Who Couldn’t Use An Interest Free Loan?
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 of income tax through strategies to minimize your current tax burden, but also the calculated deferral of income tax liability to future years, where possible. So why is it that some business owners don’t value 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 or business needs. It is extremely frustrating to hear a client, or worse, their professional advisor, denounce a tax deferral opportunity stating it is “just a deferral,” and “you’ll have to pay tax sooner or later.” Sadly, these are often the same clients who think successful tax planning involves spending cash on capital expenditures or accelerating expenses before the year’s end.
What if you had the opportunity to defer tax expenses to some date in the future? What if it was also possible to avoid interest charges on this deferral, and potentially lower your income tax rate at the time the income was recognized so you receive a true tax savings? Alternatively, what if there were tax deferral techniques available allowing you to retain your existing liquidity, and put money back to work for you in your business? If these sound like intriguing possibilities, please read on…
This article not only explores the general benefits of tax deferrals, but also serves to remind, and perhaps reassure, small business owners that it is never too early (or too late) to examine their current retirement plan, and make sure they are taking advantage of every option available to them under the Internal Revenue Code to help them reach their 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 currently offers its employees the opportunity to participate in a 401(k), 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 in doing so. Understanding the benefits associated with tax deferrals may not only help small business owners meet their retirement needs, but can also positively affect their businesses, depending on the type of deferral. Of course, companies offer these types of benefits so they can also be competitive in the marketplace. This is a testament to the widespread belief that taxdeferred 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, I can use and invest those funds generating a return for myself that I couldn’t have otherwise achieved. For example, assume that a small business owner owed $10,000 in income taxes, but through successful tax planning, had the ability to defer that tax obligation for one year. The business owner could then invest those funds and, assuming a 6 percent investment rate of return, could earn $600 on his or her investment before he or she had to pay the tax bill one year from now. This is a simple example and the amounts are small, but it illustrates a business owner’s ability to earn additional investment income from assets by simply holding on to them 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, that tax deferrals can be extended for an extremely long period of time and combined with possibly much higher dollar amounts, the real power of deferrals starts to show. For example, 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 in which 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-plus or even 50-plus years).
Reduced Tax Rates
Perhaps the primary reason that 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. During retirement, the vast majority of Americans are living off of their net worth and retirement savings which may be decreasing from year to year. During this time, retirement plan withdrawals and other investment earnings will have most retirees in a significantly lower tax bracket as compared to the bracket they were in while actively working and earning the money that was put into their retirement accounts. The difference between the tax bracket they were in when they earned the funds put into their retirement plan, and the tax bracket they are in when they withdraw their retirement savings in the future, represents a TRUE TAX SAVINGS as these amounts can turn out to be quite significant.
Let’s look at an example using existing tax rates and tax brackets for simplicity. Let’s assume you put $100,000 into a retirement savings account at age 50, and throughout the next 15 years, $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 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 8 percent (or 18 percent depending on the retirement income level previously shown), applied 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 that 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, since a deferral to a later year helps lower your income tax bracket, it is similar to forgiveness of that debt! These are the primary reasons why qualified retirement plans are so popular.
There are other advantages as well. Here are a few more to consider, some of which may also protect or improve your business:
When a tax deferral technique involves contributions to qualified (or non-qualified) retirement plans, those funds are protected from the reach of your business creditors, lawsuits and bankruptcy. This means money in your retirement plan is much better protected than the assets you have in your personal or corporate savings or brokerage accounts, which in the event of a judgment against you or your business, could be exposed to the reach of your creditors.
Increased cash Flow and/or Improved working capital
Reduced income tax expense, in some cases, could translate into more cash onhand, which could then be used for other business purposes. Consider the following:
- Since 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 may be more significant than they initially appear when you consider that getting a two percent reduction in your total expense for parting with funds 20 days early is the equivalent of receiving (roughly) a 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 not involving a cash outlay might include a change in a company’s method of accounting from accrual to cash, in which accounts payable consistently exceed accounts receivable. 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 perpetuated for a number of years.
- 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 be used to increase incentive programs. Such programs could be used to attract and help retain key-employees, which in turn can reduce employee turn-over costs.
- It is importan 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” 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.
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 improved marketability and company value.
These are simply a few of the benefits associated with tax deferral techniques. The result of successful tax planning can be similar to tumbling dominos, as the effects within your business can be far reaching. The results can be more beneficial 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.
Small business owners should also understand that there is a wide variety of retirement planning tools available to help them meet their retirement goals as well as to complete the succession of their businesses. By consulting with a qualified professional specializing in retirement plans, small business owners, armed with an appreciation of the power of tax deferrals, can better explore these options and how they fit with their businesses given their goals, employee make-up, company profitability and willingness to provide employees with benefits and incentives. For those employers that don’t feel inclined to provide significant benefits to their employees, but would prefer to simply provide benefits to owners, there are also qualified and nonqualified retirement plan options allowing for significant tax deferral opportunities that primarily benefit corporate shareholders.
Regardless, the choice regarding a retirement plan should be made with a licensed retirement planning professional present, and should include a careful analysis of the company, its ownership and the business owner’s and professional’s individual and collective goals.