Richard Wagner: Business owners, what you keep matters more than what you earn
Now that the election is over and we know who will be running this country for the next four years, I ask myself, “does knowing who won the election tell me what the tax environment will look like next year? Probably not.”
What I do know is that we still have a divided Congress, and barring further legislative action, the Bush era tax cuts will expire Dec 31, 2012. The country is deeply in debt, the economy is sluggish, unemployment is too high, and every taxing jurisdiction I can think of wants more money. I don’t think the government’s insatiable desire for funding will decline anytime soon.
So what is a successful business owner to do? We work too hard and risk too much to earn a living, and at tax time, as patriotic as many of us are, it hurts to write those big tax payment checks. The good news is there are some things you can do to reduce the tax burden, but you’d better act quickly, because the deadlines for some options have already expired and many more will expire at the end of this year.
Here is one of my favorites. I present to you the boring, unassuming pension plan. I know, you already have one, have already looked at one, or you’ve been told you can’t do better than you are already doing. Fortunately for many, I have seen this attitude before and still been able to show clients how to reduce their taxable income by as much as $200,000 to $300,000 per year more than they were previously saving. What does this mean to your bottom line?
To answer that question, we need to know a few things. First, how much money did you make this year? If your overall taxable net income is more than $388,350, congratulations. You made the top tax bracket. What that means for 2012 is that as much as 35 percent of your income may go to the U.S. Treasury, 5 percent to the state of Utah, and your ability to take other deductions may be decreased because of your income.
If this doesn’t get your heart beating, assuming Congress is unable to make any changes and the Bush tax cuts expire, you may be in the 39 percent federal tax bracket, and a new addition called the Medicare surtax increases your Medicare tax rate from 1.45 percent to 2.35 percent. Plus an additional surtax of 3.8 percent is assessed on net investment income (defined as taxable interest, dividends, capital gains, rents, royalties, annuity income and passive activity income).
Oh, and by the way, capital gains rates are going from 15 percent to 20 percent. When you add on the Medicare surtax, that is a whopping 58 percent increase from 15 percent to 23.8 percent on capital gains.
I know, you are not feeling too bad because at least you get to live on half of your income earned over these amounts right? Actually, you still get to pay sales tax, property tax, Social Security tax and a whole host of other taxes as well, but that is for another discussion. Are you ready for some good news?
Well here it is, there are still a few ways left to reduce your 2012 taxable income so that some of the risk, hard work, blood, sweat and tears may be retained for your future benefit. I present you with the lowly pension plan. Here is how it works, a standard defined contribution plan (401k, profit sharing, SEP, etc.) allows you to put money away, not be taxed on it now, and then have something, besides the government, to fall back on in retirement.
My understanding is that Social Security was created for those in poverty and unable to care for themselves. Unfortunately, Social Security has gradually become the primary retirement program for most people in this country a great idea except that it is running out of money.
So, in the spirit of self-sufficiency, here is how we take care of ourselves. Spend less than we earn and use tax savings to help save for retirement. If you have a defined contribution plan, you are able to set aside up to $17,000 of your salary as a deferral, meaning you don’t have to pay tax on it now. If you are 50 or older you can potentially defer up to $22,500 in salary and not pay tax on it now. In addition, if your company chooses to, they can contribute an additional $33,000 to the plan for your benefit and get a tax deduction for the entire amount. That is a total of up to $55,500 tax deduction, socked away for your future retirement. What a great deal!
You have probably been paying into Social Security for years, if not decades. Can you imagine the value of all the Social Security payments you have made over your working lifetime, compounded with earnings? Why don’t we have a Social Security surplus? Well, if the government can’t manage Social Security as well as we would like, at least you can still manage your own retirement with a boost from tax savings.
Let’s look at an example — assume you put $55,500 into your retirement account and you are in that 35 percent federal bracket and 5 percent state bracket for a total of 40 percent of your taxable income going to the government. If you apply your combined 40 percent tax rate to the $55,500 going into your plan, your tax savings would be $22,200 per year. Can you think of an easier way to save more than $20,000 per year out of your budget?
Many times new clients will say, “Yeah, that’s a great idea saving taxes and all, but where do I come up with the money?” As Wimpy said to Popeye, “I’ll gladly pay you Tuesday for a hamburger today.” The same thing partially works with pension plans. You can potentially deduct the $33,000 company contribution in 2012, but you don’t have to actually put it into the plan until the earlier of Sept. 15, 2013, or the date you file your 2012 tax return, including extensions. You get the deduction now, but don’t have to put the company portion of the cash in until later.
Furthermore, if you are saving $22,200 in taxes, you can reduce your estimated tax payments and withholdings by this amount, which helps you fund your plan. Take the tax deductions this year, but wait until next year to fund the company portion of your plan.
Running out of excuses? I had a new client ask me, “Could I have been getting all these tax deductions for the past 10 years?” My answer — Yes. The next question was, “If I had been doing this for each of the past 10 years, how much would I have saved in taxes?” The answer is startling and quite large.
If you assume a 40 percent combined federal and state rate, we’re talking about $22,200 per year tax savings times 10 years, which equals $220,000 in total tax savings. That figure excludes growth and compounding of interest. Not enough? Well, next week, I’ll show you another strategy capable of producing four times the deductions or more.
This is not an offer or solicitation of any offer to buy or sell any security, investment or other product. Such an offer may only be made after a suitability review has been performed and with related offering documents. Examples shown, including different percentages and tax brackets, are provided for illustration purposes only and may not be representative of your specific tax situation.
Tax data can be sourced at www.irs.gov. Advisory services are offered through Independent Financial Group, LLC (IFG), a registered broker-dealer and investment adviser that is a member of FINRA/SIPC. www.vwapro.com.
Rich Wagner, CPA, MAcc, is a tax reduction and investment expert. If you’d like more ideas on protecting, saving and growing your money, call him at 801-657-4459, or email firstname.lastname@example.org