The Personal Financial Ladder

Let's continue this important subject of financial independence in working with Dennis. Over time, I've created what I call the financial ladder. And it's a very basic concept of how to use your surplus dollar to accumulate wealth in the most effective manner possible. A lot of times I tell my clients to think and be and act like a bank. How does a bank thrive financially? As a business, they take their deposit money and they go. And they might pay a very small amount of interest, but then they go and they reinvest that money or they invest that money in ways that give them a spread beyond what they're paying their depositors and what they're earning as a bank. And banks are excellent at managing their investments and in such a way that they increase that spread. What you do with your surplus dollar matters a significant amount in you becoming financially independent and operating with that mindset of a bank. So what do you do with your dollar as it comes in? Well, the very first thing you do is you got to create that dollar. So the first rung on my ladder is that you have to establish a budget. And you've got to be disciplined enough to live on that budget. If you do that, most likely you're going to have some surplus dollars coming in. So you have some surplus dollars. What's the very first thing you do? You want to pay off any credit card debt. Credit card debt is cancerous. It is a ball and chain. So if you've got that, you create your surplus dollar, pay that off once you've paid off your credit card debt. Let's assume for a sec that you're a practice owner. If not, you can probably skip. This step is establish a working capital base within your practice. And working capital is just the amount of cash you have in your business checking account to make your payroll, cover your lab supplies, facility, marketing, admin, your debt to pay yourself, that is what is your working capital. Let's establish enough cushion in your account such that after payroll goes out, you're still sitting on somewhere around 60 to 100% of your annual of your monthly collections. So if your monthly collections are $100,000 after payroll goes out, I'd still like to see somewhere around 60 to $100,000 sitting in your account. You're going to sleep better at night. I call that your sleep insurance. So now you have extra income, you've paid off your credit card debt. You have enough cash in your practice checking account, assuming you own your practice. If not, then skip this step. Where do you go now? Now you got to Build a personal emergency reserve as well. So I would recommend at least early on, that you try to get three to six months of your monthly budget. And later on in life, that may go up to 12 months of your living budget. And once you've got enough cash in your business account, you've got enough cash in your personal account, now you can really start talking about investing. And really the first investment vehicle is going to be your IRA. Your IRA or Roth IRA. Let's assume you don't have an IRA yet. You can do as of 2020, based on the tax law, you can do this thing called a Roth conversion. You might make too much to make a tax deductible contribution to an ira if you. Now, if you're working in a practice as an associate, let's go through a couple examples here on this. If you're working in a practice and you're as an associate, and, and let's say you don't have access to a retirement plan like a 401k, you're not eligible, then you can contribute to your IRA regardless of your income, and you can get a full tax deduction for that. If you're married and your spouse doesn't have income, or your spouse is employed and doesn't have access to a retirement plan like a 401k, then they too can contribute. As of this year, it's $6,000 each. So that would be $12,000. If you older than age 50, it ends up being $7,000 each or $14,000, and that's going to go up a little bit every. Every year.

Now, if you do have access to a retirement plan, whether you fund that or not really isn't relevant per the IRS rules. But if you do have access to a 401k and you could be contributing to it, then if your income is too high, you won't be able to fund an IRA account directly. However, if you don't have an ira, you could do this strategy called a Roth conversion, which is where you set up an IRA account and you fund it with that $6,000, but you make too much, and so it's not tax deductible. You can make a billion dollars a year and still fund that. If you're eligible for a 401k with your employer and you make a billion dollars a year, you can still fund your ira, you just don't get a tax deduction for it. And then what you do is you set up a Roth IRA and you convert that $6,000 immediately, same day into the Roth IRA. Because you can't go directly into a Roth IRA if your income is that high at a certain level, most of you are going to phase out of your ability to fund a Roth IRA directly. If you can, great, do a Roth ira. But otherwise this is a great strategy to backdoor it into your Roth ira. Now, what is the difference between a Roth IRA and an ira? Well, an IRA is you put money in and when you pull it out, you have to pay taxes on it. A Roth IRA is you put money in and it's after tax, but you don't have to pay taxes on it. So one more time, an IRA is you put the money in if your income is at a certain level or if you're not eligible in a 401 plan with your employer or your own practice, then it becomes a tax deductible contribution into your ira. You get a tax deduction, you pay less money in taxes. But then in 30 years when you retire and you pull the money out of your IRA, you're going to pay taxes on 100% of that. A Roth IRA is opposite. You put that money in today after tax. So you already paid taxes on that $6,000 of income. But when you pull that money out, 100% of it is going to be tax free. So you may need to talk with a CFO advisor, talk with your tax advisor, a financial planner perhaps about this, and, and ask them, am I eligible to fund my ira? Can I do maybe fund my Roth ira? Can I do a backdoor Roth conversion into my Roth ira? But the bottom line is this is the next rung on the ladder would be to fund an IRA or a Roth ira. Now, let's assume that you're a practice owner or if you're an associate working for a practice, then you can fund your 401 through, through that. And that's going to allow you to fund a lot more than the IRA will. Assuming you're a practice owner and you set up a 401k, you can not only fund the employee portion for yourself, you can fund the employer portion for yourself up to $57,000. And watch our retirement module on this subject to see exactly how much you can fund into the different types of retirement plans. But the bottom line is that higher rung on the ladder, that highest rung on the ladder is now you're putting a lot of money every year into a retirement plan to the tune of 5, 6, $7,000. And if you have a spouse on payroll, you know it's going to be up near the upper end of those numbers. And if you're a little bit older, say 55 or above, and your staff are quite a bit younger than you, you can even fund what's called a defined benefit plan, which we talk about that as well. That would be really the next rung on the ladder. But I want you to think about how you use your spare dollars as you climb this ladder. It's important that you get to that savings as soon as possible because look at this graph. Look how the. Look at the differential between the balances on your investments after a certain number of years. On the x axis you have zero years there on the left you've got 18 years or 20 years really on the far right. And then on the Y axis you have the balance in your account. And if you were to start off with just $1,000 and you put that in your investments, that's called your principal. You put in $1,000. And over the 18 years, that's all you ever did. One time, year zero, you put in $1,000. Well, the blue is your principal. It just stays that way. You never put in more, you never take out more. So it's $1,000. However, if you were to get interest, let's say you get a basic interest on that of 10%, then every year you're going to get $100 added to your principal under a simple interest, which is no compounding interest, but the way investments really work, if you invest in a mutual fund or you invest in a stock, or you invest in.

In really in any market style investment is you're going to get compounded growth. You could call it compounded interest, but it's really just compounded growth, whether that comes from interest or whether that comes from a capital appreciation. Let's look at a mutual fund, for example. Here is just a good scenario. You might have a mutual fund that has stocks and bonds within it. And every year it's going to, let's say it grows 10%. Under compound interest, the full balance is going to grow at 10%, which includes the 10% you got from prior years, is now producing 10% growth on itself. And that is the concept of compound interest. Well, you may know that already and I wanted to show this graph just to remind you how significant the difference is between getting your compound interest versus your simple interest versus really not just putting your money in the mattress or in a basic savings account. Over time, the largest share of your balance, if you give it enough times time, ends up being the interest on the interest it ends up being the compound interest. I always say that time is like fertilizer when it comes to growing your assets. So start early in investing into your IRA, investing into your 401k, because it's a miracle what that will do over.