Invest or Pay Down Debt?

Carrying on from our last module talking about retirement plans and a dental practice. And near the end of that module I began to talk about whether you should fund a retirement plan in your practice or pay off your student debt. Well, in this one I want to take, I want to alter that a little bit and say, should you pay off your practice debt before funding a retirement plan like a 401k, it is natural for you to feel that you want to get out of that burden of debt. So as soon as you have some good cash flow surplus in your practice, you're thinking, man, if I just didn't have this practice acquisition loan, my cash flow would look so much better. And that's a very tempting thought, but I'm going to tell you to not pay off your practice debt before you fund your retirement plan. Number one, you may end up having prepayment penalty. Typically if you pay that, try to pay that off before five years, generally they'll allow you to pay some extra payments on it without penalty. But that's number one. Number two, your practice debt has a tax deduction associated with the interest on that and you're just the interest. But the principal is not tax deductible. And the farther you go down the amortization schedule, the more payments you make, the farther down you go that ladder, the more you're paying in non deductible principal and the less you're getting in tax deductible interest. So you're not getting a whole lot of tax benefit by you. In fact, when you make an extra payment on debt, it's all going to principal. That's great, but you're getting zero tax benefit. And again, tax friction. And the IRS is one of the most, one of the largest impediments to becoming financially independent. So we need to reroute money from the IRS to your future self. And the 401k is a great way to do that. So let's look at an example where let's say you have an extra.

Amount that you can pay per month. And let's say that's $64,000 a year. So a little bit more than $5,000 a month. And you're going to apply all of that toward your debt. And so your debt starts off at $700,000 and you're making an $81,000 payment on your normal loan. And normally that would be 10 years, but now you're going to take this extra surplus and you're going to pay it toward your loan. So now you're paying an extra $64,000. So after year one, your loan balance is only $574,516. And that feels great. I get it. You go to year two, you make the same payment now you're down to 447,000. Next year, 318. Well, at the end of your sixth year, you've got this thing paid off completely. Completely. And you're thinking, this is amazing. Well, that is amazing. And I'm a huge fan of getting out of debt, but I'm also a huge fan about being strategic around debt. There is debt that was healthy because it allow you to buy an asset like a dental practice that is tax deductible, like a dental practice acquisition loan. And then there's debt that is to buy something that loses the value in time, like buying a car. That's a consumer debt or credit card. Those things, I'll typically want that, sometimes those to be paid off, maybe even before funding a retirement plan, especially credit card. But here I would say let's not pay off what is considered good debt, if you can call debt good. At least the better debt at the expense of not funding early our retirement plan, which has that huge value of compounding if you start early enough. So in this scenario, you can see we don't start funding the 401k until after we've paid off the debt. And we're funding $54,000 per year into the 401k. And notice it's a little bit less than the 64,000 because we have $10,000 is going toward our staff contributions on the 401k that you're required to make. Now you're getting a tax deduction though, of $25,600 on that full $64,000. 54 going to you, 64 going to the staff. Now there's a couple years old. Now you can be doing $57,000. And if you're older than age 50, you can be doing another $6,000 into the retirement plan. So, but the, but the main concept here applies that you're now getting a big tax deduction where paying off those extra payments was giving you no tax deduction. Then we show your investment growth, which I believe we have here at 7%. And then we have your investment balance at the end of year one is what you funded at 54,000. And then you have to think about the tax savings you have now, which is $25,600. And that's money that you could go put in a tax in an investment account. A brokerage account. And maybe that's not tax deferred, but that's new money that would have gone to the irs, that's now staying with you. So you created new money for yourself by funding your retirement plan. So if we have your 401k and we have the taxable account that you put your tax savings into, and we have your investment growth, which in year one was 2007, 86.

Well, and notice it wasn't a full 7% on the full, roughly $80,000 because you were funding that little by little throughout the year. So just a little bit of investment growth on that first year. Your balance at the end of the year is 82,386. So now your net worth on the right hand side, you can see you started off with negative 700,000 from your practice debt. We're sifting out any other assets, any other debts that you have. As we talk about your net worth and we're saying you're worth negative 700,000 when you bought that dental practice. I know the value of the dental practice is worth something as well, but that's regardless of the scenario. We're just looking at the differential factors here of whether you pay off your debt early or whether you don't. So you're at negative 700,000 in this scenario and it's dropping as you pay off your debt. Then when your debt is paid off now, you're moving into positive territory by the balance in your investment accounts. Every year you're funding that max at $54,000. You're getting the tax savings, you're investing that, and now you're getting investment growth and you have an investment balance there at the end of each year. And we're going down a 25 year scale. Well, what I wanted to show you here is that after year 10 in the red box, you have $473,780 and your debt is paid off. So your net worth in this simplified version is.

473,780. As you keep going down. When you hit year 25, now you're ready to retire, you have $3,377,455 in your account. That's no small change. Keep in mind that that money 25 years from now is going to be worth a lot less in purchasing power than it is today. Nonetheless, that's still a healthy amount, but we have to compare it to the opportunity cost having invested in the 401k from year one, instead of paying off what was a good Healthy, probably low interest tax deductible loan. So now let's look in the scenario where you don't pay off your debt early. So now you see in the yellow, you don't make any extra payments on your debt and your balance goes all the way out to the end of year 10. You didn't pay anything early. Now we go over the 401k and we started funding that right away. We got our tax savings and we got our investment growth and we have more time for our investments to earn even though our debt is getting paid off a little bit slower. So we start off with that on the right hand side. In the blue we start off negative 700,000. But now our net worth is becoming less negative because we're getting out of debt and because we're saving in taxes and funding our retirement plan. At the end of 10 years you have 1.138 million. And at the end of 25 years you have 5.21 million. So if we compare these two side by side, after 10 years you have $664,501 more because you decided to invest in the 401k in the early years from year one, reroute money from the IRS, you into your pocket, your future pocket via the 401k and get those significant tax deductions go all the way down to year 25 and now you have an, you have an extra $1.833 million. So is there a value to psychologically getting out of debt? Yes. Does the investment market investing in stocks and bonds and real estate, mutual, I mean stock, bonds, mutual funds, et cetera, feel a little bit less tangible perhaps than you seeing your debt balance on the statement every month go down? Perhaps. But remember, the market is real, Esteel, you own stock in those companies and you're investing in companies that know how to run businesses pretty dang well.

You might just go in an index based approach. We set up a lot of 401 s for our clients, low cost index based structures and do a really good job at that because we know how valuable they are for our clients and becoming financially independent. So even though it might feel great to be paying off your debt, just know that it can come as a cost. And the cost is you paying a lot more the IRS rather than you paying your future self. So our recommendation is to not pay off early your practice debt and to fund that 401k first.