Question. I am an emergency physician who recently completed residency. How can I make sure I am as successful in my finances as in my clinical practice?
A. Business expert H. James Harrington once said, “Measurement is the first step that leads to control and eventually to improvement. If you can’t measure something, you can’t understand it. If you can’t understand it, you can’t control it. If you can’t control it, you can’t improve it.” As emergency physicians, we have become intimately familiar, perhaps too familiar, with business-related metrics (eg, door-to-doctor time, physician satisfaction rating, and percentage of downcoded charts). There are also metrics for your financial life that can be measured and allow you to “keep score” in working toward your financial goals. Of course, the purpose of keeping score is not to compare yourself to anybody else but to compare your performance from year to year and against your own financial goals. This article will discuss four of the most important measurements.
Your Net Worth
Perhaps the most important measurement someone seeking financial success can monitor is net worth. Net worth is the sum total of all your assets minus the sum total of all your liabilities. Assets include bank accounts, retirement accounts, investments, home equity, and the cash value portion of life insurance. Liabilities are primarily debt, such as student loans, mortgages, auto loans, and credit card debt.
Many financial professionals find it amazing that so many physicians have no idea how much they owe in student loans. It can be scary to add it all up, but it is hard to reach any reasonable financial goal if you don’t know your starting point. Pour yourself a tall drink of your favorite beverage, sit down with all of your student loan paperwork, and actually add it all up and write it down. Chances are good that, if you have never done this, the total is quite a bit more than you think given the relatively high student loan interest rates. Most physicians graduate from residency with a negative net worth due to high student loan burdens. One of their first financial goals should be to get back to a net worth of $0 as soon as possible. Many doctors find it more difficult to get to $0 than to go from $0 to $1 million in net worth!
Your Savings Rate
Another important financial metric is your savings rate. This is the percentage of money saved in a given year toward your long-term financial goals, such as retirement or college, divided by your gross income. While there are many different ways to measure savings rate, because you’re “competing” only with yourself, it only matters that you are consistent with your method. I suggest you count retirement account contributions and other investments as well as paying down debt as “savings.” If you are unsure what to count as income, keep it simple and use your total income from your tax return. It can be found on Form 1040, line 22.
Pour yourself a tall drink of your favorite beverage, sit down with all of your student loan paperwork, and actually add it all up and write it down. Chances are good that, if you have never done this, the total is quite a bit more than you think given the relatively high student loan interest rates.
I generally recommend physicians save 20 percent of their gross income toward retirement. While 15 percent may be enough if you work long enough and don’t make too many investment mistakes, and 25 to 40 percent may be required for a very early retirement, 20 percent is a good starting place for most doctors. However, 5 to 10 percent is almost surely going to be inadequate. Measure your savings rate each year, and if it is too low to reach your goals, find ways to boost it throughout the year.
Your Tax Rates
I am often surprised to find that physicians have no idea how much they actually pay in taxes. There are really two tax rates worth keeping track of. The first is your effective income tax rate. To calculate this, add up your federal income tax, state income tax, and payroll tax, then divide that sum by your gross income. For me, this number has varied quite a bit throughout my earning years. It was as low as 5 percent during my time in residency and the military, but it has since risen to around 23 percent. If you find your effective income tax rate is approaching or even over 30 percent, it may be worthwhile to seek out ways to legally lower that burden, such as contributing more to tax-deferred retirement and health savings accounts, keeping better track of potential deductions, or moving to a state with a lower tax burden.
The second tax rate worth knowing is your marginal tax rate. This number is generally significantly higher than your effective tax rate. The easiest way to calculate it is using tax software upon finishing your taxes each year. Simply add $1,000 of hypothetical income and see how much your tax bill rises. This year, my tax bill increased by $418 for that hypothetical $1,000, so my marginal tax rate is 41.8 percent. The software accounts for federal income tax, state income tax, phase-outs, and even payroll taxes if you are self-employed. Knowing your marginal tax rate is useful when making decisions about money, such as whether to invest in taxable bonds or tax-free (but lower-yielding) municipal bonds in a taxable account. It may also affect how many extra shifts you wish to work, knowing that 30 to 50 percent of every additional dollar you earn is going to taxes. Your marginal tax rate can be lowered using the same techniques used to lower your effective tax rate.
Your Annualized Investment Return
Many investors have no idea what their investment returns are. That makes it very difficult to know if you are on track to reach your goals. It is best to calculate your returns on an after-expense, after-tax basis. The most accurate way to calculate your investment return is using an internal rate of return (IRR) function in a spreadsheet or a financial calculator. The only data needed to do this are the amounts and dates of contributions and withdrawals (including any dividends not reinvested) to the account. Since the contributions will not be regular, you will need to use a function called XIRR, or the internal rate of return with nonperiodic cash flows. This function provides an annualized rate of return as opposed to an average rate of return. It is important to know the difference since the only return you can spend is an annualized one. By way of comparison, the average annual return of the S&P 500, with dividends reinvested, from the years 1927 through 2014 is 12.1 percent. However, the annualized return is just 10.1 percent. This effect is due to the volatility of investment returns; in short, you need a 100 percent gain to make up for a 50 percent loss. The more volatile your investment returns, the greater the difference between your average returns and your annualized returns. A tutorial showing how to use the XIRR function to calculate your return can be found here.
Keeping score by calculating these simple financial metrics once a year can provide you with the knowledge and motivation you need to reach financial success.