When it comes to cutting taxes, many financial advisors are missing the boat completely.
Today’s advisors are quick to bring you on as a new client. They will discover your goals, prepare a financial plan, and match that plan to investments that meet your risk tolerance and required returns. However, these plans often fail to come up with a way to cut your taxes. With the national debt approaching $17 trillion, tax rates have nowhere to go but up.
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So, what can you do about it?
First, we must understand the implications of taxes. Look at it this way: If a dollar doubled every year for 20 years subject to no taxes, that dollar would be worth $1,048,000. If the same dollar doubled every year for 20 years subject to taxation, it would be worth approximately $45,000. That’s a $1,003,000 difference!
I recently met with a prospective client who has been a doctor for 20 years. Upon walking the doctor through a discovery process, I learned he had $1.8 million in cash/stock assets and owned his home. His annual taxable adjusted gross income is $1.2 million, and his income has been over a $1 million for the last 16 years. You may be wondering why someone who has earned a million dollars a year for the last 16 years has only saved $1.8 million. The reason for that is not lifestyle; it’s taxes, and this doctor is paying over $400,000 per year in taxes. If he could have cut that tax bill in half, he would have $200,000 per year for 16 years growing at a 5% rate, which adds up to $4,968,073.
So, what could the doctor, or other professionals with a similar situation, be doing to reduce taxes? There are 3 plans you can set up to reduce taxes:
- Charitable Plan
Setting up a charitable plan would allow the doctor to take advantage of the IRS charitable contribution of up to 50% of income. In this plan, doctors or business professionals can maintain control of their assets while passing a portion of the yearly gains to a charity. Contributions are made tax free, its growth is not taxed, and income comes out of these plans tax-free.
- Captive Insurance Company
This would allow up to a $1.25 million annual tax deduction. Tax Deductible Contributions grow tax deferred. When a doctor or business professional cashes out, he or she can take the contributions plus the growth out and pay capital gains tax instead of ordinary income tax. That’s 23.8% versus 43.4%.
- Defined Benefit Pension Plan
A defined benefit pension plan would allow for a tax-deductible contribution much higher than that of a 401K. In some cases, the deduction can be $250,000 or higher.
All of these are advanced financial planning concepts that you should mention to your financial advisor. Unfortunately, many doctors, business owners, and high-income earners have none of these plans in place and may be risking their retirement income. If you are using the typical 401K or SEP IRA plans to reduce taxes and accumulate money, that wont cut it when it comes to accumulating money and reducing taxes.