Financial Changes When You Make Partner – Podcast #179

Podcast #179 Show Notes: Financial Changes When You Make Partner

What changes when you make partner? When you become a partner, you go from being an employee to being an owner. So, there are lots of financial changes. I’m a big fan of ownership and think, generally, that becoming a partner is the right move for your career. There are more risks and hassle to being a partner but more rewards and profits, as well. We discuss the advantages and responsibilities of becoming a partner in a practice including getting K-1s instead of W-2s, making quarterly estimated tax payments, writing off legitimate business expenses, paying for your own benefits, and understanding retirement accounts available to you. In this episode, listener questions are also answered about losing faith in long term market returns, being an accredited investor, value tilting your portfolio, what to do with your cash, tax gain harvesting, and the pro-rata rule.

Provider Solutions & Development is a community of experts dedicated to offering guidance and career coaching to physicians and clinicians throughout their entire job search. Whether you are looking to dive deeper into your specialty work, strive towards a healthier work-life balance, or a little bit of both, they can help find the right fit for you. Start the conversation today at www.psdrecruit.org/whitecoatinvestor.

Quote of the Day

This one comes from Robert Doroghazi, a cardiologist and published author. He said,

“Physicians make enough money that they just need to be wise and control arrogance, ego and greed to be able to live a life of financial security.”

I totally agree with that.

Financial Freedom Through Real Estate Conference 2020

Peter Kim from Passive Income MD is hosting a virtual Financial Freedom Through Real Estate Conference 2020. It has 20+ speakers.  Just click here to register. The dates of the event are October 9th-11th. The event is free for everyone who registers with an opportunity to upgrade for VIP access. The VIP access is $97 for early bird pricing (ends 10/9), $147 during the event, $197 post event.

Recommended Reading From the Blog: Making Partner

Financial Changes When You Make Partner

“The practice I’ve been working at was purchased by a PE firm last year. The group is in its beginning stages and they’re offering a physician investment program. So, I’ll finally have the opportunity to buy into the practice. After speaking with the group’s legal counsel, the shares offered to the docs, who didn’t own the practices which were purchased, are class B shares, which don’t allow voting rights. Everything else would be the same as class A shares from what I’ve been told. Do you have any experience with something like this? Obviously, voting rights are important, but would it be something that would make you avoid this investment opportunity altogether? I see a bright future with this group. The practices involved currently are highly profitable, and I plan on staying in the area long term. Additionally, what are the advantages, tax and otherwise, to becoming a partner practice rather than just a W-2 employee?”

Let’s talk about partnership:

Voting Shares

This whole non-voting shares is not a deal breaker for me. This is not that uncommon in small businesses, and even in some larger businesses they have nonvoting shares. We have some equity compensation plans for some of our employees here at the White Coat Investor, and the shares that they would get are essentially nonvoting shares, as well.

So, it’s not uncommon, in small businesses that want to retain control, to offer those. Basically, the bottom line is they usually say, “Take it or leave it. If you don’t want it, fine. But we’re not giving you anything else.” Their goal is just to retain control.

It doesn’t mean it will be a bad investment, but it does mean that you don’t have voting control. It’s not quite the same as what I have in my small, democratic group, where there is no private equity involved. It’s just us, and when we want to decide how we’re going to cover the holiday shifts, how we’re going to staff the ED, how we’re going to divide up the pool of money we make, who we’re going to hire, who we’re going to fire, etc, we all get a vote.

Your situation won’t be the same as mine but it may still be a great investment opportunity if the partnership is doing well and making money. So, I wouldn’t let that stop you from investing there or taking that as part of your compensation.

Employee to Owner

When you become a partner, you go from being an employee to being an owner. I’m a big fan of ownership. But, when you’re the owner, you take on more risk and you also have a lot more hassle. In exchange for that, if the business does well, there is more reward. Generally, when you make partner you make more money. That is the attraction of making partner.

The benefit of being an owner of the business is when the business does well, there is profit that goes to you. If you are an employee and a business does well, that profit does not go to you. That is the main difference between being an owner and being an employee.

Taxes

Instead of a W2 you will now get a K-1. This is how income is reported to partners in a partnership. A partnership fills out form 1065. That’s the equivalent of a 1040, except for a partnership. As part of that, they have schedule K and then they distribute schedule K-1 to each of the partners.

That is how your income and your share of the expenses of ownership are reported to you and to the IRS. It’s not quite as straightforward as a W-2, but it’s really not that hard. You can still do your own taxes on TurboTax, just putting in a K-1. Just follow the directions. You go down the form, you put in the numbers, and it spits out what you owe in taxes. (Or you can still hire help – see our recommended tax strategists).

W-2s often comes the third or fourth week of January. А K-1 often comes 1st of March or even the 1st of April. Sometimes, especially with a lot of syndicated real estate deals, you may not get your K-1 until July or even September, and you end up having to file these extensions to do your taxes.

So that can be a little bit of a pain that you can’t do your taxes quite as early. But honestly, you shouldn’t be aiming for some huge tax refund anyway. The ideal goal is to make a little tiny payment to the IRS come April, not to actually get any money back..

You getting a K-1 instead of a W-2, means no one is withholding your taxes. No one is withholding your payroll taxes, which are social security, Medicare, etc. No one is withholding your income taxes. You have to pay those on your own. You do that once a quarter with form 1040-ES, which is the estimated payment form.

It’s no big deal. You can send in a check or make payments online if you want. But you have to remember to make the payments every quarter. If you don’t make the payments, you get penalized and end up with penalties and interest in addition to the taxes that you owe. You also have to make sure that you’re having enough paid out in those quarterly estimated payments, because if you don’t have enough withheld, if you’re not in the Safe Harbor, you’ll end up, again, getting dinged with penalties.

It’s usually best to pay the same amount with each quarterly estimated payment. These are due in April, June, September, and January for each of the four quarters of the year. It’s easiest if they’re all equal and the IRS doesn’t really say anything, but if your income is not really equal throughout the year, that might be difficult. There is a way to fill out a separate form to justify paying taxes later in the year if you’ve made the money later in the year. But you certainly can’t do the opposite. The U.S. federal income tax system is a pay as you go system. So, you have to pay as you make the money. That means each quarter payment needs to cover the taxes more or less owed for that quarter.

Some states don’t do that. Utah doesn’t have a pay as you go system. It’s all due on April 15th of the next year. You don’t have to make a single payment between now and April 15th of the next year, but the federal tax system is not like that. So, make sure you are staying in the Safe Harbor, which means for a higher earner like you probably are, either paying 110% of last year’s tax bill, or 100% of this year’s tax bill. They’ll give you a little bit of slack the first year, but after that, you’re going to get nailed if you don’t stay in the Safe Harbor with those quarterly estimated payments.

Recommended Reading From the Blog:

Estimated Taxes and the Safe Harbor Rule

Business Expenses

Now, of course, you’re a business owner, and a business has legitimate business expenses. For example,  your phone or your work mileage. Remember, work mileage is mileage driven between two work sites. Like your clinic and the hospital or two hospitals. It is not your commute. It is not from your home to a work site or from a work site to your home. Your uniforms, white coats, scrubs, equipment, your CME costs. That is all tax deductible. You can add that in as unreimbursed partnership expenses when you put your K-1 information into TurboTax, or when your accountant prepares your taxes, they can add that in. So, keep receipts for that. That is now all deductible, whereas it really is not deductible these days as an unreimbursed employee expense.

You’re also responsible for paying for your own benefits. Not only do you have to pay both halves of your social security and Medicare taxes now, you also have to pay for any insurance, health insurance, life insurance, or disability insurance that your employer was covering for you. Maybe they provided you a CME fund. That’s probably not going to be there as a partner.

Recommended Reading From the Blog:

Tax Deductions for Medical Professionals

Retirement Plans for Partnerships

Even though you are responsible for paying a lot of expenses, you cannot just go out and get your own retirement plan. If you’re in a partnership, you can’t go open an individual 401(k). You have to use the partnership’s retirement plan. It is subject to all the usual measures of 401(k)s so that it is not just a benefit for the highly compensated partners and employees in the company.

Depending on how many employees you have and how much they make and how much they contribute to the plan, it may determine how much you are able to contribute to that 401(k). But a good partnership will often offer a 401(k) with a profit-sharing plan that you can put up to $57,000 into in 2020. I think it’s $58,000 for 2021. And maybe even a defined benefit or cash balance plan in addition to that.

So, look into those as you go to make partner and the rules and requirements for you to contribute to them. A lot of times you can defer a lot of money to some future year when you’re not at your peak earnings level.

Overall, I’m big fan of becoming a partner. Congratulations on becoming a partner. Your job becomes a little bit more secure. You usually make a little bit more money. There’s a little more hassle and risk in your life, but it’s usually worth it.

Recommended Reading From the Blog:

Cash Balance Plans for Solo and Group Practices

How to Have the Best Group Practice Retirement Plan

Recommended Practice Retirement Plan Providers

Reader and Listener Q&A

Losing Faith in Long-Term Market Returns

A listener comments that most of the questions we receive have the same flavor of answer, “What does your investment plan say?” So he asks,

“What set of circumstances, if any, would prompt you to lose faith in long-term market returns and amend or edit your written investment plan?

That is really two different questions. What circumstances would cause me to lose faith in long-term markets? And, what circumstances would cause me to make changes with my investment plan? This is really a good demonstration of why staying the course is so hard, because you’re always faced with this question. Is it different this time? Should I bail out? Should I change my plan in a reaction to the market conditions?

Usually changing your plan, assuming it was a sensible, reasonable, well thought out plan, is a mistake. What usually happens is you’re really chasing performance and you change your asset allocation just in time for the lagging asset class to finally start outperforming. If you haven’t had that happen to you in your life, you probably haven’t been investing very long. It happens very, very frequently.

So, let’s take that first question. What circumstances would cause me to lose faith in long-term market returns? Well, zombie apocalypse. Let’s say instead of Covid 19 killing 1% of the population, it’s killing 80% of the population. That is probably going to affect the economy enough that your long-term returns are not going to be very good. That would cause me to lose some faith in long-term market returns. What else? A nuclear war would probably cause me to lose some faith in long-term returns for similar reasons.

But the truth of the matter is these extreme circumstances, they’re going to cause you to have poor long-term return. By long-term, I’m talking 30-50 years. These are terrible things. They are awful circumstances that will cause you to just be grateful that you’re still alive and have something to eat. Your last thing you’re going to be worried about is going to be how the market did. So, these are the sorts of things that I would worry about as far as long-term market returns.

Bill Bernstein talked about the four risks, the four horsemen of the apocalypse.

  1. Inflation, which is obviously the most common. But he was really talking about hyperinflation like you’ve seen Zimbabwe.
  2. Deflation. Basically, the economic collapse we saw during the Great Depression.
  3. Confiscation. When the government comes in and takes everything, think about Russia in 1918.
  4. Devastation. When the economy is just destroyed like Germany in 1945.

Those are the things that cause poor long-term returns. That is the real risk in your life. He calls it deep risk as opposed to volatility, which he calls shallow risk. The truth about volatility is if you just hold on long enough, volatility comes back.

That is what we often see when the markets are going up and down and people are panicking and trying to time the market and all that. It’s just volatility. That’s not actually real risk showing up, real risk of those four factors that could show up from time to time in the history of the world.

I think that is really a good explanation of things to keep an eye out for as far as losing faith in your long-term market returns. Outside of that, other things don’t cause me to lose faith, an election certainly doesn’t cause me to lose faith, changes in interest rates don’t cause me to lose faith, world economic events or world political events. These sorts of things are par for the course.

You should expect the market to go down 10% about once a year. You should expect the market to go down 20% or more about every three years. These are expected events. They shouldn’t cause you to panic and change your investment plan.

Okay. So, what would cause me to amend my investment plan outside of a zombie apocalypse? Well, personal changes in my life. For example, if you end up acquiring more money than you thought you were going to make. You get a big inheritance. You get a big windfall of some kind. You end up reaching financial independence earlier than you thought.

These are reasons you might amend your investment plan. You’ve reached your goals, maybe you need to take less risk with your portfolio in that sort of a situation, but in general valuations of one asset class against another, those change over time. That is not something that I would necessarily change my asset allocation for.

Accredited vs Sophisticated Investors

“What is the difference between rule 506(b) and rule 506(c).”

Rule 506(b), if that is the rule that the syndicator is operating under, it means that the deal is open to accredited investors and up to 35 sophisticated investors. Sophisticated investors are people who don’t have the income nor the assets to qualify as an accredited investor.

That’s not that high of a bar. It’s a million dollars in investible assets or an income of $200,000 by yourself or $300,000 together with your spouse. That’s all it takes to be an accredited investor. It’s not a high bar. That hasn’t been indexed to inflation. As inflation has gone up over the years, the bar has gotten lower. But under a deal that’s 506(b), all you have to do is be a sophisticated investor and you can be one of those 35 people that’s let into the deal under that rule.

506(c) is a little bit stricter in that. It just requires that all the investors be accredited. Tends to have a strict verification process. They require you to prove your income or assets. Sometimes that is hard to do on your own. You sometimes have to use a third-party service. Those are the two rules that people usually put these syndications together under.

Recommended Reading From the Blog:

Accredited Investor vs Qualified Client vs Qualified Purchaser

What is an Accredited Investor

Value Tilting your Portfolio

“After doing some reading recently, I decided that I wanted to have 15% allocation to small cap value in my portfolio. So, I went into my personal capital account, looked at my current allocations and then calculated the amount of a large cap index fund that I would need to sell in my Roth IRA. And then I went and did that. And then I took that amount and purchased that amount in a small cap value ETF VBR. So, then I went back into my personal capital account and I realized that even though I purchased the equivalent of 15% of my portfolio of a small cap value, my small cap value allocation only went up to about 5%. The other areas of small cap also went up to about 5% small cap blend and growth. And then my mid-caps also went up.

I’m assuming that this means that even though VBR is a small cap value ETF it also consists of some stocks that fall in mid cap and the other areas of small cap. So, my question is if I want to achieve a 15% allocation to small cap value, does this technically mean that I need to purchase an even larger amount of a small cap value fund to achieve that 15%?”

This is a relatively in-depth question. He says he wants to tilt the small value 15%, but he doesn’t really define what he means by that. It sounds like he means that he actually wants when he runs a Morningstar instant x-ray, which is available if you just Google TD Ameritrade Morningstar instant x-ray tool, you can practice this with your mutual funds or with your entire portfolio.

But if you do that, you will see that that tool will tell you how much of your portfolio is in mid cap value, how much in a small cap value, small cap blend, large growth, etc. It divides the market up into nine portions from large cap growth to small cap value.

It sounds like he may want as much as 15% in that small cap value box, which, in order to do that, you’re going to need to have a lot more than 15% of your portfolio in the Vanguard small value fund. The reason why is the Vanguard small value fund is not that small and it’s not that value. It actually has a fair number of mid cap value stocks in it. I think it’s about half and half. Kind of always has been that way for various reasons.

So, if you want more of a small cap value tilt than what that’s going to offer you, you can find a fund or an ETF that is smaller and more value than the Vanguard fund, whether you buy it as the traditional mutual fund or whether you buy it as the VBR ETF.

For example, RZV is an ETF that follows, I think, the S&P 600 value index. It’s basically a smaller index and a more value index than the Vanguard fund follows. If you put each of these into that Morningstar instant x-ray box, you will see that the Vanguard fund has 17% of its stocks in mid cap value, 18% in mid cap blend and 7% in mid cap growth. And then it has 31% in small cap value, 21% in small cap blend and 6% in small cap growth.

As opposed to RZV which has 77% in small cap value and 19% in small cap blend and only 4% in small cap growth. So, as you can see, when you look at that, RZV is far smaller and far more value than VBR.

So, what should you use? Well, no one knows. I mean, if small value stocks outperform over your investing horizon, and there’s reasonable evidence suggests they will, although obviously no guarantees, then you’ll want the smallest, most value stocks that you can get.

If it doesn’t outperform, well, you’ll be glad that you didn’t have as value or as small of a fund or none at all. Maybe you’re a total market kind of person that doesn’t tilt your portfolio at all, and that’s fine too. But you basically have a decision to make. You can either hold more VBR or you can hold less RZV and it gets you to the same place.

But what the right move is, how much tilt you should have in your portfolio, honestly, it depends on future returns, which you can’t know and I can’t know because we don’t have a functioning crystal ball.

So be sure, especially, that you don’t tilt your portfolio more than you believe or you’ll hit a period of time like the last 10 years when large growth really smashes the snot out of small value, and you’ll lose faith in your plan and you’ll bail out of it, probably just before a small value starts doing awesome.

Maybe the next decade from 2020 and 2030 small value dramatically outperforms large growth. And those who stayed the course with their plan with a small value tilt are going to do awesome. But there’s obviously no guarantee of that.

Recommended Reading From the Blog:

Don’t Give Up on Your Small Cap Value Strategy

What to Do With Your Cash

A listener has saved $200,000 in cash that he was going to use as a downpayment on a home. He is out of debt and maxing out his retirement accounts. He feels like the housing market is pretty tight and it isn’t super appealing to him to buy a home right now. He is getting increasingly uncomfortable with this substantial pile of cash just losing value each year.

“What can I do with it so that I can at least keep up with inflation, but keep it sufficiently liquid that I can slap it down on the table as a down payment, when the right house does come along?”

This is all of our dilemma, right? With these really low interest rates, none of these fixed income options are paying that much. I think high yield savings accounts are down to about 0.8% right now, as you take more term risk and default risk with your bonds, you can get that up to 2% – 3% maybe. Maybe you can get CDs up in the 2% to 3% range. But that’s about it right now. If you want to earn any more than that, you’re going to have to take some risks, which means equity risk or real estate risk, that sort of thing.

So, a few things I should say in regard to this question. One, I’m a fan of ownership of your home when your personal and professional life are stable. So, if you’ve been putting this off because you don’t like housing prices, or you don’t want to have as big of a mortgage or whatever, but actually your personal life and your professional life are stable, it’s probably time for you to buy a home.

Buy a home that you’re going to be in for a long time, at least five years, preferably 10-15 or more so that works out well financially for you. But that’s okay to go buy a home.

If $200,000 isn’t enough for a 20% down payment on your home, save up just a little bit more or use a doctor mortgage. But maybe you ought to go out and just buy a home. It sounds like that’s what you’re saving up for. Maybe now is the time.

The second point I want to make. Chasing yield almost always comes with additional risk. You’re going to get less liquidity and more possibility of loss. Yes, it’d be great to earn more than 0.8%, but you know what? For every additional bit of yield  you’re going to get above and beyond that, you’re going to take on some additional risk. And only you can decide how much more you’re willing to take.

Third issue. The further away the date when you need the money and the less important that loss between now and then is the more risk that you can take. So maybe you could use a CD. Maybe you could use a short-term bond fund, maybe even an intermediate term bond fund or even a balanced fund.

But at least make sure the money is in a high yield savings account instead of your checking account so you’re making 0.8% instead of nothing. That’s always a reasonable thing to do to start with when you’re trying to get a little bit more yield. I mean 0.8% on $200,000 isn’t a lot of money. It’s $1,600 a year, but it sure beats nothing.

Tax Gain Harvesting

“I’ve been very fortunate to amass a sizable amount of money through investments and I currently have right around $1 million in unrealized gains in my investments. I was wondering how you would go about making the decision, whether to sell some or all of these assets now in light of the extremely low tax rates, and then immediately reinvest them to raise my cost basis for the future when tax rates are very likely to be higher. I don’t want the tax tail to wag the investment dog, but I also don’t want for myself or for my heirs to have a massive tax bill in the future.”

He is basically an early retiree with a million bucks in unrealized gains, but he’s really sounds overly worried about paying taxes on that. And I wonder if he maybe doesn’t understand how taxes work on that stuff, particularly for his heirs.

He’s wondering if he should do what we call tax gain harvesting to raise his basis on those shares in his taxable account. Now that can make some sense in certain situations. For example, let’s say you have a significant amount of money in a taxable account and you go back to school.  Well, that’s a great time to tax gain harvest because you can essentially raise the basis of those shares, what you paid for them, to a higher amount without actually costing you anything in taxes. But for someone that is in their career or even an early retiree, chances are you’re really not going to do much there unless taxes go up very dramatically.

But there’s a couple of things that would make me not want to do what he is considering doing. First, rates may not go up. Everyone’s worried rates are going to go up. People have been saying, “Rates have to go up. They have to go up. They have to go up”. Well, guess what? When President Trump was elected, rates went down. They went down dramatically, and people have been saying for 5 or 10 years before that, “The rates have to go up. They have to go up dramatically”. Well, they don’t have to. Tax rates don’t always have to go up.

So, realize that there’s no guarantee that rates are going to be dramatically higher in the future. It’s really difficult to forecast exactly what future tax rates or interest rates are going to be.

The truth is if those rates go up, it’s usually forecast pretty well. It’s all over the news. Usually it doesn’t happen retroactively. It happens starting at some point in the future. That gives you time if you really wanted to tax gain harvest to then do it at that time, before the rates go up.

Point number two. You don’t actually pay taxes on money that you leave behind even if as a very low basis. If you leave it to charity or you give it to charity while you’re still alive, or if you leave it to your heirs. Your heirs get a step up in basis at your death, meaning what they paid for that stock, mutual funds’ shares, or rental property is what it was worth on the day you die. Actually, there’s a way you can push that back even another six months. But basically, the value when you die, rather than the value you originally paid for it.

So, once you realize that, it seems really silly to pay taxes on your entire portfolio when there’s a good chance that a lot of that portfolio is never going to be spent by you, it’s going to be left to your heirs. And so, paying taxes on something that no one would have to pay taxes on later is obviously not a smart financial move. So, don’t do that.

I would really avoid tax gain harvesting at any significant rate. If you can do it free, great, go for it. But if it’s going to cost you something in taxes, I probably would put it off and maybe never realize the gains on those shares. I would simply spend the income. I would sell shares with higher basis. I would use the low basis ones to give to charity, to leave to my heirs, and try to avoid paying those taxes at all. It would take a really extreme change in tax law for me to really go for that.

One thing you ought to consider, though, especially as an early retiree with a lot of money, is using some of that money you have to pay for Roth conversions. If you’re really worried that tax rates are going up later, you’ve got to be far more worried about your tax deferred money than about your taxable money.

If you’re really worried about that, pay the taxes now and convert that tax deferred money to Roth money. The other benefit of doing that as long as you do it into a Roth IRA is you also eliminate required minimum distributions, which under current law begin at age 72 now.

You can avoid those distributions. You can hedge against future tax rate increases by doing Roth conversions, at least up to the top of your nearest tax bracket. So, I’d encourage you to look really closely at that and really maybe stop looking at tax gain harvesting. I think that’s probably going to be a mistake.

Recommended Reading From the Blog:

Roth Conversions

Top 5 Ways to Pay No Tax on Capital Gains and Dividends

Pro Rata Rule

“I was trying to conceptualize the concept of pro-rata rule. And to help me understand it, if a person who is making $120,000 a year and is self-employed and has been contributing every year to SEP IRA now decides to open up a Roth IRA and make a contribution of $6,000 directly into that account. Is this a scenario where the SEP IRA will also be subject to the pro-rata rule?”

I think there’s a little confusion here. The pro-rata rule involves the backdoor Roth IRA process. If you are going to do a backdoor Roth IRA, which is a two step process, you put money into a traditional IRA that you don’t get a deduction for and then the next day you convert it to a Roth IRA. Two steps there. The contribution step and the conversion step. If you’re going to do that, the pro-rata rule applies. Meaning that you really need to zero out your SEP IRAs, traditional IRAs, rollover IRAs, simple IRAs, etc by December 31st of the year you do the conversion step.

But in this situation, it doesn’t sound like the pro-rata rule applies at all. The example given was making $120,000 a year with some money in a SEP IRA and contributing to a Roth IRA. There is no pro-rata rule involved there. You can make a direct contribution to a Roth IRA if your modified adjusted gross income is less than $139,000 for single people and $206,000 for those filing married, filing jointly in 2020.

So, at $120,000, this doesn’t apply to you at all. You can just contribute to your Roth IRA directly.  The pro-rata only applies when you’re doing backdoor Roth IRAs.

Now, if your income is doubled, all of a sudden, you wouldn’t be able to do a direct Roth IRA contribution. If you want to contribute to a Roth IRA, you would have to do a backdoor Roth IRA, and you’d have to do something with that SEP IRA. What most people do is open a solo 401(k) for their 1099 work and make their contributions there going forward and roll the SEP IRA in there, going forward. Then that eliminates the pro-rata issue. But in this case, there is no pro-rata issue.

Recommended Reading From the Blog:

Backdoor Roth IRA Tutorial

17 ways to Screw Up a Backdoor Roth IRA

Ending

If you have questions you would like answered on the podcast, leave them as a speak pipe for us. Come back next Thursday for another episode of Physician Millionaires. They are not actually all physicians this time but they are all women, sharing the knowledge of how they reached millionaire status.

Full Transcription

Transcription – WCI – 179

Intro:
This is the White Coat Investor podcast where we help those who wear the white coat get a fair shake on Wall Street. We’ve been helping doctors and other high-income professionals stop doing dumb things with their money since 2011. Here’s your host, Dr. Jim Dahle.
Dr. Jim Dahle:

This is White Coat Investor podcast number 179 – Partnership and your finances.
Dr. Jim Dahle:
Welcome back to the podcast. I hope you had a great week. I know I did. I spent the whole week canyoneering in Glen Canyon. So, I’m back now and doing a whole bunch of work in the six days between that trip and my next one to go float the middle fork of the Salmon river.
Dr. Jim Dahle:
So, we’re trying to wedge a bunch of stuff in today. Actually, we are recording a couple of podcasts today. It’s September 21st. We’re recording this one for October 8th. I don’t know about you guys, but the pandemic here is in full bore, as far as Utah goes.
Dr. Jim Dahle:
We’re having as many cases we’ve ever had. Now peaking it over a thousand a day in the state, which while it might not seem a lot to those of you on the coast, it is a lot here, with all the universities and the school’s back in session. There’s a lot of virus being passed around out here.
Dr. Jim Dahle:
The interesting thing though, is every time our virus case counts go up, it seems like our ED volumes drop. I don’t know, people are afraid to come in or what it is, but it can sure make for some boring shifts when nobody wants to come in. I’m not sure what your work’s like, but that is what we’ve been seeing lately. Luckily, we’re nowhere near overwhelmed. So even if our Covid got worse, I suppose we can still handle it.
Dr. Jim Dahle:
At any rate, it does provide an opportunity to get out and do some fun things outdoors that are totally safe. And of course, spend time with the family, which has been one of the many unforeseen consequences of this pandemic is we really grown a lot closer together as a family during this time. So, I’m grateful for that.
Dr. Jim Dahle:
Let’s take a minute and talk a bit about our sponsor for this episode. Is a career change part of your strategy for the future? Provider Solutions & Development has a team of experts ready to guide physicians and advanced practice clinicians through today’s job landscape.
Dr. Jim Dahle:
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Dr. Jim Dahle:
Whether this is your moment to shine, pivot direction, or discover something new, Provider Solutions & Development has access to hundreds of opportunities across the country. To get started, reach out to a career coach today at www.psdrecruit.org/whitecoatinvestor.
Dr. Jim Dahle:
And of course, that link will be in the show notes as always. You should read the show notes. They are award-winning show notes. Cindy does a fantastic job putting them together. We had lots of compliments about them. They don’t get read quite as often as our regular blog posts, but they do get read quite a bit.
Dr. Jim Dahle:
That is also a good place to leave questions and comments and feedback about the episode. It’s just in the comments below in each of those published show notes. They’re published on Thursday on the blog, same day that the podcast drops so you can download it.
Dr. Jim Dahle:
All right, let’s get into some content here for this podcast. Isn’t that why you’re listening? You want to hear all this good stuff we put together for you today? Well, here comes our first question. This one comes in by email.
Dr. Jim Dahle:
Doc says, “The practice I’ve been working at was purchased by a PE firm last year. The group’s in its nymph stages and they’re offering a physician investment program. So, I’ll finally have the opportunity to buy into the practice”. That’s good. I like ownership.

Dr. Jim Dahle:
“After speaking with the groups legal counsel, the shares offered to the docs who didn’t own the practices, which were purchased are class B shares, which don’t allow voting rights. Everything else would be the same as class A shares from what I’ve been told. Do you have any experience with something like this? Obviously, voting rights are important, but would it be something that would make you avoid this investment opportunity altogether?
Dr. Jim Dahle:
I see a bright future with this group. The practices involved currently are highly profitable, and I plan on staying in the area long term. Additionally, what are the advantages, tax and otherwise to becoming a partner practice rather than just a W-2 employee? As I understand I’d be K-1 rather than a W-2. I would imagine I would be able to write off business expenses, depreciation, but I would also start having to make quarterly estimated payments”.
Dr. Jim Dahle:
Okay. So, let’s talk about partnership. First of all, this whole non-voting shares thing. This is not that uncommon in small businesses, and even in some larger businesses to have nonvoting shares. We have some equity compensation plans for some of our employees here at the White Coat Investor and the shares that they would get are essentially nonvoting shares as well.
Dr. Jim Dahle:
So, it’s not uncommon in small businesses that want to retain control to offer those. Basically, the bottom line is they usually say, “Take it or leave it. If you don’t want it, fine. But we’re not giving you anything else”. And the goal is they just want to retain control.
Dr. Jim Dahle:
It doesn’t mean it will be a bad investment, but it does mean that you don’t have voting control. It’s not quite the same as what I have in my small democratic group, where there is no private equity involved. It’s just us. And when we want to have something out, how we’re going to cover the holiday shifts, how we’re going to staff the ED, how we’re going to divide up the pool of money we make, who we’re going to hire, who we’re going to fire, et cetera. We all get a vote.
Dr. Jim Dahle:
And so, it’s not the same thing as that, but it may still be a great investment opportunity if the partnership is doing well and making money. So, I wouldn’t let that stop you from investing there or taking that as part of your compensation necessarily just because you don’t have voting rights.

Dr. Jim Dahle:
Okay. So, let’s talk about partnership. What changes when you make partner? When you become a partner, you go from being an employee to being an owner. So, there’s lots of changes there. I’m a big fan of ownership. In fact, I’m probably completely unemployable at this part in my life. I just think people would interview me for an employment position and my demands would be so much higher than anybody else’s they’d never hire me.
Dr. Jim Dahle:
Not that I necessarily demand more money, but when you demand 28 weeks of vacation a year, you’re probably not the most attractive employee for somebody. I also like kind of being the captain of the ship and being able to make the call on the things that matter most to me. So, I’m probably unemployable. Many docs I’m sure feel the same way.
Dr. Jim Dahle:
But when you’re the owner you take on more risk, you also have a lot more hassle. In exchange for that if the business does well, there’s more reward. And so, generally when you make partner, you make more money and that’s the attraction of making partner.
Dr. Jim Dahle:
The benefit of being an owner of the business is when the business does well, there is profit, there’s money left over after paying all the expenses. And that profit goes to you. Now, if you are an employee and a business does well and is profitable, that profit does not go to you. That’s the main difference between being an owner and being an employee.
Dr. Jim Dahle:
So, there’s a few different tax things. For example, you get K-1 forms every year. And this is how income is reported to partners in a partnership. A partnership fills out form 1065. That’s the equivalent of a 1040, except for a partnership. And as part of that, they have schedule K and then they distribute schedule K-1 to each of the partners.
Dr. Jim Dahle:
And that’s how your income and your share of the expenses and your share of ownership and everything is reported to you and to the IRS. It’s not quite as straightforward as a W-2, but it’s really not that hard. You can still do your own taxes on TurboTax, just putting in a K-1. It’s really not that big of a deal. Just follow the directions. You go down the form, you put in the numbers and it spits out what you owe in taxes. It’s not a huge issue.

Dr. Jim Dahle:
But the truth is you usually get it later. W-2 often comes the third, fourth week of January. А K-1 often comes 1st of March or even the 1st of April. And sometimes, especially with a lot of syndicated real estate deals you may not get your K-1 until July or even September and you end up having to file these extensions to do your taxes.
Dr. Jim Dahle:
So that can be a little bit of a pain that you can’t do your taxes quite as early. But honestly, you shouldn’t be aiming for some huge tax refund anyway. The ideal goal is to make a little tiny payment to the IRS coming April, not to actually get any money back at any rate.
Dr. Jim Dahle:
So that’s one change. You get K-1 instead of a W-2. What that means for you is nobody is withholding your taxes. Nobody is withholding your payroll taxes, which are social security, Medicare, et cetera. Nobody’s withholding your income taxes. So, you have to pay those on your own. And you do that once a quarter with form 1040-ES, which is the estimated payment for.
Dr. Jim Dahle:
It’s no big deal. You put your name and your address and your social security on it, and how much you’re paying. That’s it. Those are all the lines on there. And you send it in with a check. You can also make payments online if you want. But you have to remember that you have to make the payments every quarter. If you don’t make the payments, you get penalized and you end up with penalties and interest in addition to the taxes that you owe.
Dr. Jim Dahle:
You also have to make sure that you’re having enough paid out in those quarterly estimated payments, because if you don’t have enough withheld, if you’re not in the safe Harbor, you’ll end up again, getting dinged.
Dr. Jim Dahle:
It’s usually best to pay the same amount with each quarterly estimated payment. These are due in April, June, September, and January for each of the four quarters of the year. I know those aren’t all three months apart. I don’t make the rules, okay? You got to make that second quarter payment after only two months after April, but that’s just the way it is. But you have to make those payments or you’ll get dinged.
Dr. Jim Dahle:
It’s easiest if they’re all equal and the IRS doesn’t really say anything, but if your income is not really equal throughout the year, that might be difficult. And there is a way to fill out a separate form to justify paying taxes later in the year if you’ve made the money later in the year. But you certainly can’t do the opposite.
Dr. Jim Dahle:
The U.S. federal income tax system is a pay as you go system. So, you have to pay as you make the money. And that means each quarter payment needs to cover the taxes more or less owed for that quarter.
Dr. Jim Dahle:
Now, some states don’t do that. Utah doesn’t have as pay as you go system. It’s all due on April 15th of the next year. You don’t have to make a single payment between now and April 15th of the next year, but the federal tax system is not like that.
Dr. Jim Dahle:
So, make sure you are staying in the safe Harbor, which means for a higher earner like you probably are, either paying 110% of last year’s tax bill, or 100% of this year’s tax bill. And that’s how you stay in the safe Harbor. They’ll give you a little bit of slack the first year, but after that, you’re going to get nailed if you don’t stay in the safe Harbor with those quarterly estimated payments.
Dr. Jim Dahle:
Now, of course, you’re a business owner and a business have legitimate business expenses. For example, maybe your phone or a pager, if anybody’s still has a pager, I don’t think anybody does. Your work mileage. Remember, work mileage is mileage driven between two work sites. Like your clinic and the hospital or two hospitals.
Dr. Jim Dahle:
It is not your commute. It is not from your home to a work site or from a work site to your home, but in uniforms, white coats, scrubs, equipment, your CME costs. That’s kind of a big boondoggle out there. That’s all tax deductible. And you can add that in as unreimbursed partnership expenses when you put your K-1 information into TurboTax, or when your accountant prepares your taxes, they can add that in. So, keep receipts for that. That is now all deductible, whereas it really is not deductible these days as an unreimbursed employee expense.
Dr. Jim Dahle:
You’re also responsible for paying for your own benefits. Not only do you have to pay both halves of your social security and Medicare taxes now, you also have to pay for any insurance, health insurance, or life insurance or disability insurance that your employer was covering for you. Maybe they provided you a CME fund. That’s probably not going to be there as a partner.

Dr. Jim Dahle:
But the downside is even though you’re responsible for paying for all that, you can’t just go out and get your own retirement plan. If you’re in a partnership, you can’t go open individual 401(k). You have to use the partnership’s retirement plan. And it’s subject to all the usual measures of 401(k) is so that it’s not just a benefit for the highly compensated partners and employees in the company.
Dr. Jim Dahle:
Depending on how many employees you have and how much they make and how much they contribute to the plan, it may determine how much you are able to contribute to that 401(k).
Dr. Jim Dahle:
But a good partnership will often offer a 401(k) with a profit-sharing plan that you can put up to $57,000 into in 2020. I think it’s $58,000 for 2021. And maybe even a defined benefit or cash balance plan in addition to that.
Dr. Jim Dahle:
So, look into those as you go to make partner and the rules and requirements for you to contribute to them. And a lot of times you can defer a lot of money to some future year when you’re not at your peak earnings level.
Dr. Jim Dahle:
So, overall, I’m big fan of becoming a partner. Congratulations on becoming a partner. Your job becomes a little bit more secure. You usually make a little bit more money. There’s a little more hassle and risk in your life, but it’s usually worth it. So, I hope that’s helpful.
Dr. Jim Dahle:

 

 

All right, let’s take a question off of the Speak Pipe today. This one comes from Brendan.
Brendan:
Hi, Dr. Dahle. Thanks for all that you do and for taking this question. I’m a primary care doc, two years out of training and with a modest but steadily growing portfolio. About five years ago, my wife and I put together a written investment plan predicated on an 80/20 asset allocation with indexing as the backbone.
Brendan:
Each mercifully small digression from the plan has been an excellent learning opportunity. Like at that time I bought airline stock right before a pandemic. Turns out failure is a great teacher.
Brendan:
As an avid reader of your blog and listener to the podcast it seems that many of the questions posts had the same flavor of answer. Something to the tune of, “What does your investment plan say?”
Brendan:
As a young investor I would be curious to know, however, what set of circumstances, if any, would prompt you to lose faith and long-term market returns and amend or edit your written investment plan. Again, thank you for all that you do.
Dr. Jim Dahle:
Okay. That’s really two different questions. You’re asking what circumstances would cause me to lose faith in long-term markets and what circumstances would cause me to mend with my investment plan. And that’s really a good demonstration of why staying the course is so hard because you’re always faced with this question. Is it different this time? Should I bail out? Should I change my plan in a reaction to the market conditions?
Dr. Jim Dahle:
And usually changing your plan assuming it was a sensible reasonable, well thought out plan is a mistake. What usually happens is you’re really chasing performance and you change your asset allocation just in time for the lagging asset class to finally start outperforming. And if you haven’t had that happen to you in your life, you probably haven’t been investing very long. It happens very, very frequently.
Dr. Jim Dahle:
So, let’s take that first question. What circumstances would cause me to lose faith in long-term market returns? Well, zombie apocalypse. Let’s say instead of Covid killing 1% of the population, it’s killing 80% of the population. That’s probably going to affect the economy enough that your long-term returns are not going to be very good. That would cause me to lose some faith in long-term market returns. What else? A nuclear war would probably cause me to lose some faith in long-term returns for similar reasons.
Dr. Jim Dahle:
But here’s the truth of the matter. These extreme circumstances, they’re going to cause you to have poor long-term. By long-term, I’m talking 30, 40, 50 years. My investment horizon, we’re talking about things that will cause a long-term poor return.
Dr. Jim Dahle:
These are terrible things. They are awful circumstances that will cause you to just be grateful that you’re still alive and have something to eat. The last thing you’re going to be worried about is going to be how the market did, right? So, these are the sorts of things that I would worry about as far as long-term market returns.
Dr. Jim Dahle:
Bill Bernstein talked about the four risks. The four horsemen of the apocalypse. He talked about inflation, which is obviously the most common. But he was really talking about hyperinflation like you’ve seen Zimbabwe. Deflation. Basically, the economic collapse we saw during the Great Depression. Confiscation. When the government comes in and takes everything. Think about Russia in 1918. And devastation. When the economy is just destroyed like Germany in 1945.
Dr. Jim Dahle:
Those are the things that cause poor long-term returns. That’s the real risk in your life. He calls it deep risk as opposed to volatility, which he calls shallow risk. And the truth about volatility is if you just hold on long enough, volatility comes back.
Dr. Jim Dahle:
And that’s what we often see when the markets are going up and down and people are panicking and trying to time the market and all that. It’s just volatility. That’s not actually real risk showing up. Real risk of those four factors that could show up from time to time in the history of the world.
Dr. Jim Dahle:
And so, I think that’s really a good explanation of things to keep an eye out for as far as losing faith in your long-term market returns. Outside of that other things don’t cause me to lose faith. An election certainly doesn’t cause me to lose faith. Changes in interest rates don’t cause me to lose faith. World economic events or world political events. These sorts of things are par for the course.
Dr. Jim Dahle:
You should expect the market to go down 10% about once a year. You should expect the market to go down 20% or more about every three years. These are expected events. They shouldn’t cause you to panic and change your investment plan.
Dr. Jim Dahle:
Okay. So, what would cause me to amend my investment plan outside of a zombie apocalypse? Well, personal changes in my life. For example, if you end up acquiring more money than you thought you were going to make. You get a big inheritance. You get a big windfall of some kind. You end up reaching financial independence earlier than you thought.

Dr. Jim Dahle:
These are reasons you might amend your investment plan. You’ve reached your goals. Maybe you need to take less risk with your portfolio in that sort of a situation. But in general valuations of one asset class against another, those change over time. And that’s not something that I would necessarily change my asset allocation for. I hope that’s helpful and answered the question, Brendan.
Dr. Jim Dahle:
All right. Next question is what is the difference between rule 506(b) and rule 506(c). When we’re talking about this, we’re mostly talking about these private real estate syndications that a lot of you as higher earners are eligible for.
Dr. Jim Dahle:
Rule 506(b). If that is the rule that the syndicator is operating under, it means that the deal is open to accredited investors and up to 35 sophisticated investors. Sophisticated investors are somebody who doesn’t have the income nor the assets to qualify as an accredited investor.
Dr. Jim Dahle:
That’s not that high of a bar. It’s a million dollars in investible assets or an income of $200,000 by yourself or $300,000 together with your spouse. That’s all it takes to be an accredited investor. It’s not a high bar. That hasn’t been indexed to inflation. As inflation has gone up over the years, the bar has gotten lower and lower and lower. But under a deal that’s 506(b) all you have to do is be a sophisticated investor and you can be one of those 35 people that’s led into the deal under that rule.
Dr. Jim Dahle:
506(c) is a little bit stricter in that. It just requires that all the investors be accredited. Tends to have a strict verification process. We require you to prove your income or assets. Sometimes that’s hard to do on your own. And so, you sometimes use a third-party service. There’s a number of men out there that might help make it a bit less of a hassle. But those are the two rules that people usually put these syndications together under.
Dr. Jim Dahle:
Okay, next question is going to come from Joe off the Speak Pipe.
Dr. Jim Dahle:
Before we get into that, I wanted to make sure that you are aware of an opportunity coming up, which we call PIMD con. Passive Income MD con. And if you’re interested in real estate, whether passively through syndications and funds, or if you are interested in investing directly, this sort of a conference is good for you.
Dr. Jim Dahle:
Last year, we had a wonderful time out in California. It was a one-day conference. It has been expanded this year. It’s going to be a three-day conference I believe. I think it’s October 9th through 11th, and it’s going to be all virtual this year due to the pandemic, but it is coming up right away.
Dr. Jim Dahle:
If you would like to learn more details about it, if you’d like to attend there, be sure to check it out. You can do that at whitecoatinvestor.com/pimdcon. Just like a Passive Income MD con. And that will take you right to the link that will give you more information about pricing, what the terms are of the deal, who’s going to be speaking at the conference. I’m one of the speakers, but there’s going to be a number of other great sponsors there as well.
Dr. Jim Dahle:
So, if you’re into real estate, if you’re into passive income, if you’d love to free yourself from your practice, this conference is for you. Be sure to check it out – whitecoatinvestor.com/pimdcon.
Dr. Jim Dahle:
All right, let’s listen to Joe’s question off the Speak Pipe now.
Joe:
Hey, Dr. Dahle. My name is Joe and I have a question about small cap value investing and asset allocation. To give you some perspective, I’m 35 years old. I keep an 80/20 stock to bond ratio in my portfolio. It’s a very simple portfolio and consists only of Vanguard index funds. I previously haven’t done any tilting of any kind and I don’t own any individual stocks.
Joe:
After doing some reading recently, I decided that I wanted to have 15% allocation to small cap value in my portfolio. So, I went into my personal capital account, looked at my current allocations and then calculated the amount of a large cap index fund that I would need to sell in my Roth IRA. And then I went and did that. And then I took that amount and purchased that amount in a small cap value ETF VBR.
Joe:
So, then I went back into my personal capital account and I realized that even though I purchased the equivalent of 15% of my portfolio of a small cap value, my small cap value allocation only went up to about 5%. The other areas of small cap also went up to about 5% small cap blend and growth. And then my mid-caps also went up.

Joe:
I’m assuming that this means that even though VBR is a small cap value ETF it also consists of some stocks that fall in mid cap and the other areas of small cap. So, my question is if I want to achieve a 15% allocation to small cap value, does this technically mean that I need to purchase an even larger amount of a small cap value fund to achieve that 15%? Hopefully, this isn’t too confusing of a question, and hopefully, I don’t sound too much like an idiot. I appreciate any advice you might have. And thanks for all that you do.

Dr. Jim Dahle:
Okay. This is a relatively in-depth question. Joe says he wants to tilt the small value 15%, but he doesn’t really define what he means by that. It sounds like he means that he actually wants when he runs a morning star instant x-ray, which is available if you just Google TD Ameritrade morning star instant x-ray tool, you can practice this with your mutual funds or with your entire portfolio.
Dr. Jim Dahle:
But if you do that, you will see that that tool will tell you how much of your portfolio is in mid cap value, how much in a small cap value, small cap blend, large growth, et cetera. It divides the market up into nine portions from large cap growth to small cap value.
Dr. Jim Dahle:
And it sounds like he may want as much as 15% in that small cap value box, which in order to do that, you’re going to need to have a lot more than 15% of your portfolio, at least have the equity in the Vanguard small value fund.
Dr. Jim Dahle:
And the reason why as the Vanguard small value fund is not that small and it’s not that value. It actually has a fair number of mid cap value stocks in it. I think it’s about half and half. Kind of always has been that way for various reasons.
Dr. Jim Dahle:
So, if you want more of a small cap value tilt than what that’s going to offer you, you can find a fund or an ETF that is smaller and more value than the Vanguard fund, whether you buy it as the traditional mutual fund or whether you buy it as the VBR ETF.
Dr. Jim Dahle:
For example, RZV is an ETF that follows, I think the S&P 600 value index. It’s basically a smaller index and a more value index than the Vanguard fund follows. For example, if you put each of these into that box, that Morningstar instant x-ray box, you will see that the Vanguard fund has 17% of its stocks in mid cap value, 18% in mid cap blend and 7% in mid cap growth. And then it has 31% in small cap value, 21% in small cap blend and 6% in small cap growth.
Dr. Jim Dahle:
As opposed to RZV which has 77% in small cap value and 19% in small cap blend and only 4% in small cap growth. So, as you can see, when you look at that, RZV is far smaller and far more value than VBR.
Dr. Jim Dahle:
So, what should you use? Well, nobody knows. I mean, if small value stocks outperform over your investing horizon and there’s reasonable evidence suggests they will, although obviously no guarantees, then you’ll want the smallest, most value stocks that you can get.
Dr. Jim Dahle:
If it doesn’t outperform, well, you’ll be glad that you didn’t have as value or as small of a fund or none at all. Maybe you’re a total market kind of person that doesn’t tilt your portfolio at all, and that’s fine too. But you basically have a decision to make. You can either hold more VBR or you can hold less RZV and get you to the same place.
Dr. Jim Dahle:
But what the right move is, how much tilt you should have in your portfolio. Honestly, it depends on future returns, which you can’t know and I can’t know because we don’t have a functioning crystal ball.
Dr. Jim Dahle:
So be sure, especially that you don’t tilt your portfolio more than you believe. Because what will happen is you’ll hit a period of time like the last 10 years when large growth really smashes the snot out of small value, and you’ll lose faith in your plan and you’ll bail out of it, probably just before a small value starts doing awesome.
Dr. Jim Dahle:
Maybe the next decade from 2020 and 2030 small value dramatically outperforms large growth. And those who stayed the course with their plan with a small value tilt are going to do awesome. But there’s obviously no guarantee of that.
Dr. Jim Dahle:
Oh, let’s see. Oh, I just got a message. Some more details from Peter Kim, the Passive Income MD. He says there’s going to be a 15 plus speakers on topics such as buying cash flowing rentals, investing by leveraging other people’s time and experience, asset protection, tax saving strategies. There’s going to be a popup Facebook group for it for community discussion.
Dr. Jim Dahle:
It’s actually free. This thing is free. Now there’s a VIP all access pass option that includes replays and Q&A sessions with the speakers. I think you’re going to have to pay for that, but the conference itself is free. So, if you want to register for that whitecoatinvestor.com/pimdcon. Check that out today.
Dr. Jim Dahle:
All right, let’s take another question off the Speak Pipe. This one’s coming from John. I don’t know John, but John, like many of you has a difficult job and works hard and spent a long time learning how to do that job. And I just want to say thank you to all of you out there like John who have dedicated your lives to medicine, to dentistry, to law, to whatever your profession might be, and made those sacrifices. It’s a big deal. And it’s not until we really need your services that we realize how grateful we are that you’re there. So, thanks for what you do.
Dr. Jim Dahle:
All right. Let’s take John’s question.
John:
Hi, my name is John. I’m a little over four years out from my fellowship training as a private practice radiologist. I paid off my medical school loans in their entirety, which was approximately $280,000. I’m making anywhere between $550,000 and $700,000 a year. I have approximately $50,000 going into my 401(k) maxing my backdoor Roth contribution and maxing my cash balance plan contribution, which is around $90,000 a year for my age. My retirement accounts, total about $500,000 at present.
John:
My question is this. I’m still renting primarily because I’m quite debt averse and wanted to save an appropriate down payment for a place. The housing market in Portland is pretty tight right now, and I just can’t find anything that’s super appealing to me so I keep kicking that can down the road.
John:
My cash in my checking account just keeps growing and growing. Currently at about $200,000. I’m still looking at the houses, but who knows when I’ll actually find something. I’m getting increasingly uncomfortable with this substantial pile of cash just losing value each year.
John:
What can I do with it so that I can at least keep up with inflation, but keep it sufficiently liquid that I can slap it down on the table as a down payment, when the right house does come along? Thank you for all that you do. About 90% of my financial literacy is due to your work and I’m hugely appreciative for that. Have a good one.

Dr. Jim Dahle:
Okay. Great job, John, on paying off your loans to start with. You paid them off really quickly. You’re maxing out your retirement accounts. You’re doing fantastic. You got a lot of money in cash, though. You got $200,000 sitting there in cash and you’re still renting.
Dr. Jim Dahle:
It sounds like you’re okay with that. You just want to still keep it safe and liquid, but still have it available for a down payment at some point in the future, but maybe earn a little bit more on it.
Dr. Jim Dahle:
Well, this is all of our dilemma, right? With these really low interest rates, none of these fixed income options are paying that much. I think high yield savings accounts are down to about 0.8% right now, as you take more term risk and default risk with your bonds, you can get that up to 2% – 3% maybe. Maybe you can get CDs up in the 2% to 3% range. But that’s about it right now. If you want to earn any more than that, you’re going to have to take some risks, which means equity risk or real estate risk, that sort of thing.
Dr. Jim Dahle:
So, a few things I should say in regard to this question. One, I’m a fan of ownership of your home when your personal and professional life are stable. So, if you’ve been putting this off because you don’t like housing prices, or you don’t want to have as big of a mortgage or whatever, but actually your personal life and your professional life are stable, it’s probably time for you to buy a home.
Dr. Jim Dahle:
So, once you take that cash, go buy a home with it. Buy a home that you’re going to be in for a long time, at least five years, preferably 10, 15 or more so that works out well financially for you. But that’s okay to go buy a home.
Dr. Jim Dahle:
If $200,000 isn’t enough for a 20% down payment on your home, save up just a little bit more or use a doctor mortgage. Still no extra insurance costs you have to pay. Nobody likes paying that stuff for the bank in order to insure them against you defaulting on your loan. That’s called PMI – Private Mortgage Insurance. It doesn’t do you any good. It’s just insurance they make you buy to protect them. But maybe you ought to go out and just buy a home. It sounds like that’s what you’re saving up for. Maybe now is the time.

Dr. Jim Dahle:
The second point I want to make. Chasing yield almost always comes with additional risk. You’re going to get less liquidity and more possibility of loss. Yes, it’d be great to earn more than 0.8%, but you know what? For every additional bit of yield, you’re going to get above and beyond that, you’re going to take on some additional risk. And only you can decide how much more you’re willing to take.
Dr. Jim Dahle:
Third issue. The further away the date when you need the money and the less important that loss between now and then is the more risk that you can take. So maybe you could use a CD. Maybe you could use a short-term bond fund, maybe even an intermediate term bond fund or even a balanced fund.
Dr. Jim Dahle:
But at least make sure the money is in a high yield savings account instead of your checking account so you’re making 0.8% instead of nothing. That’s always a reasonable thing to do to start with when you’re trying to get a little bit more yield. I mean 0.8% on $200,000 isn’t a lot of money. It’s $1,600 a year, but it sure beats nothing. So why don’t you take a look at that?
Dr. Jim Dahle:
All right, let’s do our quote of the day here. This one comes from Robert Doroghazi. He is a cardiologist who wrote a book. He said, “Physicians make enough money that they just need to be wise and control arrogance, ego and greed to be able to live a life of financial security”. I totally agree with that.
Dr. Jim Dahle:
All right. Our next question about the Speak Pipe comes from DJ. Let’s take a listen.
DJ:
Hi, Jim. Thanks for all you do. I have a question about tax gain harvesting. I’m 51 years old and recently retired. I’ve been very fortunate to amass a sizable amount of money through investments and I currently have right around $1 million in unrealized gains in my investments.
DJ:
I was wondering how you would go about making the decision, whether to sell some or all of these assets now in light of the extremely low tax rates, and then immediately reinvest them to raise my cost basis for the future when tax rates are very likely to be higher.

DJ:
I estimate I have to pay around $220,000 in federal tax and another $40,000 in state tax if I did this in 2020. If tax rates go up to the possible 39%, either next year if Biden wins or in 2025 when the current tax bill expires, I would be paying 17% more in taxes, which will be an additional $170,000.
DJ:
Obviously, I would lose the compounding interest on the amount of tax I paid now $260,000 if I went that route. I don’t want the tax tail to wag the investment dog, but I also don’t want for myself or for my heirs to have a massive tax bill in the future. Would you do?
Dr. Jim Dahle:
Okay. DJ, you’re doing great. Congratulations on your success. He is basically an early retiree with a million bucks and unrealized gains, but he really sounds like overly worried about paying taxes on that. And I wonder if he maybe doesn’t understand how taxes work on that stuff, particularly for his heirs.
Dr. Jim Dahle:
He’s wondering if he should do what we call tax gain harvesting to raise his basis on those shares in his taxable account. Now that can make some sense in certain situations.
Dr. Jim Dahle:
For example, let’s say you have a significant amount of money in a taxable account and you go to school. You go back to dental school or something and your income goes to nothing.
Dr. Jim Dahle:
Well, that’s a great time to tax gain harvest because you can essentially raise the basis of those shares, what you paid for them to a higher amount without actually costing you anything in taxes. But for somebody that’s in their career or even an early retiree, chances are you’re really not going to do much there unless taxes go up very dramatically.
Dr. Jim Dahle:
But there’s a couple of things that would make me not want to do what he is considering doing. First rates may not go up. Everyone’s worried rates are going to go up. People have been saying, “Rates have to go up. They have to go up. They have to go up”.

Dr. Jim Dahle:
Well, guess what? When President Trump was elected rates went down, tax rates went down. They went down dramatically and people have been saying for 5 or 10 years before that, “The rates have to go up. They have to go up dramatically”. Well, they don’t have to. Tax rates don’t always have to go up.
Dr. Jim Dahle:
And so, realize that there’s no guarantee that rates are going to be dramatically higher in the future. No matter how much scaremongering an author, a YouTuber or a blogger does. It’s really difficult to forecast exactly what future tax rates or interest rates or whatever are going to be.
Dr. Jim Dahle:
And the truth is if those rates go up, it’s usually forecast pretty well, right? It’s all over the news. And usually, it doesn’t happen retroactively. It happens starting at some point in the future. And so, that gives you time if you really wanted to tax gain harvest to then do it at that time, before the rates go up.
Dr. Jim Dahle:
Point number two. You don’t actually pay taxes on money that you leave behind even if as a very low basis. If you leave it to charity or you give it to charity while you’re still alive, or if you leave it to your heirs.
Dr. Jim Dahle:
You get a step up in basis at death, meaning your heirs, their basis, what they paid for that stock or what they paid for those mutual funds’ shares, what they paid for that rental property is what it was worth on the day you die. Actually, there’s a way you can push that back even another six months. But basically, the value when you die, rather than the value originally paid for it.
Dr. Jim Dahle:
So, once you realize that it seems really silly to pay taxes on your entire portfolio when there’s a good chance that a lot of that portfolio is never going to be spent by you, it’s going to be left to your heirs. And so, paying taxes on something that no one would have to pay taxes on later is obviously not a smart financial move. So, don’t do that.
Dr. Jim Dahle:
I would really avoid tax gain harvesting at any significant rate. If you can do it free, great go for it. But if it’s going to cost you something in taxes, I probably would put it off and maybe never realize the gains on those shares. I would simply spend the income. I would sell shares with higher basis. I would use the low basis ones to give to charity, to leave my heirs, et cetera, and try to avoid paying those taxes at all. It would take a really extreme change in tax law for me to really go for that.
Dr. Jim Dahle:
One thing you ought to consider thou, especially as an early retiree with a lot of money is using some of that money you have to pay for Roth conversions. If you’re really worried that tax rates are going up later, you got to be far more worried about your tax deferred money than about your taxable money.
Dr. Jim Dahle:
And so, what you do, if you’re really worried about that is you pay the taxes now and convert that tax deferred money to Roth money. And the other benefit of doing that as long as you do it into a Roth IRA is you also eliminate required minimum distributions, which under current law begin at age 72 now.
Dr. Jim Dahle:
And so, you can avoid those distributions. You can hedge against future tax rate increases by doing Roth conversions, at least up to the top of your nearest tax bracket. So, I’d encourage you to look really closely at that and really maybe stop looking at tax gain harvesting. I think that’s probably going to be a mistake.
Dr. Jim Dahle:
If you would like to lose questions for this podcast, get your questions answered on here like DJ did. You can do that at whitecoatinvestor.com/speakpipe and you can just record it. It can be up to a minute and a half. If you screw it up, just record another one and tell me, “Don’t use the first one”, and we’ll get you on here and get your questions answered.
Dr. Jim Dahle:
Our next one, however, comes in by email. I found it pretty interesting. I didn’t really have an answer. I’m hoping maybe some of you do. This is a medical student. He says, “I’ve been receiving your newsletter for a few years now and had a significant change in my life.
Dr. Jim Dahle:
I was a Caribbean medical student that was completing my third-year rotations that were unceremoniously canceled due to Covid-19. The school was not very transparent, as you can imagine. When I pressed them and provide a plan forward that includes all of my canceled rotations being rescheduled, I’ve been accused of being difficult. Needless to say, I’m in a financial pickle. Do you offer any programs that will help with what I’m facing now and, in the future, as I go forward? On a side note, I do have the time to complete one of your financial literacy programs now.
Dr. Jim Dahle:
Well, that’s great. I suppose that’s really looking for the silver lining there. This is a big problem. This is a problem not only with some Caribbean schools, but a big problem with a lot of the DO schools out there where the students are kind of expected to go line up their own rotations.
Dr. Jim Dahle:
And of course, with hospitals going, we don’t want anybody extra in the hospital because of coronavirus. All of a sudden, all these students are being put on hold. They’re either ended up with a crappy education. They’re missing rotations. It’s hard to decide what specialty you want to go into because you haven’t rotated in it and it’s costing you more money. You’re not getting anything for your tuition dollars.
Dr. Jim Dahle:
There are all these issues. It’s totally unfair. It’s a real risk you take when you go to medical school in the Caribbean, or at some DO schools that don’t have a hospital associated with them. And so, I try to warn premeds about those risks. Obviously, this is an example of those risks showing up.
Dr. Jim Dahle:
But I don’t have a program that lines up rotations for you. I don’t even know where to send you. I guess I’d just caution remind our readers that medical education occurs primarily out of the goodness of the hearts of its practitioners and to maybe be a little bit more flexible with taking on students, contacting you to do a rotation because they really may be in a terrible situation like this student is.
Dr. Jim Dahle:
Our next question comes from Sumeet off the Speak Pipe let’s take a listen.
Sumeet:
Hey Jim, this is Sumeet Seagal from Las Vegas. I was trying to conceptualize the concept of pro-rata rule. And to help me understand it, if a person is making $120,000 a year and is self-employed and has been contributing every year to SEP IRA. Now decides to open up a Roth IRA and make a contribution of $6,000 directly into that account. Is this scenario where the SEP IRA will also be subject to the pro-rata rule? Thank you so much.
Dr. Jim Dahle:
Okay. Sumeet is asking about the pro-rata rule. I think there’s a little confusion here. The pro-rata rule involves the backdoor Roth IRA process. If you are going to do a backdoor Roth IRA, which is a two-step process, right? You put money into a traditional IRA that you don’t get a deduction for and then the next day you convert it to a Roth IRA.
Dr. Jim Dahle:
Okay. Two steps there. The contribution step and the conversion step. If you’re going to do that, the pro-rata rule applies. Meaning that you really need to zero out your SEP IRAs, traditional IRAs, rollover IRAs, simple IRAs, et cetera by December 31st of the year, you do the conversion step.
Dr. Jim Dahle:
But in this situation, it doesn’t sound like the pro-rata rule applies at all. The example given was making $120,000 a year with some money in a SEP IRA and contributing to a Roth IRA.
Dr. Jim Dahle:
Well, there’s no pro-rata rule involved there. You can make a direct contribution to a Roth IRA if your modified adjusted gross income is less than $139,000 for single people and $206,000 for those filing married, filing jointly in 2020.
Dr. Jim Dahle:
So, at $120,000, this doesn’t apply to you at all. You can just contribute to your step IRA. You can contribute to your Roth IRA. There’s no pro-rata at all. The pro-rata only applies when you’re doing backdoor Roth IRAs.
Dr. Jim Dahle:
Now, if your income is doubled, all of a sudden, you wouldn’t be able to do a direct Roth IRA contribution. If you want to contribute to a Roth IRA, you would have to do a backdoor Roth IRA, and you’d have to do something with that SEP IRA. What most people do is open a solo 401(k) for their 1099 work and make their contributions they’re going forward and roll the SEP IRA in there, going forward. And then that eliminates the pro-rata issue. But in this case, there is no pro-rata issue. So, you should be fine.
Dr. Jim Dahle:
All right. I hope that was enjoyable. I hope you enjoyed learning about those different situations these doctors are facing. I’m sure there are some other questions you have that we can answer for you. Send them in by email, tweet them at me. It’s at White Coat Investor. Get them on the SpeakPipe at whitecoatinvestor.com/speakpipe and we’ll try to get those questions answered to you.
Dr. Jim Dahle:
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Dr. Jim Dahle:
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Dr. Jim Dahle:
Thanks for those of you who are leaving us a five-star review and telling your friends about the podcast. The most recent one came in from Name675. I’m assuming that’s anonymous, who said, “Avoid the financial pitfalls. Jim gives excellent advice on the major aspects that affect physician finances. It’s info you need to make an informed decision on your financial future”. Five stars. So, thank you to Name675 for that.
Dr. Jim Dahle:
Keep your head up, your shoulders back. You’ve got this and we can help. We’ll see you next time on the White Coat Investor.

Disclaimer:
My dad, your host, Dr. Dahle, is a practicing emergency physician, blogger, author, and podcaster. He’s not a licensed accountant, attorney or financial advisor. So, this podcast is for your entertainment and information only and should not be considered official personalized financial advice.

 

 

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