The importance of tax deferred retirement vehicles (and tax deferrals in general) and how they can positively effect your retirement and your business.
One of the most important considerations in tax planning is not just the avoidance or elimination of your current income tax obligation, but also the calculated deferral of what would otherwise be current income tax by transferring that tax obligation to future years. So why is it that some small business owners (and even their tax professionals) don’t value tax deferral techniques? One logical answer, of course, is that they simply don’t understand deferrals or the positive effect they can have on their retirement. Even more common is the lack of understanding regarding the effect that deferrals can have on the overall health of their businesses. It is incredibly frustrating to hear a small business owner, or worse, their professional advisor who should know better, denounce a tax deferral opportunity stating that “it is just a deferral” and “you’ll just end up paying that same tax later.”
Sadly, these are often the same advisors who also think sound tax planning involves spending available cash on capital expenditures or accelerating expenses before year-end. In other words, you should spend $1,000 to get the benefit of $350 in tax savings. This has about the same ring to it as when your children spend your money on things they don’t need only to tell you how much money they saved you because the item they bought was on sale! If you are a small business owner and you are receiving these types of “planning recommendations” from your tax advisor, it may be time to ask around for a referral.
What if, instead of paying all of your taxes today, you had the opportunity to defer some of those tax expenses to some date in the future? What if it were also possible to avoid interest charges on this deferral and possibly even lower your income tax rate at the time the income was recognized so that what you really ended up with was not just a timing delay in the payment of taxes, which has its own measurable value, but also a true tax savings by changing your income tax bracket? In addition, what if there were tax deferral techniques available to you that would allow you to retain or improve your liquidity and put your available cash flow to work for you in your business?
The following not only explores the general benefits of tax deferrals, which can come in many different shapes and sizes, but also serves to remind, and perhaps reassure, small business owners that it’s never too early (or too late) to examine your current retirement plan and make sure that you are taking advantage of the best options available to you under the Internal Revenue Code to help reach your retirement goals.
The benefits associated with a tax deferred retirement plan are well documented. There is a reason that nearly every large company in America today offers its employees the opportunity to participate in a 401(k) plan, or some other retirement vehicle that offers employees the ability to defer income into future years. The reason, of course, is that there is a significant benefit to doing so for both the corporation and its employees. Understanding the benefits associated with tax deferrals may have a very positive impact on helping you meet your retirement needs, and also have a very positive effect on your business, depending on the type of deferral. Of course, companies offer these types of benefits so they can be competitive in the marketplace as well, but the fact that they need to do so is again a testament to the widespread acceptance that tax-deferred retirement vehicles are a powerful planning tool.
The financial benefits associated with tax deferral techniques can come in many forms. Consider the following:
Time value of money – Most individuals are familiar with this concept. Simply stated, because of the investment return that we can earn on our money while we have it, a dollar in hand today is worth more than a dollar we receive tomorrow. In other words, if I can avoid paying my taxes today and instead pay that obligation in a future year, then I can use those funds and invest them, generating a return for myself that I couldn’t have otherwise achieved. For example, assume a business owner owed $10,000 in income taxes but through good tax planning had the ability to defer that tax obligation for just one year. The business owner could then invest those funds and, assuming just a six-percent investment rate of return, could earn $600 on his investment before having to pay his tax bill one year from now. This is a very simple example and the amounts here are very small, but it illustrates the ability to earn additional investment income from assets by simply holding on to those assets for a longer period of time (provided, of course, that any expense or additional cost of the deferral doesn’t outweigh the investment return).
When you consider that the deferral period associated with many tax planning vehicles can be far longer than the one-year period used in the previous example, and that tax deferrals can be extended for an extremely long period of time combined with possibly much higher dollar amounts, the real power of deferrals starts to show. In the case of monies contributed to a qualified retirement plan, like an IRA, you could theoretically extend the deferral of income taxes on these monies over your entire lifetime and then pass the benefit on to the next generation where the beneficiary designee is a child (in the case of a Stretch IRA). In such an example, mandatory withdrawals after the account owner’s death will be based on the life expectancy of the child. This could allow tax on the funds to be deferred for decades (25 or even 50 or more years).
Reduced tax rates – Another significant reason tax deferrals associated with retirement planning can be so attractive is because during our “earning” years, we are often in the highest tax brackets we will ever be in as individuals. For the vast majority of Americans, when we retire and are living off of our net worth and retirement savings, which may very well be decreasing from year to year, our retirement plan withdrawals and other investment earnings will have most retired individuals in a significantly lower tax bracket than they were when they were actively working and earned the money that they put into their retirement accounts. The difference between the tax bracket you were in when you earned the funds that were contributed to your retirement plan and the lower tax bracket that you are likely in when you later withdraw your retirement savings and have to pay tax, represents a true tax savings! These amounts can turn out to be incredibly significant.
Again, let’s look at a simple example using existing tax rates and tax brackets. Let’s assume you put $100,000 into a retirement savings account at age 50 and over the next 15 years until retirement, let’s presume that $100,000 earns a seven-percent return. After 15 years, when you turn 65, your account would have nearly tripled to approximately $276,000 (rounded). Let’s also presume that at age 50, you were married and your combined net income was $200,000 per year, which placed you in the 33-percent federal tax bracket. At age 65, you are still married, but because you and your spouse have retired and are living off of a fixed income, your combined income is now down somewhere below $123,000, which places you in the 25-percent federal tax bracket (or, for further illustration, assume your income is below $61,000, which would place you in the 15-percent bracket). This tax rate differential of eight percent (or 18 percent depending on the retirement income level shown previously), applied now to the total investment of $276,000 would yield a tax savings of $22,080 in the 25-percent bracket, or $49,680 in the 15-percent bracket. This is money you could never get back if expended at the time the monies were earned without the benefit of a tax deferral. This reduction in your investment also means significantly less earning power.
The “time value of money” concept, combined with the likelihood of being in a lower tax bracket at retirement, is not only like receiving an interest-free loan from the government that you can invest for yourself, but since extending that deferral to a later year helps lower your income tax bracket, it is actually like a forgiveness of that debt! When properly considered in this light, it should come as no surprise why qualified retirement plans are so popular.
Of course, these are not the only benefits. There are other advantages as well. The following are a few more to consider, some of which may also protect or improve your business.
- Asset protection – When a tax deferral technique involves contributions to qualified (or even non-qualified) retirement plans, those funds are protected from the reach of your business creditors, lawsuits and bankruptcy. This means that money in your retirement plan is much better protected than the assets you have in your personal or corporate savings or brokerage accounts, which could be exposed to the reach of your creditors in the event of a judgment against you or your business.
- Increased cash flow and/or improved working capital – Reduced income tax expense today, in some cases, could very well translate into more available cash on hand, which could then be used for other business purposes. Consider the following:
Where a deferral technique does not involve a cash expenditure (like a retirement plan contribution does), the improved cash flow can allow a business to consider taking advantage of better vendor terms (i.e., 2/10 net 30), thereby directly reducing hard expenses and creating “real” savings. This may sound like a minor benefit, but improved vendor terms can be more significant than they initially appear. Receiving a two-percent reduction in your total expense for parting with funds 20 days earlier than they are otherwise due is the equivalent of receiving an approximate 36-percent return on your funds. In other words, to make two percent in investment return in 20 days requires an investment with an annual return rate of roughly 36 percent.
One example of a deferral technique that does not involve a cash outlay might include a change in a company’s method of accounting from accrual to cash where accounts payable consistently exceed accounts receivables. When the excess receivables over payables are taken into income, the effect would be to reduce taxable income. If you are in a business where this differential remains consistent, then it is conceivable that the deferral could be continued for a number of years.
Another example of a deferral technique that does not require a cash outlay is the acceleration of depreciation deductions. By accelerating certain permitted deductions, one can reduce current income tax expense. The corresponding offset is that you would not have these deductions available to you in future years, which means you will have effectively exchanged current tax liability for future tax liability. This is the nature of a deferral.
Increased cash flow could also be retained to build a war chest and secure a source of funds for future use. This could create a safety net for a business owner to cover unexpected costs associated with exigent circumstances. Increased cash flow could also be used to increase incentive programs. Such programs could be used to attract and help retain key employees, which in turn can reduce employee turnover costs.
It is important to note that even when a deferral technique requires a contribution to a retirement plan (as previously discussed), thereby not improving corporate cash flow, individuals may often “borrow” against plan assets for liquidity. While these funds need to be paid back to the plan, there are no penalties, interest is paid to your own account and it can provide a readily available source of funds when a bank loan may not be possible.
- Reduced debt and reduced interest expenses – When the excess cash is used to reduce debt, the result is improved financial statements and improved balance sheet ratios, which can translate into greater ease in securing bank loans and perhaps even improved marketability and company value.
These are simply a few of the benefits. Hopefully, the message communicated is that the result of good tax planning can be like tumbling dominoes, with far-reaching effects throughout your business. The results can be more than just a better return on your investment and tax dollars saved (not just deferred). Rather, it can provide an infusion of working capital that can be reinvested in your business to save real dollars in other ways.
As a small business owner, you must understand there are a wide variety of retirement planning tools to help meet your goals for retirement, as well as for the succession of your business. By consulting with a qualified professional specializing in retirement plans, you can better explore these many options and see how they fit with your business, employee makeup, company profitability and willingness to provide employees with benefits and incentives. For those that don’t feel inclined to provide significant benefits to employees but prefer to simply provide benefits to the owners, there are also qualified and non-qualified retirement plan options that allow for significant tax deferral opportunities that would primarily benefit the corporate shareholders.
No matter which choice is made, it should be done with a licensed retirement planning professional and should include a careful analysis of your company, its ownership and your individual and collective goals.