Many investors spend hours trying to figure out how to engineer an extra half percent on their investments, but they haven’t given much thought to tax planning. Proper tax planning can increase your ultimate returns by 30% or more. Your future financial security probably depends much more on your ability to master the tax system than it does on squeezing an extra one or two percent or 2 out of your investment returns.
You need to understand the “theory” of taxes to effectively play the tax game. Taxes obviously generate revenue for the government, but they also allow the government to influence our social behavior. The government wants employers to give employees benefits and provide for retirement, so it has passed laws that give employers tax breaks. It even encourages individuals to provide for their own retirement by giving them personal tax deductions for money saved into retirement plans.
Business growth is also a priority of the government, so lots of tax laws benefit businesses. Your small business, is your most important tax shelter. If you are a W-2 employee, you need to establish some sort of a small business. A small business is anything from a medical practice to a hotdog vendor on the street. The most common small business is a consulting business, where you provide a service to somebody other than your W-2 employer. Once you have a source of income that is not straight W-2 income, you have a whole world of tax possibilities open to you.
One radiology group I work with has a single doctor handle all night calls during a month. That is a brutal schedule, until you realize that he reads the x-rays from a plush condo in England. Of course, the night shift in the United States falls during daytime hours in England. All expenses associated with the doctor’s “night shift” duties are deductible expenses, including the condo. I suspect that the doctor and spouse do things in England on their off hours that they wouldn’t do in their hometown, so the tough night duty becomes bearable.
But deductions can only go so far in eliminating your tax pain. Bigger tax relief can be obtained using the tax code and Employee Retirement Income Security Act laws. Retirement expenses and benefit expenses for your business can dramatically save taxes and simultaneously give you great economic advantages. The most common complaints against retirement plans are the deduction limitations. Putting your $5,000ish into an IRA isn’t going to have a big impact. You have to turn to other plans where higher deductions are possible.
Defined-contribution plans are going to provide a maximum of $50,000ish in annual deductions. Defined-contribution plans (eg, simplified employee pensions, 401 (k) s, etc) are simpler to establish and cheaper to maintain than defined-benefit plans. A standard defined-benefit plan will provide as much as $195,000ish in annual deductions. A 412 (i) plan, a special type of defined-benefit plan, is easy to establish and cheap to maintain, plus it allows even larger tax deductions.
Using a 412(i), a 50-year-old can deduct around $300,000 and fund their retirement plan. Because contributions are deductible, the IRS is effectively funding about half of your plan for you. Historically, 412(i) has not been a popular plan, because the investments had to be made in guaranteed insurance products, which have had very poor long-term yields. A big tax deduction doesn’t mean much if your invested funds have a very poor long-term return. Under the protection of a US patent, several companies have recently developed 412 (i) plans that give even bigger tax deductions and permit you to invest in market-driven securities. You can now play the tax game to its maximum and squeeze every possible extra percent out of your investment.
You must remember that all retirement plans and welfare benefit plans must be established prior to the end of the tax year. Some retirement plans may not need to be funded before the end of the year, but they need to be fully established. So, now is the time to take action to save on taxes. Waiting until December 29 to start planning is always a disaster.