a C corporation. If you're a partnership, please own your partnership through a wholly owned S corporation. That's what's called a partnership of corporations. And so you will as an S corporation owner you need to pay yourself a W2 as an employee of your own corporation, how much should you pay yourself? That's the subject of this episode. It's going to be a shorter1. Number one. Number one is if you do not have a retirement plan and when I say retirement plan, there's two semantics around retirement plan. One is you met with the financial planner. You forecast it out. When you want to be financially independent, you back into what you need to be savings and what you need to be doing to meet that long term goal. That is a retirement plan. But in the context of your business, a retirement plan is These things called 401ks or SEP IRAs or, or simple IRAs or cash balance defined benefit plans. And there's a few others. These are all under this act called the ERISA act, the Employee Retirement Income Security act, which was I think from like the 60s or 70, a long time ago. But it put into place this sort of tax advanced advantaged investment vehicle that businesses can set up large or small. Even if you're alone with no employees, you can set up a Solo 401k, which actually a beautiful thing, but you can set these up. You're able to get a tax deduction by funding it and by deferring some of your income that you would pay taxes on today into it and getting a tax deduction. So in other words, it's not tax. That portion of your income is not tax, is not taxed Are you looking.

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Which is the same thing as a tax deduction. It's not taxed and or you can do a Roth 401k, which I love Roth 401ks. You do pay the taxes today. It goes into your 401k or Roth IRA on the outside of your business, but on the inside of your business it's a 401k. Not, not, not a traditional IRA. I don't like SEP IRAs. Never have. You can't fund as much into them and you have to fund a lot more for your for your team. I've never been a fan of simple 401ks because you can't fund much into those things. And never, never, never have I intentionally set up a simple or SEP IRA. I've set up plenty of solo 401ks for doctors who are independent contractors, maybe roaming specialists who don't have employees. Done a lot of those. And I and but our standard is doing a traditional 401k. When you set that up, you as the employee of your own corporation can do a regular 401k or you can do a Roth 401k contribution. It is 23,000 if you're under today, in 2025. If you're under age 50, you can add on another 7,500 if you're older than age 50 for 30,500 total. That is the employee portion. And then on top of the employee portion, you can fund an employer portion and there's two buckets there. There's what's called the safe harbor and the second one is called the profit share you can fund. The safe harbor is means that if you Safe harbor always means this in the tax code. If you do A, then you're allowed to do B. In this case, the safe harbor is if you fund a certain amount to the employees as an employer contribution as a benefit, not not them paying out of their own paycheck, but you pay them. If you pay them a certain amount, it allows you to fully fund that portion for yourself. The 23,000 I just mentioned. Or if you're older than 50 to 30,500. Okay. That the employee portion is called the elective deferral. They're electing to defer some of their income into the 401k elected deferral. EDS elected deferral. And.

And your employees, they determine, they determine that amount. That's no skin off your back. But in order for you to fund your own elected deferral as the owner or your spouse on there as well, you got to fund a little bit to your, your team. And that's called the safe harbor contribution safe harbor. If you do this, I. E. Fund a little bit to your team, you can do that, I. E. Fund your elective deferrals and you as well as an employee of your incorporation, get a little bit of safe harbor. Now, the safe harbor allows you two options. You can do a match where you match dollar for dollar what they put in, or you can do an automatic 3%. So if they don't put in anything but they're eligible because they've been there long enough, then they get 3% of their pay no matter what. Now, if you're going to do that third bucket called the profit share. So the three buckets are the elected deferral, the safe harbor, the profit share, the safe harbor and the profit share is the employer portion. If you're going to do that third bucket of profit share, then we usually recommend you actually do the 3% automatic option for the safe harbor because that, that plays double duty. That dollar that you put in the safe harbor also covers your staff in the profit share portion, which is a bigger portion. You can, you can throw in usually another roughly 25 to $30,000 a year into the profit share for yourself. But that's usually going to come at about 20% of that will be added to it to cover your team. And the safe harbor option of 3% allows you to do more at a lower staff cost collectively across the safe harbor and profit share. Typically, if you don't do that last layer of a safe harbor, then I would recommend the match the match option for your safe harbor. If you don't do that last option of the profit share. Sorry, that last option of the profit share, then I probably would just do a match for the safe harbor. Now that was maybe a bit much, synthesizing that down, topping off one more time. In the 401k, you have three buckets that you can fund. You, you have the elected deferral out of the your employee paycheck. In your own paycheck, you have the Safe harbor, which you have to do if you want to do your bucket one for you personally. And then you have the profit share, which is bucket three, which is this additional sort of bonus amount that you can put in to get more tax deductible contributions. Now, out of all of that, the only one, it's all 100% tax deductible. 100%. Your business deducts 100% of the employer contribution. And from your W2, you get to deduct 100% of your own elective deferral. Same with your spouse. However, of those three buckets, the only one where you have an after tax Roth option, where you don't get a tax deduction for it now, but it grows tax free as opposed to tax deferred, which means it'll grow tax free. And when you pull the money out, you don't pay taxes on it, on the contribution or the growth. That's why I love Roth so much. We don't know what our tax situation is going to be like in the future. It sure is nice to know that we have a portion of our saving that is in a bucket that will never, ever, ever be taxed again. Now, I don't think that the IRS will ever go in and try to get their sticky paws on that tax free money because you already paid taxes on it. Could that happen if the government is desperate? Who knows? We're in a massive debt situation economically in this country and they may get desperate. However, I don't think that will ever, ever happen because you already bit the pain, the bullet of paying taxes on that Roth. So the safe harbor and the profit share, you cannot do a Roth contribution that will always be tax deductible to the employer, tax deferred to the employee. And so even if you're in the highest tax bracket, if cash flows allow it. I really like to do that Roth IRA for you. And if your spouse is on there and you're older than 50, that is $61,000 that you could get in there, that's going to grow tax deferred. So that turns into three, $400,000 over 15 to 20 years. You're not going to have to pay a dollar of taxes when you pull that out. And it's a beautiful thing, I call this tax diversification. I like it when you have a tax free bucket of investments, a tax deferred bucket of investments, and if those two are sort of capped out, then you can even have a taxable bucket of investments through a normal brokerage account as well, and that's tax diversification. And then what you invest in each of those accounts should be different. Like in your tax free bucket, I would put the highest risk, highest growth stuff like emerging markets over time they're very volatile, but they tend to have larger returns over time because of the related risk. And therefore if that grows the most, that's what I want to be tax free. And then you're in your tax deferred that has certain types of investments are better suited for that. And in the taxable, there are better suited investments in your taxable, like in your taxable, you want high growth stocks, tech stocks, they don't issue dividends, they just grow, they appreciate and you don't pay taxes on appreciation. And so in essence you're able to defer those taxes until the time that you sell those investments. You don't want high dividend producing stocks or mutual funds. You don't want taxable interest like corporate bonds in a taxable account because then you're going to pay these taxes and every year. And that sucks. So this is one of the key things we do here at practice CFO as an as investment advisors, managing our doctor's assets is tax allocation across these different buckets, what you put in them. Most people, if you go to like Morgan Stanley, you go to Edward Jones, Raymond, Raymond James, most typical investment advisors may do a little bit of that like not putting, they'll put maybe tax free California muni bonds in your taxable accounts. But they beyond that they're not doing a lot of tax strategy around positioning of your investments across these different buckets of tax free, tax deferred and taxable. And yet that can get you 1 to 2% extra return over time. That alone pays our investment fees in my opinion as what I have found. And so this is a really important part of tax planning. And good investment advisors who are a little bit more savvy on the tax side may do this. And we pay good money to a tax software that allows us to configure in the software how or which investments are selected based on the type of account to optimize over all accounts the tax minimization on the growth of those investments. Okay. And then you have a defined benefit plan. And defined benefit plan is this additional thing, it's sometimes called a pension plan. Big corporations used to have them back in the 80s where the government, the company pays 100%, the employee doesn't contribute to this, the company pays 100%. And you're defining the benefit when you retire. How much are you going to pay out per the design of this benefit that you're offering to your employees? How much are you going to pay out when they retire and you pay for the rest of their life? Now, in reality, when you sell your practice and you close down the benefit plan, everyone rolls it out into their own ira. That's what happens every time. So you're not actually going to be paying your employees benefit from the time they retire to the end of their life? No, you're going to, you're going to close it down, package it up in a lump sum, drop into the Roth ira, and you'll do the same for your own defined benefit plan. Now, what I love about defined benefit plans is the vast majority of it goes to you. In a 401, you might have only 75 to 80% going to you, the owner and spouse, but in a defined benefit plan, you're getting like 90% to you. But they're more expensive, they require an actuary, they're very delicate. You can't do it wrong. Otherwise, trust me, you're going to regret it. With tax letters and penalties and excise taxes and all this stuff. This requires careful curating every, in the beginning and every year inside the ecosystem of all of your global cash flows. This is, I just can't emphasize that enough. I would never do a defined benefit plan if you don't at least have a modest amount of business and personal financial planning and tax planning in place as the foundation to do that. Right. Okay. So if you do not have a 401k defined benefit plan or any sort of retirement plan in your practice, you want to keep your W2 as low as possible because you're paying 15.3% FICA taxes on your W2. Now again, as an S corporation owner, you take out income in two ways. Your W2 and your K1. Your K1 being the net profit. If your W2 to yourself goes up, that's an expense to the corporation and therefore your profits go down. So your K1 goes down. If you pay yourself a lower W2, your profits go up, means your K1 goes up and therefore your, yeah, your K1 is higher. But the sum of your K1 and W, your personal W2 are always going to be the same.

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Foreign W2 +K1 equals X that X isn't going to change no matter how you shift your W2 and K1 because they're directly inversely related to each other. And so if you don't have a retirement plan like a 401k defined benefit plan, let's try to get your FICA taxes down as much as possible by paying you a low W2. Now I emphasize that teeter totter analogy because what your W2 is has very little effect on your taxable income. When you don't have a 401 plan, it doesn't. If you lower your W2, your K1 goes up because the sum is the same. You're going to have the same amount of income.

That is taxable income to the IRS and the state income tax agency. What's different on those two ends of the teeter totter is that only Social Security and Medicare, which is called FICA, which is 15.3% combined up to $176,000. That is only that is only applied on your W2. And so if I can take you down from $150,000 W2 to $50,000 W2, I'm going to save you about 7 to $8,000 in FICA taxes. And who doesn't want 7 or $8,000? And I think at $100,000, even if you have a really good big practice and you have a pretty big K1, let's your let's say your K1 is 4 or 500,000. If your W2 is 100,000 six figures. You're probably not going to be audited. You're probably just fine. It's when you're paying yourself like $25,000 W2 and your K1 is $400,000, the IRS is going to say no, you should have paid yourself a higher W2 and that's therefore more in FICA taxes. So there's a limit there. I usually don't go under a hundred thousand. I unless your practice is running a loss. Maybe you're a startup or maybe you're an independent contractor and you and Your total revenues, that is revenue, which is your production pay, is maybe 200,000. I may justify going down to $75,000 or so, but I almost never go down below 75. Ever. Ever. Now that's if you don't have a retirement plan and that's us trying to save in FICA taxes. Again, income tax, it doesn't matter. Let's go to the 401k without a profit share. The 401k without a profit share. Or if you have a 401k but you're not doing that, that other bucket of profit share, getting that additional 25, 30,000. You're just doing the elected deferral and the safe harbor bucket. Then same thing. I want to go above maybe 100,000, 125,000. It's when you want to fund that profit share bucket, that last layer in the 401k bundle, that last layer and. Or that defined benefit plan. And I never do a defined benefit plan without the 401k. It's called a combo plan. You first. These are like stairs. You first do the elected deferral safe harbor. I would never set up a 401k if I, if I as the doctor, I'm not doing at least the elected deferral in the safe harbor. That's the first step. The second step is the profit share and the third step is the defined benefit plan. I always go in that order depending on how much surplus money you have in your practice that you can allocate to these things. The more you can allocate, the more I tend to move into that next stair. And eventually if you have a lot where you above the 401k profit share above that, if you have another 100 $200,000 to invest and you don't have many staff or you're a bit older than your staff, then I'm starting to look hard at a defined benefit plan because of the massive amounts of money these things can save. And Sometimes a doctor will complain and say, wes, I'm having to pay $5,000, $6,000 a year to fund my defined benefit plan. Oh, I'm like, yeah, that's true. Because there's an actuary in place and they're more regulatory intensive and so they require more work. And you're going to pay the TPA more money for that. That said, you're funding $250,000 in that thing. Do you know what that thing is saving you in taxes? $100,000 in taxes. And you're going to get, you're going to need this massive amount of money, 250,000, that's going to grow tax deferred for a long time and even end up being $1 million in your retirement account in 15 to 20 years. I don't mind you paying $6,000 every year to do the administrative compliance and actuarial work on this defined benefit plan. So you can't. You got to see the forest through the trees. That, yes, there is a cost with these things, but the forest is massive tax savings and massive a massive propulsion toward financial independence. Okay, so tier 1, no retirement plan at all. Pay yourself as low W2 as you can. Never below 75 or 100,401k without a profit share. Same thing. All right, now you get in the profit share and the defined benefit plan layered on. Now you want to go, you want to jack your payroll way up, all the way for 20, 25, that's 350,000. Every year that's going up about 10,000. But you want to find out what it is for that year that max W2 limit in order to optimize your profit share and defined benefit plan, which simply allows you to get more in and at a lower employee cost. And I'm not trying to be Scrooge. It's not that you don't want to provide the benefit to your staff. Trust me, if you have a defined benefit plan, they're getting way more contribution than they would at any other practice. Trust me, even at the minimum amount now, it still is a huge benefit to you. Way more than the staff. This is about you. But they will get some defined benefit plan contribution and some safe harbor contribution. But when all is said and done, if you can get above 75 to 80% out of pocket is going to you, it is an absolute win. Now, when you layer on a defined benefit plan and you're funding 2, 3, 3 and 50,000 in this thing a year, you're getting somewhere closer like 92 to 95% is going to you and it's all 100% tax deductible. So it's a, it's a beautiful thing, actually. It is a beautiful, beautiful thing to do that. All right, so those, those are the primary drivers for me of what your W2 target should be for the year. So the action plan is have your CPA recommend a payroll structure consistent with your tax plan and 401k or defined benefit plan. I have a resource called the 10 Questions to Ask your CPA each year that I will include in the show notes that can help drive that conversation. Ideally, your CPA can sort of do this more finance perspective analysis and not just be a historian. Or you can look at more of a CFO model. There's a few of us out there as what is just built in from the ground up. It's like some software now are built in from the ground up with AI and they're probably going to do a lot better than the old legacy systems that are trying to sort of embed AI in there as well. For us, AI is embedded from the ground up, meaning that business planning, personal financial planning, tax planning, it's all embedded from the ground up in our model since we are a finance wealth management firm first and a CPA firm second, with the CPA firm driving the data engine and X rays to be great business and personal financial planners. Thanks everybody for joining another episode of the Dental Boardroom podcast. Until next time.