Observe your monetary targets with these 4 measurements
Investors need to know their savings rate, return on investment, tax rates, and wealth in order to track progress toward financial goals.
Today’s classic is being republished by White Coat Investor. You can see the original Here.
[Editor’s Note: Today’s post originally published at ACEPNow and discusses metrics to use in your financial life that allow you to “keep score” as you work toward your financial goals. Use these metrics once a year to compare your year to year performance.]
Question. I am an ambulance doctor who recently completed residency. How can I ensure that I am as successful in my finances as I am in my clinical practice?
Business expert H. James Harrington once said:
The measurement is the first step that leads to control and finally 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 an emergency doctor, you’re very familiar, perhaps too familiar, with business-related metrics (e.g., time to doctor, doctor satisfaction rating, and percentage of down-coded charts). There are also metrics for your financial life that can be measured and will allow you to “earn points” as you meet your financial goals. The purpose of the score, of course, is not to compare yourself to others, but to compare your performance from year to year and against your own financial goals. This article explains four of the most important ways you can measure your financial goals.
4 measurements to help you track your financial goals
# 1 your wealth
Perhaps the most important metric anybody seeking financial success can monitor is wealth. Net worth is the total of all of your assets minus the total of all of your liabilities. Assets include bank accounts, retirement accounts, investments, home equity, and the present value portion of life insurance. Liabilities are primarily debts such as student loans, mortgages, auto loans, and credit card debt.
Finance professionals find it amazing that so many doctors have no idea how much they owe in student loans. It can be scary to put it all together, but it can be difficult to achieve any reasonable financial goal if you don’t know your starting point.
Pour yourself a big drink of your favorite beverage, sit down with all of your student loan papers, and then add it all up and write it down. Chances are, if you’ve never done this before, given the relatively high student loan interest rates, the sum is way higher than you think. Most doctors graduate with negative net worth due to the heavy burden of student loans. One of your first financial goals should be to get back to a net worth of USD 0 (#livelikearesident) as soon as possible. Many doctors have a harder time getting to $ 0 than going from $ 0 to $ 1 million in net worth!
# 2 your savings rate
Another important financial metric is your savings rate. This is the percentage of money saved for your long-term financial goals like retirement or college in a given year divided by your gross income. While there are many different ways to measure the savings rate, since you are only “competing” with yourself. However, the only important thing is that you agree with your method. I suggest you count retirement and other investments and debt repayments as “savings”. If you’re not sure what to count as income, keep it simple and use your total income on your tax return. In 2020 you can find it on Form 1040, line 7b.
In general, I recommend that doctors save 20 percent of their gross income for retirement. While 15 percent can be enough if you work long enough and don’t make too many investment mistakes, and 25 to 40 percent can be required for a very early retirement, 20 percent is a good place to start for most doctors. However, 5 to 10 percent will almost certainly be insufficient. Measure your savings rate every year. If it’s too low to meet your goals, find ways to increase them as the year progresses.
# 3 your tax rates
I am often surprised that doctors have no idea how much they are actually paying in taxes. There are really two tax rates worth keeping an eye on.
Effective tax rate
The first is your effective income tax rate. To calculate this, add your federal income tax, state income tax, and wage tax, and then divide that total by your gross income.
For me, that number has changed a lot over the course of my earning years. During my time in residence and in the military it was only 5 percent, but in 2014 it was around 23 percent and since 2017 it has been over 30 percent. If you find that your effective income tax rate is similar, it may be worth looking into ways to legally reduce this burden, e.g. B. to contribute more to tax-deferred retirement and health savings accounts, to keep a better eye on potential deductions or to change a country with a lower tax burden.
Marginal tax rate
The second tax rate you should know is your marginal tax rate. This number is generally significantly higher than your effective tax rate. The easiest way to calculate this is to use tax software when closing your taxes each year. Just add in a hypothetical $ 1,000 income and see how much your tax burden increases.
When I did this, my tax charge on that hypothetical $ 1,000 increased by $ 418, making my marginal tax rate 41.8 percent. The software takes into account federal income tax, state income tax, exit tax, and even payroll tax if you are self-employed. Knowing your marginal tax rate is helpful when making decisions about money, such as: B. whether you want to invest in taxable bonds or tax-free (but low-yielding) municipal bonds in a taxable account. This can also affect how many extra shifts you want to work, as 30 to 50 percent of every extra dollar you make goes towards taxes. Your marginal tax rate can be lowered using the same techniques that you use to lower your effective tax rate.
# 4 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 the right track to meet your goals. The best way to calculate your return is by expenditure and tax. The most accurate way to calculate your return on investment is to use an internal rate of return (IRR) function on a spreadsheet or financial calculator.
The only data required for this is the amounts and dates of deposits and withdrawals (including dividends not reinvested) to the account. Since the contributions are not regular, you’ll need to use a function called XIRR, or the internal rate of return with non-periodic cash flows. This feature offers an annualized return as opposed to an average return. It’s important to know the difference as the only return you can spend is an annualized one.
For comparison, the average annual return on the S&P 500 with dividends reinvested from 1927 to 2014 was 12.1 percent. The annualized return over this period was only 10.1 percent. This effect is due to the volatility of investment returns. In short, you need a 100 percent profit to make up a 50 percent loss. The more volatile your investment returns, the greater the difference between your average returns and your annualized returns. A tutorial on using the XIRR function to calculate your ROI can be found here.
Calculating these simple financial metrics once a year will give you the knowledge and motivation you need to achieve financial success.
What do you think? What metrics do you track in your financial life and why? Comment below!