Using Tax Deductions the Smart Way
In the last blog post, we talked about how tax deductions can come back to bite you if they don’t work toward a greater strategy. Today we’re going to talk about how to make the most out of deductions and ways they can be used constructively.
Obviously, most taxpayers think about their taxes one year at a time. New Addicus clients regularly ask the Addicus team to bring them the lowest tax bill possible each year.
But hear this: Aggressive tax avoidance one year can lead to paying excess in taxes the next, and more taxes overall in the two years combined.
Especially when your income may be balanced between years, it’s smarter to take full advantage of the progressive tax bracket. People usually miss out on this because it requires thinking about taxes over a five- or ten-year span.
Here’s an example:
Marty runs a successful delivery company. So successful that this year, he bought and renovated a new warehouse a few counties over so he could make more total deliveries with greater efficiency. Because of the cost of this investment, his tax returns show his business suffered a $75,000 loss. However, with this new capacity for business, he projects $2 million in taxable income the next year. So Marty expects a fat tax refund this year, but he knows he’ll owe a lot more next year.
Because Marty was also receiving significant personal deductions for state income tax and mortgage payments, the “loss” on this year’s tax bill almost eliminates the value of this year’s deductions.
By restructuring his PFE, Marty moves $500,000 in deductions from this year into next year. He pays ahead. This restores the value of his deductions and lowers his future tax bill, and Marty saves over $100,000 in income taxes he would have owed the following year.
Strategy, strategy, strategy. Why would you want to apply deductions at very low percentage rates, only to fall in the highest federal bracket the next year? If you’ve been focusing on achieving an almost-zero tax bill, you’ve been missing the forest for the trees. Sometimes it’s better to reserve some of your deductions to apply them in a high-income year, when your tax rates are much higher.
Addicus also keeps in mind other ways of reducing your taxes—avenues like state and local tax credits, federal credits, and others, depending on your own unique set of circumstances. Taking advantage of these programs is mostly a matter of being aware of them.
But often, the most advantageous tools at our disposal are right under our nose. It takes an element of creativity.
For example: your children.
You already know that declaring a child as a dependent results in large child-tax credits, academic credits, and other deductions. But most wealthier taxpayers have incomes so great they receive almost no tax benefit from declaring their children as dependents.
However, taxpayers can use their children in their overall PFE by having those children earn, or absorb, some of the PFE’s income. The children can then pay tax on some of their own income at a much lower tax bracket, receiving credits their parents wouldn’t have been entitled to otherwise. This also generates additional deductions. In fact, they can usually earn between $10,000 and $20,000 each without having to pay very much income tax. On the short term, such restructuring means more income that you get to keep. On the long term, it can begin the transition of wealth to the next generation and side step gift-tax costs.
By incorporating your children into your PFE, letting them play a role in it, you can show them the ropes of money management and your business, which will help them grow into responsible stewards of the resources they may one day manage themselves. Smart, long-term structuring can protect your wealth from lawsuits, bankruptcies, divorce, and other disruptions. This is what we’re talking about when we talk about taxes fitting into the bigger picture of your PFE. Your family, your legacy, are as big picture as it gets.
The entities of your PFE are like the parts that make up your own body, and cash flow is its lifeblood. In a healthy body, blood is intentionally directed and flows freely from one part to the next. They all work together to serve each other, as well as the whole.
Certainly, your tax strategy shouldn’t be the driving force of your PFE, but it is an important component of the larger holistic plan, the plan that serves other goals and concerns outside of a minimal tax bill. A solid plan serves as a road map for tax mitigation and a vehicle for economic growth.
Addicus experts guide your decisions with your entire PFE in mind. Most importantly, they care about their clients.
Hopefully, this blog series has demystified the taxation process, at least a little bit, for there is certainly more to talk about. We’ll get to that. In the meantime, whatever level of wealth you possess, we hope you think about your taxes and finances in a holistic way, a way that takes the long view into consideration.