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The Five Most Common FInancial Mistakes Physicians Make
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SEAN – Hello, my name is Sean O'Brien. I am the Vice President of Membership Programs for the Cooperative of American Physicians and I am sitting here today with Ravi Davis, Senior Partner with Hippocratic Financial Advisors. Recently CAP has partnered with Hippocratic Financial Advisors and many of our members have utilized Ravi's services and we feel that they're a great resource for our members.
The first one that's come up is actually the fiduciary rule and what that means and what people need to know about that? Is that something you can talk to us about?
RAVI – Yeah, it's in the news a lot these days with the change of the Administration. The outgoing Administration had made a very concerted effort to expand the fiduciary rule to cover all of Wall street and its actually in my opinion, one of the most important things that Physicians need to understand about where they get financial advice. Because it really changes the nature of what the obligations are of the person who is giving you the advice. So, simply put a fiduciary is someone who is legally obligated to put your interest ahead of their own. It a lot of ways it's like a Hippocratic oath for financial advisors and that's actually why we named our firm Hippocratic Financial Advisors, because we willingly adopted that standard and it really should be the standard in my opinion for everybody.
The issue is that, if you are not a Fiduciary and you're getting advice from let's say Merrill Lynch or any of the big wire houses, wall street firms then the advisor that you are talking to is only held to what is call the suitability standard and a suitability standard is a far lower standard. As long as they can make a case that whatever it is they sold you has some degree of suitability for your particular financial situation, then they don't have any liability. You don't have any way of going back and saying. hey, these guys took advantage of me and now I want to try and figure out how I can get this fixed.
So when physicians are looking at that sort of breakthrough or breakdown on those two pieces, if you have someone who is a non fiduciary, they are typically also going to be what is called Series 7 licensed and what that means is that their first obligation, there first legal obligation is actually to their employer, not to you. That's in addition to the fact that their employer actually employs them, so you can imagine not only are they...
SEAN – Not in the best interest of the client obviously, OK.
RAVI – That's right, where a fiduciary is going to, there first legal obligation and in my option there first moral obligation is to give advice that serves their clients.
SEAN – Ok, well thank you very much. I think that helps and clears up a lot of confusion that a lot of the members have been having. The next that we've gotten a lot of is, “Is what investing safeguards to prevent unauthorized use of monies can you put in place?”
RAVI – That's a great question. You see these; a couple of years ago there was the story in the news about a financial advisor who had, he had stolen his clients funds and tried to fake his own death. It was pretty funny for those of us in the Advisory community and he had actually flown a plane and radioed in that he was in distress and then jumped out with a big bag full of money and a parachute. Hi plan was foiled when the Air-force actually had a plane come alongside his plane which was on autopilot and see there was no one in there.
The main thing, the biggest thing is really to just use what is called a custodian. So some advisory firms will actually take, you give them your money and they have it and if they decide they want to withdraw it, it's in their account. I think a much better way of doing things and what we do is we use a custodian., so we use TD AmeriTrade, Fidelity. The money actually sits in an account in one of those major institutions. The owner of the account is clearly titled to whoever owns it and we are unable to withdraw money at all. We can manage the money, but we can't take money out beyond whatever our contract calls for advisory fees.
SEAN – Now is that just a document that somebody signs in terms of where the money goes and where the money is held for a physician? I mean if, for example putting it into something like you mentioned a custodian, is that just a document or is that normally what happens, or?
RAVI – Yeah, I know it's the choice of the advisory firm basically. So the advisory firm will decide how funds are going to be held. Do they want to keep them sort of in house or do they want to use one of these, you know major institutional platforms? I just think that you know, legally your advisor doesn't have the ability to one day wake up and try to go fly off with the a bag full of your money, it just removes it as an option.
SEAN – Now let me ask you, what type of fees, when you are adding that extra layer, what type of fees are going to be? You know that you are going to incur with putting it into a custodial account? Is that substantial?
RAVI – Actually, yeah none. That is going to be purely coming out of the advisors side of things. So you're going to pay your normal fee, whatever it is to the advisor and the advisor will pay fort the custodian if it is important to them.
SEAN – So Ravi, let me ask you, a lot of our physician members own their own business or are thinking about starting a business, starting a practice. This question came in a lot. Do you , would you recommend, should a Physician incorporate or when should they incorporate?
RAVI – Yeah, it's a great question. We get it all the time. If you're employed by someone else, incorporation is not really a big question. It's what's called a w-2 employee, which is a more traditional sort of employee employer relationship, like Kaiser for instance is w-2. If you are a smaller practice or if you are in certain specialties, like anesthesia, emergency medicine for instance, those tend to hire actually in an independent contractor setting. In that independent contractor setting, there are some real advantages to incorporating relative to not incorporating. If you're an independent contractor, or even if you just own your own business, but you don't have a corporation, the default and the way the IRS will look at you is what's called a sole proprietorship. Sole proprietorship just means that everything is reported on your tax return, so you're going to take all the income in on your tax return and you're going to have to run all the expenses on your own tax return and you're going to have everything show through on your return. The real big cost there, hidden cost relative to incorporating for physicians actually really is on the tax side.
SEAN – Versus sole proprietorship
RAVI – Yes, versus sole proprietorship. If you're a independent contractor and you get that money in, it's coming in as a sole proprietorship. You're actually responsible for what's called the self employment tax. If you're the employee, you get a w-2 and if you look at your pay stub or the pay stub of your spouse, you'll see that there are payroll taxes they're taking out and that's in addition to actually your income taxes which are a whole other system
SEAN - Of Course
RAVI – That's right. They have a lot of different ways of slowly taking it out. The slowly boiling frog. So, when that happens, you're paying about 8.65% typically in California on the first $130, $140 thousand of income. What you don't see is that your employer is actually paying a parallel 8.65% on your behalf. When you become self employed you are responsible for both sides of that payroll tax and that is called essentially the self employment tax. When you incorporate, you now have the ability to protect yourself from some of that. You are able to take the money in through a corporation. The corporation then actually you can do all of your expencing and other pieces inside the corporation as opposed to your tax return. There are some advantages just in that in the sense that physicians are already at a really elevated risk of audits, just because they're high income earners and the IRS tends to focus their limited audit resources on high income earners. So, they're already in an elevated risk. If you have a separate return for your corporation, then often times those tend to get audited less often than an individual returns for high income people.
SEAN - So you would recommend incorporating, versus LLC. Obviously a sole proprietorship you probably wouldn't want to go into because that doesn't protect your assets if something catastrophic happens. Whether it be in your practice or outside your practice. Something, you're responsible for. Your run somebody over or something like that, they can go after all of your assets in a sole proprietorship. Incorporating kind of separates those two. Personal versus company assets by incorporating.
RAVI – That's a great question Sean. I get that a lot from practicing physicians and also people who are just transitioning from training into practice or considering moving from let's say a major employer such as Kaiser into private practice. It's really important I think that physicians understand this. The biggest benefit to physicians is really on the tax side for incorporating. Normally, when you are w-2 employee, as you are when you are a resident or a fellow when working at a Kaiser or when you are in a direct employee sort of relationship. You are paying something called payroll taxes, but you're not paying the full amount. If you look at a payroll stub that you have or a spouse has you can see that they have that gross amount that you get paid right, then they'll take a bunch of money out and you're like what happened to all that money.
SEAN - Right, right, every week.
RAVI – So part of what happens is that they are taking out things like 401K contributions and things that you've agreed to and then they're also taking out things that you haven't agreed to that the government is going to come in and take in the form of taxes. The taxes that come out of a w-2 employee, they're really only paying half of the payroll taxes. The employer is actually paying the other half and it's a pretty substantial tax. It' works out to about 8.65% on your first $140 thousand dollars of income and then they're taxed a lower rate beyond that.
The big advantage when you're incorporating versus a sole proprietorship, lets say you go into practice by yourself and you don't incorporate. You're what's called a sole proprietorship by default by the IRS and that tax treatment requires that you report all of your income and all of your expenses on your tax return. That's one of the advantages of incorporating is that physicians are already at a really high risk of being audited, because the IRS is going to focus it's limited audited resources on high income earners and everyone knows physicians are high income earners
When you incorporate, you're actually able to have a separate entity and that entity you report all of your income and expenses on that separate tax return and then that income flows through to you. When that flows through to you when you are a sole proprietorship, whatever you get after your profit is all going to be subject to those payroll taxes. When you look at that same juncture for someone who has their own corporation, where they've taken the money into the corporation and then they've expenses out whatever expenses they have and now they're left with their profit. They're able to distribute the money from the corporation to themselves in two ways. The IRS does require that they pay themselves a certain amount of w-2 income, but they can also pay themselves profits from the corporation and when a corporation declares profits, it pays those profits to its shareholder and when you're talking about a sole proprietorship, of course there is only one shareholder. The big advantage is that the income that flows through that side is not subject to payroll tax. And so you can actually save a substantial amount of money in that balance. And that is really the primary advantage for incorporating for physicians. The question about when it makes sense for them to do it. One of the questions I get a lot from residents and fellows is that, hey, I'm moonlighting and getting that w-2 income, but I'm also moonlighting a lot. Should I be incorporating or not? There are actually some downsides to incorporating primarily related to expenses related to maintaining the corporation. You'll have an $800 minimum that you owe to the Franchise Tax Board. You obviously have to pay to form the corporation itself, although that's not an on-going expense and then you will have additional tax returns and a couple of others things that is going to come in there. So we typically try to look at where that cross-over point is between those benefits we were just talking about on the payroll tax side right and these expenses on the other side.
We would typically put that number at about $25,000 and up. So, if you're not making more than $25,000 of 1099 income, even though you could save money on the payroll tax side, it's typically not worth it from an expense side to incorporate at that point. But, if you are making over that, then typically it does make sense because the savings that you can generate through that distribution of income through the w-2 and what's called the K-1 will more than offset those expenses and makes sense there.
SEAN - It sounds very complex actually. It sounds like a topic some people need to follow-up and probably answer more questions. There's probably a lot more questions regarding that.
RAVI - There's no one way to answer that question for everybody. There are some specialties that it pretty much makes sense in the majority hiring structure the way they are set up like anesthesia, emergency medicine. Those specialties tend to have a built in independent contractors relationship with the group. But it really comes down to talking to someone a lot of times, to see if it make sense for you.
SEAN – But, it sounds like what you saying is that the tax benefit could be substantial in terms of being incorporated versus a sole proprietor.
RAVI- Yes, definitely. Once you're over $25,000, you do start to realize that benefit. Now that benefit actually increases as your income above that $25,000 increases as the 1099 side increases.
SEAN – That makes sense. Moving along. One of the other big questions we had was, how do you go about setting reasonable goals for retirement? A lot of physicians in various stages of their careers, just have that question come out. It really doesn't matter if it was someone just getting started early in their career, or middle career or getting ready to retire, They really kind of wanted to know what type of goals they should be setting. Is there a certain percentage of their income, they should be putting aside? Are there general rules regarding that, or what would you say?
RAVI – The questions that you are getting from your members are very much on point. These are a lot of the most salient issues that people face. And there, you know finance is not science. One of the things that I think a lot of financial people try to do is to cast finance in the light of science and it's not. There are actually multiple different answers and we don't necessarily have one objective reality that is going to answer the question definitively. So, if you look into this question on the academic side, there are lots of different attempts of answering this. Our focus is really on satisfaction in retirement. That's really how we try to drill down into what do people need to do in order to reach a certain satisfying retirement.
SEAN – So you kind of do it backwards, like how much...
RAVI – That's exactly right. We actually figure it out in reverse. So, if you look at the academic studies on this question about satisfaction in retirement. There are actually three main factors. The first is your physical health. The second one is family connections and social connections and the third one is money. When you then look at the attempts to drill down into this question of; hey, is that everybody who has more than 2 million dollars heading into retirement? What you find unsurprisingly once you know the answer, is that it's actually related to your pre-retirement income. So what they found is that you know; hey, listen if you were making you know 75 thousand dollars a year and then you get to go into retirement and live on ninety thousand dollars a year it's a party. If you were making 500 thousand dollars a year and you go into retirement and have to live on ninety thousand dollars a year that can be would be disappointing. Yes, it's probably an unhappy doctor to boot. So what we look at is typically it's about seventy to eighty percent income replacement is really where the academic studies point to in terms of that satisfaction sweet spot. So you can obviously plan for more than that but you get a diminishing return as you get above those numbers. When we look at that number as it relates the doctors you know the cohort that those studies were done on was not just doctors it was sort of a broader population and some of them don't you know have as much income as physicians do so we tend to scale the number down to the lower end of that range and focus on the seventy percent income replacement. And the best way to get to those numbers are really to use some calculations called discounted cash flow and you basically look at what their current income is and then you have to do some adjustments for inflation. Figure out in today's dollars what kind of dollars they're looking for at their retirement point right and then how can they draw down seventy percent of their current income on average over the retirement period on the back end. It's unfortunately not a question that lends itself to sort of heuristic answers right there's not just one simple hey you should have 20 times your income heading into retirement. You can look at it that way but I think it's much more valuable to really focus on satisfaction because in the end you know doctors are in the ultimate delayed gratification profession. They train forever and they give up a lot on the front end and a lot of that is to have sort of that security and know that they're going to be able to have you know on the back end of those sacrifices a solid financial life. And obviously that's going to need to extend into retirement as well And so you know our way of thinking satisfaction is really you know the thing that if you were to name one thing that you're looking for in your retirement it's going to be a satisfying retirement
SEAN - Robbie what would you say the most important things physicians need to consider when choosing a mutual fund or retirement plan .
RAVI – That's also. That's a great question again
SEAN – We have great members. They come up with really great questions.
RAVI - You know the biggest thing that I think that is misunderstood out there is you have to sort of decide how we look at answering these questions. You really do need to figure out what perspective you're going to take. So for me while I recognize that science is not you know that finance is not necessarily going to lend itself entirely to science. I still believe that academic approach of inquiry is the best inquiry for answering you know these types of questions. And if you look at the academic literature related to investment styles and how people should be investing their money one of the biggest sort of dissonance is between what a lot of people do and what the academic literature says you should do. Although this has been changing you know in the last five or ten years. A lot of people invest in mutual funds that use something called active management and what that means is you have a team of you know guys in a building in wall street somewhere, who you know have Harvard MBAs and they're going to try to figure out and pick you know the 20 or 30 best stocks of all the stocks that are out there. Take highly concentrated positions and the idea is that with their research and intellect and experience they're going to be able to outperform the market. And it makes intuitive sense honestly you know there's some really impressive people who are trying to do that. But if you look at the body of academic literature that actually looks at the results historically over long periods of time those active managers don't tend to outperform the market and especially when you add in the fees which is the other big part of this. Most people are charged fees at multiple levels in the investment process so they're often times going to be paying an asset manager a certain fee, and then on top of that that asset manager is then going to invest them in mutual funds that have expense ratios. And for actively managed mutual funds those expense ratios average about point between point eight and one point two depending on which types of mutual funds you're looking at and those are really high numbers. The compound effect of that on returns typically isn't justified at the mutual fund level, so what we really recommend is that you stay with the academic literature and look at more passive style investing. Passive doesn't sound like something you want in investing but what it really is, is simply recognizing that trying to outsmart the market taking highly concentrated positions just doesn't work. Even though it sort of makes sense that maybe it would and it's really not a function of being smart right. You can be, you know the smartest guys in the room. There was a company called long-term capital management if any of your members are curious.
I believe four nobel laureates in economics at the head of the company and they were investing and they did really well for a while and then they made some bad bets on the Russian ruble and imploded and actually needed a government bailout to sort of help the stock market. Such a big implosion. So it really isn't about being smart, instead it's about taking broad diversification right. Imagine for a moment if one of those twenty stocks were wrong right. Enron was the darling of a lot of the investment community and then all of a sudden it blew up. Now if you had a really diversified position and Enron goes out you'll lose some money but it'll be a little. But if you're in a highly concentrated position it will be a lot so when you have these diversified return we have this diversification and it protects you from those types of things. It's also been shown that a properly diversified portfolio should actually be able to get a better risk-adjusted return. One of the biggest things that I see physicians missing when they look at investing and they're actually famous in the investing community for taking on highly risky highly illiquid types of investments. You can't just look at a return, you really actually should be focusing first on risk and then figuring out what the risk adjusted return is right you know from the perspective if you ignore risk. The single best investment than anybody ever made was the one dollar that was spent on the the big Powerball ticket that won. Now was that a smart investment when they made it? No because the risk was overwhelming that they weren't going to make any money, but they happened that one guy happened to spend that one dollar and get there. You're much better off looking first at risk and trying to minimize the risk in the portfolio and minimize the fees. So when you're using these more passive management styles they're not trying to pick just a few stocks and they're also going to have much lower fees associated with them.
SEAN – Now are those negotiable fees or are they kind of set:
RAVI - Those are set at the mutual fund levels. You know, no individual investor is going to be able to go in let's say tell Vanguard; hey you know what your S & P 500 fee is you know point ten. It really should be point eight. But those fees are set by the companies. A stronger place to go typically is just is to stay away from some of that higher priced asset management and to make sure that you're getting low expense ratios inside your funds. Make sure that you're having a diversified portfolio and then it also is going to matter a lot about not only what you're investing in but where you hold it, because the different types of investments and different types of assets have different tax treatments associated with them. So you want to have a diversified portfolio. You want to have low fees and then you also after that portfolio try to match the different types of assets into the different types of retirement accounts that are available to you
SEAN - And so I know you were talking about different accounts. Like for example; here we have you know there's a there's a Roth IRA or traditional IRA and I mean what are the differences of those? And what are those fees? Do they vary substantially or how does it how do those work. How do those differ.
RAVI - Yeah, so the main thing between a Roth IRA and traditional IRA and when you hear the word Roth what it really just means is basically post tax and post tax for the long haul. So when money goes into a Roth you've already paid taxes on that money and it grows tax-free and when you take it out it's also tax-free at least under current tax law. The other types of investing vehicles you know normal 401k, a traditional IRA, 403B's that a lot of people have coming up from their training time. Those are all pre-tax. What that means is you're getting a tax deduction at the time the money goes in. It grows tax-free when it's in the account, but everything that comes out of the account is subject to tax income tax. Yo know as it comes out, one of the questions that I get a lot is you know; which one is better and then you know my answer to that is both. Which is can be frustrating for a moment but but in reality you know if you look on the internet and you look at this question you'll find people who've sort of found religion on both sides of this argument about whether you should be you know taking the tax deduction now and you know having it grow tax-free and then paying it later. When you're in a lower bracket or should you take the tax hit now and then just you know free up all that growth down the road. One of, I think the big fallacies as it relates to physicians is the idea that they can anticipate being in a low bracket when they're in retirement. A lot of the financial advice that's out there is focused on a different cohort of people and physicians they are very unique in a lot of ways financially from he vast majority of people that financial advice is actually meant for. Physicians cannot anticipate being necessarily in a lower tax bracket or at least not a significantly lower tax bracket when they're in retirement because as we talked about right. If you're earning four hundred thousand a year and you're going to plan for a seventy percent income replacement that's two hundred eighty thousand dollars a year that's still a very high bracket. So physicians need to pay attention to that difference, but even outside of that when you look at that question about Roth versus traditional and you go on the internet you will see that they'll typically have you know an argument where they'll say; well if tax rates are this you know for the next 30 years and returns are this for the next 30 years, then you know clearly you were stupid to put the money in the Roth because you would have earned more by taking the difference that you would have saved in taxes and investing it right. And then if you go look at the other side of the argument they are going to have basically the same analysis, but they're going to use different variables and it's going to make it look like well you're a dummy for putting in the traditional. One of the most important things that your members can know is that for a financial planner answering these questions, intellectual humility is key.
You have to have the ability to distinguish between what is predictable and what is not. If any of your members have someone an advisor talking them and act like they know what interest rates are going to do. What the stock market's going to do. What tax rates are going to be. They should run, because that advisor either doesn't know what they're doing or they are trying to take advantage of that physician. We think the much better way to approach this is to try to look at tax diversification. So the idea would be that you want to have money in both types of accounts so that when those variables that those guys are you know they're trying to use a calculation to show; hey this is what tax rates are going to be 30 years in the future. There's no way to know that. But if you have money in both types of accounts when those variables actually manifests in the physicians life they'll have the ability then to make choices then instead of trying to make a bet now 25 years later and just see how it works out. One other thing I want to just briefly touch on is; I get a lot of physicians who come in we have an integrated CPA firm. And you know that the tax picture is rough and physicians really do get hammered. I mean one of the realities for physicians that they face is that their income stream is very different than most professions you know they have a extra long training cycle right and then where they make almost no money and then they all of a sudden jump up into a really high tax bracket and then spend their professional years which are shorter than let's say a plumber in a very high tax bracket the whole time. So the taxes are going to hit them pretty heavily and they have to plan for that. But there's also I think a misunderstanding about where we sit historically with tax rates and what types you know and this should inform I think some of their planning. Right now the long-term capital gains rate is at fifteen percent or twenty percent if you make over a certain amount of money. Fifteen percent is the lowest rate on record for long-term capital gains. The top federal bracket right now is a bit over thirty nine percent and if you look at the average top federal bracket since the inception of the federal income tax it's actually fifty-seven percent. That's just the average. So if you believe in the idea of regression to the mean, you know things are going to tend towards their long-term trend line. Then from that perspective you would expect that actually taxes are going to rise in the future and there's no argument that taxes are actually historically low right now. The one piece of literature that we've really been able to see that does have some slight predictive ability is that as it relates to tax rates is the size of the national debt. That is the one correlated thing that they've been able to find. And as we know, the size of the national debt is massive right now. So you know again, no one can predict tax rates, but certainly if you take all these pieces of information it does suggest that there's a pretty strong chance that taxes are likely to be higher in the future
SEAN - Robbie thank you very much for being here today. I think the information you provided has been very tremendous help Is there anything else in terms of common mistakes that physicians make that you'd like to comment on
RAVI – Yeah, I think in closing there are two big pieces that I think I want to make sure that your members are taking into consideration when they're looking at financial advise. One of them is that, I think it's important that they work with someone who has a awful lot of physicians. They don't necessarily have to be fully specialized in physicians like we are, but physicians are different as we talked about earlier in many ways financially from what a sort of garden-variety financial professional would be used to advising or planning for. The other thing I think is really important is that most physicians consume financial advice on a piece meal basis. That leaves them having to ultimately be the expert in some ways. And what I mean by that is a lot of people who come in mid-career especially to our office they have one person who's doing you know their tax returns and someone else is doing their investing and someone else is doing their financial planning and there someone else doing their insurance and none of those things are coordinated. So when they go to these individual practitioners who aren't talking among themselves. What invariably happens is that they get a series of recommendations that have some degree of conflict and might not even fit into the budget of the physician regardless of how much money they're making. I think it's really important that they have a financial team that has some degree of integration between the CPA and their financial advisor and their financial planner, if those are all different people so that they're not stuck then getting a series of dissonant pieces of financial advice and then ultimately having to figure out which expert is right. I mean in some ways that's the opposite of why they went to a financial professional in the first place. You're ultimately looking for advice that is going to be actionable. That as long as you understand it, it's going to be actionable. But if you understand five different pieces of advice at ten percent and they conflict I think it's really challenging to then figure out which one of those experts is right.
SEAN – Great, well thank you again Ravi. I really appreciate your time.
RAVI - It's been a pleasure Sean thanks for having me.