There are two ways to pay less taxes – you can either be unprofitable or be very profitable.
This may seem a bit counterintuitive. You might be thinking if I make more money, doesn’t that mean I have to pay more taxes? I mean, these things go hand in hand, right? That is true to a point. But you also have an opportunity to save more as your income increases.
Now, I get that we all must pay our fair share of taxes. But the system we have is not built to allow you to easily pay only your fair share. Many Americans end up paying unnecessary taxes every year.
So how can we avoid this? Here are a few things to look at:
Focus on a healthy cash flow first.
Many business owners who ask me to develop their tax strategy don’t only have a tax problem. They have a cash flow problem. Sometimes I review their tax returns to find out they are paying very little in tax. But their perspective is they can’t make the tax payments, so taxes must be the issue.
If we dig a little deeper, we find the real root cause of their pain is that their cash flow is not healthy. Many business owners still have to pay something in taxes (i.e., their fair share). Even with our Comprehensive Tax Strategy implemented.
There is one thing you can do to improve cash flow for tax time. Start setting aside a fixed percentage of every dollar you collect in your business in a separate savings account. Label that as your tax account and don’t touch it unless you have to make an income tax payment. Most of my optometrist clients allocate 5% – 10% of their gross collections to their tax account.
Don’t spend all your profits to reduce taxes
This is a trap business owners fall into near the end of the year. Usually it is because they haven’t focused on a comprehensive strategy throughout the year. Then their CPA projects their taxes and the business owner gets surprised by a huge tax bill.
Because of the timing, there are a limited number of things that may still have a big impact for that year.
I’ve seen people fall into this trap for years. The end of the year comes, they expect a big tax bill, and their focus goes to doing whatever they can to lower that tax bill. It’s a narrow focus that leads to bad decision-making.
The story is almost always the same. Buy a new vehicle over 6,000 pounds so you can write it all off. Buy or finance some new equipment, whether you were planning to or not. Go into debt, spend a dollar to save 40 cents.
The key to avoiding this trap in the future is to develop a Comprehensive Tax Strategy for the next 1-5 years now. Your end-of-year planning should include a projection for this year. But most of the focus should be on the next 1-5 years.
Good tax reduction is more about positioning cash, not spending it
So now you’re setting aside money, paying attention to cash flow and working a Comprehensive Tax Strategy. What does it mean to position cash for tax reduction? This means positioning your money where it helps you reduce your taxes while still increasing your wealth.
Let’s use a simple example. Say you’re ready to max out a 401(k). You’ve been contributing $19,000 per year, but this year we want to max it out at $57,000. That’s $38,000 extra to your retirement account.
Obviously, if you don’t have an extra $38,000 to fund the plan, this strategy will be hard to pull off.
This is the same concept whether we are talking about funding a 401(k) or IRA, hiring your kids or spouse, contributing to an HSA or a 529 plan, etc., etc. The appropriate strategies will take cash to pull off.
And the more cash we have to work with, the more advanced tax strategies we can use to reduce your tax bill.
If you liked this post, check out our Independent Optometrist’s Guide To Financial Freedom.
Eric Levenhagen, CPA CTS is the only financial consultant who helps private practice optometrists improve the financial health of their practice with a simple, proven process called Financial Harmony which will reduce their taxes and increase their after-tax profits by at least $10,000 in the first year, guaranteed.