Maximizing the cash you are keeping in your practice.
By Adam Cmejla, CFP®
Nov. 1, 2023
In my last article, we discussed how practice owners should think about how and whose capital to use as they look to invest in their practice. As a partial continuation of that last piece, I would like to share strategies and concepts on how practice owners can think about optimizing the cash they choose to keep in their practice.
While the rate of inflation has tempered compared to 2022, we still find ourselves in a higher interest rate environment reminiscent of the mid-to-late nineties, with rates the highest they’ve been in over 15 years. Given those facts, there’s real opportunity for cash management within practices, allowing practice owners to earn a rate of return on their cash. Owners who are letting their cash sit idly by are costing themselves secure, yet relevant, rates of return on cash in their practice, sometimes to the tune of thousands of dollars of lost interest income annually.
There are many reasons why a practice owner would be keeping cash in the practice. I’m a long-time advocate for minimizing “lazy money” on a practice’s balance sheet and investing the cash that’s generated from the business into higher-potential return investments. There is, however, prudence in ensuring that the practice has ample cash reserves for working capital or future investments back into the practice.
One of the first questions that needs to be answered before implementing any strategy to make the most of the cash you keep in your practice are any time constraints you may be dealing with. If you have limited time, it may behoove you to look at purchasing individual Treasuries from the U.S. Treasury. For example, you may have the following time-limited needs to consider:
- Quarterly estimated tax payments (granted, while this is a personal expense, we’ve seen practice owners keep this cash in their practice checking account until it’s time to pay their taxes)
- Down payment on a new building
- Purchase or down payment on future equipment
Purchasing Treasuries can be done via a brokerage account or directly from the Treasury Department. Note that the U.S. government’s website has a less-than-ideal user interface, but it still gets the job done. If you choose to open the account via one of the many available brokerage platforms, it’s best to consult with either your financial professional or your platform of choice to ensure that the process is done correctly.
The benefit of buying U.S. Treasuries is many-fold. First, as long as you hold it to maturity, you’re guaranteeing that you’ll earn the interest rate on the note or bond when purchased. Second, (and this is especially relevant if you live in a high income tax state) interest earned on U.S. Treasuries is exempt from state income taxes. Assuming that you are the owner of a pass-through entity like a partnership or LLC that files an S-corp return, remember that all income earned in your business flows through to your personal return and is taxed at your individual income tax rate. Since bond income is taxed at ordinary income rates, and not long-term capital gains rates, this can have a sizable impact on your after-tax rate of return.
Like Treasuries, municipal bond funds can offer tax-free income to you as a bond holder, with some notable differences compared to Treasuries. First, it’s not nearly as common to find municipals with as short of a maturity date as Treasuries. Whereas you can buy Treasuries with a 30-day maturity, most municipal bond funds will carry a much longer maturity (typically at least one year). However, given that at the time of this article the yield curve is inverted, it’s likely possible to find shorter-term municipals with attractive yields.
Because of this, it’s important to understand that the underlying price of the bond can change as interest rates change. Regardless of the type of bond (municipal, corporate or government), there’s an inverse relationship to bond prices and interest rates: as interest rates go up, bond prices go down (and vice versa). Therefore, if you buy a municipal bond, and choose to sell it prior to maturity, the price that you’ll get for the bond on the open market may be lower or higher than when you purchased it. This is influenced by the change in interest rates in the economy. It’s important to understand this concept so you’re not lulled into the common sense of security that bonds are safe and cannot go down in value.
Unlike Treasuries, municipals do not have the explicit guarantee of the U.S. Government, so paying attention to the credit rating of the bond that you’re purchasing is more important. If you’re unsure how to evaluate the credit quality of the bonds you’re looking at purchasing, it’s best to consult with your advisor or look at different alternatives. You should always feel confident and clear in your financial decisions.
Lastly, certain municipal bonds can influence whether you will trigger any alternative minimum tax (AMT), so be sure to let your advisor and CPA know if you’re purchasing those investments. If you’re working with an advisor, they should have already taken this into consideration, but nobody wants any surprises at tax time. In addition, income that is earned from municipal bonds issued outside of your state will likely trigger state income taxes. This is why you’ll likely see some of the fund families offer municipal bonds that are specific to New York and California, as these two states specifically have high state income tax rates.
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High-Yield Savings Accounts
This is the more popular option that we see practice owners implement. A high-yield savings account is typically going to be found at an online banking institution; it’s not uncommon to see these online institutions offering rates that are 10 times higher than your traditional brick-and-mortar large national banks.
The benefit of online banks is that they typically have a pretty smooth user interface and user experience (UI and UX). Most have an app that’s able to be downloaded, and setting up accounts is relatively straight-forward via these institutions’ phone app or website.
The drawbacks of some of these banks is that they are limited in the type of accounts they can set up. Many of them do not allow an LLC or partnership to be an account owner; they must be owned by a person(s). Another drawback of this type of account is that the income is taxed similarly to bond income: it’s taxed at your ordinary income tax rate rather than long-term capital gains rates. If you find yourself in your peak earning years, it will benefit you to calculate your after-tax yield on these online savings accounts. Don’t forget to include your state income tax rate into the equation. You’ll be surprised what your after-tax yield is on these accounts.
Another drawback of these accounts is that rates are constantly changing and the account that you opened may not be the highest yield in the future. There are different platforms that allow savers to utilize one platform for their cash, and then the platform will aggregate funds, using technology to get savers the best rate on their cash as various institutions change their rates. One such platform that we’ve been using with success is Flourish. More information on that offering is here (disclosure: this is only available to clients we serve and does not have a retail offering. This is not the only platform that exists, but rather, an example of one).
CDs can give you a good combination between Treasuries and high-yield savings accounts. You can choose the maturity date of the CD and essentially guarantee the yield/return earned on those funds. Inverted yield curve notwithstanding, generally the longer the maturity date of the CD, the higher the APY (annual percentage yield) of the CD.
Some of the downsides of CDs are as follows. First, each financial institution is different as to whether business accounts can own CDs, so it’s best to ask each institution to determine if it’s possible. Second, income earned from CDs is the same as high-yield savings income and bond income: ordinary income tax rates. Third, CDs are illiquid, and if you choose to surrender/cash in your CD, you’ll face a penalty in the form of forfeiting some of the earned interest. Some institutions do offer a “no lockup CD,” which gives you liquidity, but you’ll generally see that those CDs are offering a slightly lower yield than illiquid CDs. There’s always a tradeoff…
Every little bit of added available cash helps in running a business. Whereas current interest rates over the past 15 years haven’t warranted this type of attention to cash, utilizing one or a combination of the above strategies can help you leverage some of the positives of a higher interest rate environment. While most of the financial attention in the practice management world has been focused on the negatives, like high loan interest rates, this is one way in which practice owners can essentially try and hedge the cost of capital.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com/ and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.