By Adam Cmejla, CFP®
Jan. 11, 2023
If a practice owner wants to use the free cash flow (remaining cash from the practice after expenses and debt service) to build toward financial independence, being intentional and prudent with those dollars is paramount. One of the most impactful and direct statements I can make to an optometrist is: “show me your calendar and checkbook and I’ll show you your priorities.”
I’m a big fan of the simplistic approach of “letting savings habits dictate your spending habits.” If we can ensure that we’re saving into the correct savings vehicles, and using the practice as a conduit for cash flow, it can free up the owner to “spend at will” in their personal lives, knowing their long-term strategies are helping them build wealth.
But with this mindset and approach, practice owners can still be left asking themselves the question, “Where should I invest, and in what vehicles?” To answer that, let me give the simple hierarchy that we recommend and then expand on each of them briefly:
- Yourself/your practice
- Retirement Plan (up to the match)
- Roth IRAs
- Retirement Plan (maxing out contribution)
- Brokerage account or other investments
Invest in Yourself
This might not have been the traditional answer you’d get from a traditional financial or wealth advisor, and rightfully so. When compared to the public markets of stocks and bonds, I believe the best return on invested capital one can earn is within their practice…and by a long shot.
Whether it’s an investment in personal development, adding or replacing equipment, building out the office by adding another lane or expanding your optical, or adding another specialty service to expand the care you provide to your patients (think dry eye, scleral fittings, etc.) the return you’ll earn on that investment into yourself and/or on your practice is traditionally going to be far higher relative to the rate of return on any public investment.
Not only do these types of investments increase the likelihood of increased net income/cash flow to the owner, they also inherently increase the enterprise value of your practice, thus allowing you to capture a higher sales price when you choose to sell your practice.
The Health Savings Account (HSA) is one of the most under-utilized savings vehicles for long-term growth and wealth creation. To contribute to an HSA, you must first be a covered individual on a high-deductible, HSA-specific healthcare plan. The deductible limits in 2023 are $1,500 for an individual and $3,000 for a family. The maximum amount you can contribute to an HSA if covered under an individual or family plan is $3,850 and $7,750 respectively.
The tax benefits of the HSA are three-fold in that (1) contributions are an “above-the-line” deduction, which reduces your personal Adjusted Gross Income, (2) funds invested inside the HSA grow tax-deferred and (3) qualified distributions from the HSA are tax-free.
In addition, there are no income phase-out limits for the HSA, which means that any practice owner, regardless of income, can contribute to an HSA.
Retirement Plan (up to the match)
If we’re analyzing these strategies on a dollar-for-dollar basis, then investing into the retirement plan sponsored by the practice (usually a 401(k) or SIMPLE IRA) is typically anywhere from a 50-100 percent return on your investment. A SIMPLE IRA will generally provide a 100 percent match on the first 3 percent of contributions and most practices that sponsor a 401(k) will have a “Safe Harbor” matching formula, which is a 100 percent employer match on the first 3 percent of contributions and then a 50 percent match on the next 2 percent of contributions. In summary, the practice matches 4 percent if the employee contributes 5 percent.
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I acknowledge that practice owners are probably thinking, “But I’m matching with my own money. It’s my practice.” You’re correct. As I see it, there are a couple of key benefits and differentiators compared to just taking the funds as a distribution:
- It’s an investment in your team. Your team members don’t have a practice they can sell at retirement and use to fund their post-working lifestyle.
- The sale of your practice alone likely won’t be enough to fully fund your retirement lifestyle. This is a “forced savings” benefit which the owner can participate in alongside their team members.
- The match the company makes is a tax-deductible expense to the business and grows tax-deferred inside the retirement plan.
The Roth IRA
One of the most common retirement saving vehicles, the biggest benefit to the Roth IRA is that the funds invested inside of a Roth IRA grow tax free for the owner. While there is no upfront tax deduction on the contribution, the benefit of the tax-free growth means that a practice owner will need to accumulate less in a Roth IRA compared to a traditional/tax-deferred 401(k), since distributions from a 401(k) in retirement will bring with it a tax bill. Said differently, you’d need to distribute a larger amount out of a 401(k) to end up with the same after-tax amount compared to a Roth IRA distribution in retirement.
While there are income limits on who can contribute directly to a Roth IRA, the backdoor Roth IRA strategy still exists and is a popular planning strategy for high-earning optometrists whose incomes exceed the thresholds.
Fill Up the Retirement Plan
Now that we’ve maxed out savings in both our match- and tax-free accounts, we’ll go back into the retirement plan and max out the contributions in the respective accounts such as a SIMPLE IRA or 401(k).
If a practice has sponsored a 401(k), one of the most important options that should be available in the plan is the ability to make Roth 401(k) contributions. While the employer match is always made into the tax-deferred “bucket” inside of a retirement plan, a 401(k) allows the option of making contributions into a Roth account within the 401(k), thus increasing the dollars that one could accumulate in tax-free retirement assets. Unlike the Roth IRA, the Roth 401(k) does not have any income limits. Generally-speaking, the younger someone is the more advantageous the Roth can be, since they have more years for their funds to compound and grow tax-free.
Brokerage or Other Investments
This is where we open up Pandora’s box and we can insert any variety of investments. From real estate to crypto currency, private equity to hedge funds, angel investing to mezzanine debt…there are a variety of options to invest additional free cash flow from the business that isn’t already allocated to the tiers already mentioned.
However, there’s nothing wrong with “just” a boring brokerage account that holds a well-diversified, low-cost, tax-efficient investment portfolio. In the end, all of investing is the transfer of risk and reward, and those two variables are correlated: the higher the risk, the higher the (potential) reward.
When it comes to your saving and investing, ask yourself the following two questions: (1) what am I solving for with my investment strategy and (2) why am I choosing to use this investment vehicle? We’ve had many conversations with very successful ODs who think that, since they’ve climbed the savings ladder illustrated here, they need to start getting involved in complex, opaque and “sexy”-sounding investment vehicles. I’ll always challenge that thought process with one question: “Why?” Based on their answer, we’ll then lead into the other two questions mentioned above.
While everyone should have their own investment philosophy and process to follow, the most important part of all of this is that you’re acting with intention and purpose, using the cash flow from the practice to grow your personal net wealth and worth—in and out of the practice.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com/ebooks/ and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.