What Should I Be Thinking About When Making a Capital Investment in a Rising Rate Environment?

Whether you want to upgrade to the newest technology, need to replace worn equipment or give your lobby a facelift, what should you consider before making a capital investment in your business? Unlike recent years, business owners now face increasing costs to carry debt. How do you make improvements to your business while still remaining financially solvent? I have outlined five key factors to consider before committing to a capital investment:

Will your current cash flow support new debt? Any recent debt will need to be structured in a way that is not burdensome to cash flow and allows you to obtain advantageous lending terms.

Know your targeted cash reserves. COVID-19 taught many practice owners that navigating business interruptions is a crucial piece of a strong and healthy financial plan. Knowing your targeted cash reserves is critical. It’s important to take into account your current debt picture if you are carrying any loans that should be paid down first. If you do not know your cash reserves target, take a moment to work with a financial service specialist to determine that amount.

Make sure you are getting competitive loan offers. If you decide to move forward with your capital investment project, how do you structure the loan in a rising interest environment? While the banking industry is continuing to offer competitive terms for borrowers, working with multiple banks to secure the best loan is something that should not be skipped. Do not settle for one bank’s offer without checking what competing banks are willing to do for you. Letting banks know they are in a competitive bidding process will help to drive the best possible terms.

Optimize the mix of down payment and amount borrowed. Now that you have spoken to multiple banks about your borrowing needs, how much money do you want to put down for the project? For many years when rates were suppressed, it made good sense to finance as much of the project as possible. Today, that may not always be the case and the impact on cash flow of a new loan should be tested. Financial service professionals can stress test your cash flow, determine the impact to your bottom line and create a financially responsible path to move forward. You do not want to sacrifice retirement savings or necessary cash on hand to complete a project if you do not know how it may impact your business.

Know the short and long-term cash flow impact and profit contribution of each capital investment. In the past, practice owners would make a purchase with the mindset they will refinance the debt later and secure better terms. New equipment purchases were a common item to be bought directly through the seller to secure incentives for the deal. In many cases, the buyer planned to refinance the debt in six to twelve months. This is no longer a guarantee and makes the initial terms of the loan more important.

There is no hard and fast rule for how much money should be put down when securing a loan. The bank will have its requirements, but should you consider putting more dollars down for the project? Or is it more advantageous to elect a different loan that has a higher interest rate, but helps to protect your cash reserves due to a lower capital requirement at the time of the purchase?

Practice improvements are commonly made to increase production, streamline your business operation or to update an office space to create an optimum patient experience. All of these projects can be good investments over the course of your lifetime as a business owner but determining the short and long-term impact on your cash flow and profitability should not be left for chance. Know before you commit your dollars to the project. As you navigate this process, it is important that you have a fiduciary advisor supporting you along the way and not someone who stands to collect a commission for closing the loan.

The practice integration advisors at Buckingham help dentists achieve financial success by incorporating a thought-out and customized approach to managing your practice. We are happy to help you understand how a capital investment in your practice fits into your business and can help support your professional and personal financial plan. Schedule a conversation a conversation with us today!

About the author:
Brian Roemke, Buckingham Strategic Wealth Practice Integration Advisor

As a practice integration advisor, Brian provides comprehensive financial planning services to clients. He appreciates the importance of a well-rounded team working collaboratively to develop, implement and monitor a plan that helps clients achieve their distinct goals.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information may be based upon third party information and may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. R-22-4166

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Why The Location Of Your Investments Matters

Most investors have a process for deciding which investments to buy in their portfolio—with different objectives for building wealth over time. But once you’ve selected your investment mix, have you considered how the account that holds your investments affects what you ultimately earn?

A potential game changer for your expected returns is the amount of tax you’ll need to pay, which may be annually or when you make withdrawals depending on the account type. The type of account also makes a big difference in the amount of tax owed. Thinking about asset location—or being strategic about which account holds each of your investments—can help investors keep more of their income.

Leveling the Playing Field Among Accounts

If you have ever received a Form 1099 from the IRS for investment gains or losses, or if you’ve paid income taxes after taking money from your retirement account, you know that Uncle Sam is your investment partner. Just like you, the government wants these accounts to grow because bigger returns generally mean more tax dollars to collect.

From a tax perspective, taxable brokerage accounts, traditional individual retirement accounts (IRAs) and Roth IRAs are not created equal. To level the playing field, it’s important to consider the after-tax expected return of any investment—the amount we keep. Knowing how an investment is taxed within different types of accounts is critical in determining where to own each of your investments.

Non-Qualified Accounts (Taxable)

  • In taxable accounts, such as a brokerage or joint account, you pay taxes each year you receive dividends and interest payments or when you sell investments for more than you paid for them.
  • Qualified dividends and the capital gains on investments held for at least one year are generally taxed at a preferential rate. This is also known as the capital gains rate, and it is either 0%, 15% or 20% depending on your income bracket.
  • Interest income—such as from bonds—and gains from selling investments held for less than one year are taxed at the ordinary income rate, which ranges from 10% to 37% depending on your income level. So, if you don’t plan to hold your investments for very long in a taxable account, you could wind up paying much more in taxes than if you held them for at least one year.
  • The government bears some of the risk of each investment since it receives a portion of the income in taxes (unless your tax rate is 0%).

Traditional IRAs (Tax-Deferred)

  • Traditional IRAs are tax deferred—there is no immediate tax consequence when you buy or sell investments within the account or when you receive dividends or interest payments.
  • Although you have the benefit of only paying income taxes when taking funds out, you do so at ordinary income tax rates.
  • A good way to think about your traditional IRA is to imagine it is split into two identically invested accounts: one owned by you and the other by the government (the portion of which would equal your tax rate). You’ll receive all of the income from your portion, but you also take on all the risk. Likewise, the government will receive all of the income from its portion and take on all the risk.

Roth IRAs (Tax-Deferred)

  • In Roth IRAs, you make contributions with after-tax dollars, and you don’t pay income taxes on any earnings or when taking funds out as long as you meet certain conditions.
  • Therefore, you can expect to receive all of the income from your returns on investments in these accounts. However, this also means you bear all of the risk on the entire balance.

Deciding Which Accounts Should Own What Is a Game of Prioritization

When making investment decisions, the first step is to decide what type of investments will meet your personal goals—the accounts you already have should not dictate those decisions. Only after deciding on your overall allocation target can you review your existing accounts to determine the optimal location for each of your investments.

When considering location, it’s helpful to view all of your accounts as one household portfolio, rather than separately. Although exchanging investments between accounts may lead to differing returns in one account compared with another, the goal is to create more after-tax wealth overall through tax efficiency.

To make the most of tax treatments, it’s generally favorable for most investors to prioritize tax-inefficient investments in IRAs, either traditional or Roth. As you move these investments to tax-deferred IRAs, you’ll have room in your taxable accounts to take advantage of the preferential rates for tax-efficient investments. Some examples below illustrate how to think about these decisions.

When deciding whether to place your investments in a taxable account or IRA, it’s also important to give the greatest consideration to those investments with higher expected returns—and therefore generally higher risk. For example, it may seem like simple logic to hold investments with the highest expected returns in a Roth IRA because your income won’t be taxed. However, you aren’t always better off taking all the investment risk.

Additionally, there are some instances when the placement of your investments requires more consideration, such as if you anticipate using any of your traditional IRA funds for future qualified charitable distributions because there could be greater tax advantages in doing so. Ultimately, deciding which account should own which investment will depend on each investor’s circumstances. Working with a financial advisor can help you navigate your specific case and help you set up a plan to maximize your after-tax returns.

If you are not currently working with a financial advisor, Buckingham would love to help you reach your wealth goals. Please visit our website for more information or connect with us for a short introductory conversation.

About the author:

As a wealth advisor, Patrick Kuster believes a financial plan is only as good as its implementation, and seeing the plan through is one of the most rewarding parts of his job. He loves helping clients solve their financial puzzle, pulling apart plans and discovering concepts that question industry norms. He also likes educating clients and providing them insight that keeps them on track toward achieving their financial goals.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth®. R-22-4212

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