The word ‘investing’ can seem overwhelming: the terminology, the different strategies, and, of course, the actual investment selection. But the truth of the matter is that ‘investing’ itself is not as scary as it sounds. In fact, if you have funds set aside in a savings account or you have been contributing to your retirement account, then you are already taking steps in the right direction! But will that money create financial freedom for you and your family down the road?
As financial planners to physicians, dentists, and executives, we encourage our clients to look beyond the scope of basic savings when planning for their financial success.
The three essential considerations when determining suitable investment options are:
While it’s important to establish an emergency fund and make maximum contributions to your retirement plan, the next crucial step is to make your money work for you—and this is where investing comes in.
As we discuss savings and investment strategies today, we will highlight examples taken from a case study from the framework of a real physician involving two of our friends: Dr. Sarah and Caleb Smith.
We will be covering the benefits of investing, the importance of setting your goals, assessing risks, and determining when you should invest. Along the way, we will provide explanations for how money is managed and offer investment strategy ideas for you to consider. Let’s get started.
One of the first steps in successful investing is defining why it’s important to you—what are your goals? The theory behind goal-based investing is that by setting goals, you’ll be more likely to save for (and attain) those goals. Whether you're saving for a new car or thinking further out towards retirement, it’s important to highlight what this money will be used for and when it will be used.
Once you have determined your goals, you can start planning. During the planning process, you will want to uncover both the total cost of the investment and your initial funding amount, as well as how much you’ll be able to contribute over time. Knowing these key factors ahead of time can increase the likelihood of achieving your goals.
When choosing your investments, it is important to evaluate your sensitivity to risk. A simple way to do this is to ask yourself what you would do in the situation of a market correction. If your answer is to take your money and run, then chances are you are more risk-averse, and you may want to consider more conservative options. As the saying goes, higher risk is associated with the possibility of higher returns—but of course, this can also mean the potential for greater loss.
Outlining your goals and a time frame will better help you determine a comfortable level of risk. If your goal is more short-term, you may not be willing to take on the same amount of risk as someone who has a longer time horizon. It’s important to understand that aggressive and conservative investment vehicles serve two different purposes: respectively, to seek higher returns and to preserve capital.
Another factor to consider when choosing your investments is when. When is the right time to invest?
You will not be ready to invest until . . .
Once you have checked all of these boxes, you can start exploring investment options that will help you achieve your goals.
You need to understand how money is managed and how a mutual fund works. This knowledge is key to helping you make educated investment decisions.
Mutual funds can invest in a whole bunch of things, not just stocks. A mutual fund is nothing more than a group of people pooling their money together and working with an investment company that is going to find a portfolio manager (a mutual fund manager) whose job is to take all of the money and decide how it is going to be invested. It’s up to his or her discretion to decide whether he’s going to buy AT&T, Wal-Mart, or Microsoft, whether they want to buy CDs or real estate, a whole host of opportunities … bonds, stocks, real estate, etc.
What governs and guides the manager is based on the objective of the fund.
One of the interesting things we hear when working with clients is when they say, ‘I don’t think I have a good portfolio.’ It’s not uncommon for the fund itself to be perfectly fine; it’s just that the investor's objective doesn’t match the fund's objective.
There are three advantages to investing in mutual funds: diversification, professional management, and money growth.
Once you understand how money is managed, you will need to understand how you should invest. Two primary strategies, the buy and hold investment strategy and the dollar-cost averaging investment strategy, can be used to mitigate the fluctuations within the stock market.
The first is called buy and hold. Over time, the market has a history of moving in an upward direction. However, there are also times when the market goes down. Simply put, when employing a buy and hold strategy, you invest a sum of money and hope and trust that when you need the money back, the market will have gone through its gyrations and that your principal will be worth more than when you invested it. The longer you hold, the more likely it is that the account may have appreciated.
The second strategy you could employ is called dollar-cost averaging. It’s a system of subsequent periodic purchases that allow an investor to manage their risk.
There are fees and charges associated with investing in mutual funds. Mutual funds are subject to market risk, including the potential loss of principal.
Now that we have a general understanding of goal setting, assessing risks, the best times to invest, how money is managed, and an overview of a couple of investment strategies, we can take a closer look at this case study involving Dr. Sarah and Caleb Smith. Take a look at this snapshot of their financial picture.
Dr. Sarah and Caleb Smith Financial Snapshot
Assets
Liabilities
They have many of the same questions you do about how much to have in savings, whether to pay off debt, Roth IRAs, and when and where to invest.
Now I think we’d agree that Sarah and Caleb can answer yes to each of the “when should invest” questions, so it seems reasonable for them to consider investing. Obviously, this may not be true in your situation and that’s OK. We’ve created their scenario specifically to allow us to discuss some of the other investment questions you raised, but if you would answer “no” to any of these questions, then it really makes the most sense to work on those issues first.
But since Sarah and Caleb can start investing $400/month, we need to understand how to choose where to start. To do that, we’ll introduce the TAX CONTROL TRIANGLE.
It’s helpful to begin reviewing investment options while understanding their tax implications, so we’re going to introduce you to a concept we call the tax control triangle.
The first category of investment vehicles is considered pre-tax because contributions are made on a tax-deductible basis or before your paycheck is deposited. [For example, 401k, 403b, Keough plans, IRAs, SEP IRAs, etc.]
Next, we have “after-tax” investment vehicles, such as savings accounts, money market accounts, mutual funds, CDs, and brokerage accounts with stocks and bonds.
The final category uses after-tax contributions, but the proceeds are ultimately tax-free. Can you think of something that might fall into this category? Yes: Roth IRAs, College savings plans/529s, the cash value in a life insurance policy, and home equity in a primary residence. Money that you invest here is after-tax, but after you put in the initial deposit, any dividends, interest, or appreciation happens without any tax liability – and 100% of the proceeds come back to you!
So, let’s go back to Dr. Sarah and Caleb. The point here is not that all your money should be in one bucket or the other, which is sometimes a hasty conclusion, but that there are benefits to each category, and it’s helpful to understand these so that you can make an informed decision for Dr. Sarah on where to put her $400 a month.
Since Sarah is already contributing to a 401(k) and receiving the maximum matching dollars, and they have enough in an emergency fund to get through their transition, the other avenue that’s really attractive right now is the after-tax bucket, and that's a Roth IRA.
Traditional IRA vs. Roth IRA
The difference between a traditional IRA and a Roth IRA is that the money we put in a traditional IRA is deductible today but in the future will be fully taxable. Whereas money that we put in a Roth IRA is after-tax today, no matter how big it grows in the future, it’s tax-free. That sounds pretty good, doesn’t it? In fact, it sounds so good that the IRS wants to severely limit who can put money into Roth IRAs. Most physicians may not be eligible to put money in Roth IRAs when in full practice because they may be earning too much and exceed the income limits on contributions.
Dollar-cost averaging does not inherently double your money, but it is important to be intentional about how you invest. Dollar-cost averaging helps you reduce risk because you end up with more shares at cheaper prices and fewer shares at more expensive prices, so even a small rise in the value of the stock helps increase return.
Specializing in the financial planning needs of physicians and dentists, our goal at Spaugh Dameron Tenny is to help you make smart financial decisions that will ultimately help you achieve your goals. We firmly believe in the value our in-depth services can provide, as annual financial planning allows you the opportunity to formally review your goals, make any updates (if needed), and evaluate your progress along the way. Whether you are in training, practice, or retirement, we invite you to explore our services. Contact us today to learn more about how we can help you.
Editor’s Note: This article was originally published in December 2018 and has been completely revamped and updated for accuracy and comprehensiveness.
1 To be eligible for tax-free income, you must have established your Roth account at least five years ago and be at least 59½ years old unless deceased, disabled, or distribution was for a qualified exception.
2 Municipal bonds are often exempt from federal income tax; however, depending on the specific bond, some taxpayers may be subject to federal and/or state taxes. Municipal bonds are purchased and the investor typically receives interest on a pre-determined basis until the date of maturity. An investor cannot withdraw income from the bond.
3 Taxable annuity withdrawals are subject to income tax and, if made prior to age 59½, may be subject to a 10% federal income tax penalty. Variable annuities do not provide any additional tax advantage when used to fund a qualified plan. Investors should consider buying a variable annuity to fund a qualified plan for the annuity’s additional features such as lifetime income payments, living and death benefit protection.
4 The decision to purchase life insurance should be based on long-term financial goals and the need for a death benefit. Life insurance is not an appropriate vehicle for short-term savings or short-term investment strategies. While the policy allows for loans, you should know that there may be little to no cash value available for loans in the policy’s early years.
Distributions under a life insurance policy (including cash dividends and partial/full surrenders from a whole life policy or withdrawals from a universal life insurance policy) are not subject to taxation up to the amount paid into the policy (cost basis). If the policy is a Modified Endowment Contract, any distributions or policy loans are taxable to the extent of gain and are subject to a 10% tax penalty if the policy owner is under age 59½. Access to cash/ account values through borrowing, partial surrenders, or withdrawals will reduce the policy’s cash/account value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.
5 Withdrawals are subject to IRS taxation as ordinary income. If taken prior to age 59½, withdrawals may be subject to a 10% federal income tax penalty.
This information provided is not written or intended as specific tax or legal advice. We are not authorized to give tax or legal advice. Individuals are encouraged to seek advice from their own tax or legal counsel.
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Shane Tenny, CFP®, is the Managing Partner of Spaugh Dameron Tenny and a nationally recognized financial advisor. Since 2000, he has combined extensive financial knowledge with a passion for behavioral finance—helping clients make informed decisions based on both data and mindset. Shane often contributes to industry publications, appears as a guest on podcasts, and has been a leader in the financial planning field for years. He is known for making complex topics clear and practical for busy, high-income professionals seeking personalized advice they can trust.
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