Whether you’re in business alone or with others, the government—federal, state, and local—can feel like a silent partner. And like all partners, the government wants its share of your profits, which it takes in the form of taxes. No matter whether your business is organized as a sole proprietorship, partnership, S-corporation or C-corporation, the tax laws are unavoidable.
However, being privy to the finer points of the tax law can allow you to legally save or delay your payments for decades—sometimes even into the next generation.
CWA Partner and CPA Tom Sanders says: “When used under the right circumstances, tax-deferred planning is a tool available to help owners retain more of their earned money today, and build the savings needed to reach their long-term retirement goals.”
When working with a new client, he reminds them that the financial implications of saving money in a tax-deferred environment versus any other environment can be massive.
Take a look at this example:
At the end of the year, a practice owner and spouse has $75,000 of remaining profit in their business. When they take the profits home, they would likely pay up to $30,000 in taxes, leaving the remaining $45,000 to invest in an after-tax brokerage account.
Another option is funding this money into a 401(k) plan, which is a tax-deferred vehicle. For 2019, the maximum allowable contribution to a 401(k) account, including employee salary deferrals and after-tax Roth contributions, as well as employer matching and elective contributions is $56,000. When a spouse also contributes, savings can be considerable.
This option allows the couple to defer taxes and invest the full $75,000 into the plan; however, the choice isn’t as simple as getting an extra $30,000 in this business owners pocket.
Let’s assume the couple in this illustration is in their early forties and repeats this process year-over-year until retirement—the accumulated savings difference could be massive. You see, not only is the couple saving into the 401(k) account saving more money ($75,000 versus $45,000), but they have the opportunity to compound on the principal, which could make the earnings grow much faster due to compounding interest.
In addition to more money to save, Tom says there are even more benefits to tax-deferred vehicles:
– Asset protection: Dollars are protected if an account owner is sued professionally or personally
– Tax-free growth of the earnings while accumulating money: There are no interest, dividends nor capital gain taxes that need to be accounted for on a personal tax return.
– Helps keep you on track: When money is kept somewhere other than in an accessible bank account or after-tax brokerage account, it is harder to access and spend. Saving money in a tax-deferred vehicle builds a barrier or moat around one’s life savings.
It is important to remember that “deferred” means delayed, not stopped all together. But when you do finally start triggering those deferred tax payments in retirement, you are usually in a lower tax bracket than before, allowing you to typically pay less in tax over the long term.
Your custom plan
Tax-deferred vehicles are not the only way to reach your goal. Even though tax-deferred savings has advantages, Tom says it’s not a one-size-fits-all solution. It is important to sit down with a financial planner to understands not only the details, but the timing around it all. There may be cases where another option is best.
For example, tax deferred may be the right vehicle for someone who has a long-term goal, like retirement, but may be a poor choice for a short-term need like the down payment of a house in the next three years.
“It all goes back to needing to know the rules of the game,” Tom said. “The IRS’s rule book is thousands of pages long, more than busy people have time to read, less understand. This is where an experienced CPA comes in. By knowing the rules backwards and forwards, we can offer our clients the insight needed to create a custom plan leveraging all the savings vehicles out there.”
To get additional insight into the best way for you to allocate more of your money toward reaching your short and long-term financial goals, reach out to a member of our team for a complimentary consultation.
To hear Tom weigh in on the different types of tax-advantaged vehicles, Defined Benefit Plans, 529s, IRAs and more, listen to his episode of the Accumulating Wealth Podcast.