Who doesn’t like the idea of saving on taxes? We all look for ways to lessen our tax burden, but it can be easy to let the idea of tax savings overrides basic economics. Not all tax-cutting strategies make good financial sense.
Weigh Tax-cutting Strategies Against Your Business Needs
Here is an example of a bad tax-cutting strategy. Your unincorporated consulting business wants additional tax deductions, so you purchase $10,000 of office furniture that the business does not really need. If you are in a 28% bracket and you deduct the entire cost, this purchase will trim your tax bill by $2,800 (28% of $10,000). But you just spent $10,000 to get that $2,800 savings, and now you have furniture that was not really needed.
A better strategy would be to look at the actual business needs over the next few months and see what you may be able to move into the current year. For example, do you typically place a large supply order in January each year? It could make sense to move these items to December to get the deduction in the current year. This is money that your business already needs to spend, you are just rethinking the timing of the expense. You have not increased your overall cash needs, and have accelerated your tax savings by pushing the expense into the current year. (This example assumes your business is a December year end.)
Look at the Big Picture
It is easy to focus on tax savings and ignore the bigger financial picture. Common examples are:
- Increasing the size of a home mortgage solely to get a larger mortgage interest deduction, or hesitating to pay off a mortgage just to keep the interest deduction. If you actually need a larger mortgage or need a home equity loan, then this is a sound strategy, but if you are adding or keeping debt solely for the purpose of saving on your taxes, you should rethink that strategy. For a person in a 28% tax bracket, you would save only $28 for every $100 spent on interest.
- Turning down extra income, because it might push you into a higher tax bracket. This thinking is flawed. Tax brackets are staggered. When your income moves into a higher tax bracket, only the portion above the lower levels is taxed at the new higher rate.
- Holding an appreciated asset indefinitely, solely to avoid paying the capital gains tax. If selling the asset makes sense for your portfolio, then speak with your advisor about ways to lessen the impact of the capital gain on your taxes. You may have capital losses that can be utilized to offset the gain. Or you may be able to conduct a tax-deferred exchange.
Keep Control of Your Money
As a general rule, the best tax strategies are those that generate a deduction and leave you in control of your money. Contributing to IRAs, 401(k)s, and other retirement plans can gain you a deduction, while adding to your own retirement nest egg. The tax on these monies can be deferred until you withdrawal the funds during retirement. To a large degree, you control when that happens.
Tax-cutting strategies are usually part of a bigger financial picture and need to be tailored to your own unique situation. Your advisor can suggest strategies for you, and help you stay focused on your overall financial picture.