Following key tax tips can put you on the road to financial freedom.
Mother Goose always said, “It’s not what you make, it’s what you keep after taxes.” This wisdom is more timely than ever with the complicated, ever-changing tax code.
Before looking at some high-impact tax tips, it’s important that you keep in mind the bigger purpose of tax planning, which is to advance your overall progress toward financial freedom. Many dentists treat tax planning as an end in itself. If saving taxes doesn’t advance your financial freedom goal, then it is a pointless exercise. So, take your spouse on that continuing education trip to Hawaii. Just don’t expect the big deduction to help you retire!
With that said, here are the latest tax tips to improve your bottom line.
Retirement planning
In 2006, the fully-phased-in 401(k) deduction is finally available. Your spouse and you can contribute $15,000 each, plus a $5,000 catch-up contribution, to your practice’s 401(k) plan for those age 50 or older. These deferral contributions, unlike the practice’s profit sharing payments, must be made on or before Dec. 31, 2006. Your spouse cannot receive benefits in another plan at another job to be able to participate in your plan.
Also, in 2006, the maximum allowable retirement contributions in a defined contribution plan are $44,000 per participant. If you are 50 years or older and employ your spouse in your practice, you could contribute as much as $44,000, plus $5,000 for yourself, plus $15,000, plus $5,000 for your spouse for a total of $69,000. Besides this, you could contribute any additional profit-sharing for your spouse. Of course, your income needs to be large enough to meet the requirements. Prior to the recent changes in the 401(k) rules, it did not make sense to employ a spouse because of the increased payroll taxes. However, with the ability to fund 100 percent of pay for the spouse’s 401(k), this has changed. Be careful that your spouse meets all requirements to participate, such as the 1,000 hour-per-year requirement.
The hot topic in 2006 is whether you should add a Roth 401(k) option to your retirement plan. Beginning this year, you have the option to contribute salary deferrals into tax-free Roth 401(k) accounts. Unlike regular 401(k) deferrals, the Roth deferrals are not tax deductible but accumulate tax free. Normally, high-income dentists are unable to contribute to Roth IRAs if their adjusted gross income (AGI) exceeds $160,000. These income limitations do not apply to the Roth 401(k). The Roth 401(k) option is not automatic. Your plan must be formally amended to add it.
Should you add this feature? In general, when we run the numbers on regular 401(k) vs. Roth 401(k), we find that the Roth 401(k) works best for younger, lower tax-bracket employees. Typically, the higher bracket doctor and spouse benefit more from regular deductible 401(k) contributions even if their tax bracket is the same or higher in retirement. Have your CPA run the numbers for you.
Advanced retirement planning
With the repeal of Section 415(e) of the tax code, doctors now are allowed to combine a defined contribution or 401(k) plan with a defined-benefit-type plan. Conceptually, if you imagine all of the 401(k) benefits just reviewed and then imagine adding a $50,000 defined benefit payment on top of the 401(k) amounts, you can understand the basic concept. The idea is to obtain retirement plan deductions in the $100,000-plus range. Every dental practice has its own mix of ages and salaries. Some practices are a perfect fit based upon the facts, and others are not.
To benefit from advanced retirement planning, the doctor typically needs to be over 45 years of age and have access to sophisticated actuarial expertise. The costs of maintaining this two-plan combination are higher than the 401(k) plan; however, the benefits can be phenomenal for the right fact situation. Many older dentists are behind in their retirement savings and need to catch up. These plans allow the dentist that ability in a deductible environment.
Equipment expenditures and office buildings
Dentistry is uniquely situated to benefit from the extremely liberal current rules for depreciation deductions. For 2006, up to $108,000 of equipment may be expensed in the year of purchase under Section 179. The original $100,000 of Section 179 has been increasing annually with inflation. This will continue through 2007. Currently, this amount is scheduled to revert to $25,000 in 2008.
Once again, the idea is not to purchase equipment to save taxes but to plan the tax benefits of equipment purchases in the overall framework of financial freedom. In this regard, sometimes it is not wise to expense a large amount of purchased equipment if your income drops so much that you are unable to fund your retirement plan. Because of the large deduction potential, more planning than ever is required by your CPA to assure that you get the greatest benefit overall.
Many doctors and their advisors still have not heard of the Hospital Corporation of America tax case, and the ability to use “cost segregation” to greatly increase deductions on office buildings. Assume, as an example, that you are considering building a new dental office at a cost of $1 million. Under current depreciation rules, your depreciation deductions would be limited to a 39-year life on a straight-line basis. If the building was completed in January 2006, your depreciation deduction this year would only be $24,610.
Under the HCA tax case, you could perform a cost segregation study and allocate typically between 20 to 40 percent of the building cost to a shorter five-year life property. The reason this is allowed is that much of the costs of the building (plumbing, wiring, etc.) are associated with treating patients and dental equipment. If 30 percent of the cost of the building, or $300,000, could be allocated to a five-year life, then the first year’s depreciation deduction would skyrocket to $92,227 ($75,000 for five-year + $17,227 for 39-year).
Splitting income among family members
There are three major benefits of employing children in your practice: (1) the ability to use the child’s full standard deduction ($5,000 in 2005), (2) the ability to fund a full IRA deduction of $5,000 in 2006; and (3) the ability of the parents to reduce their adjusted gross income with the children’s salaries. By reducing their own AGI, the parents can save exemptions and itemized deductions from phase out. Finally, the child could earn $7,300 in 2005 and pay tax in only the 10 percent federal income tax bracket. So in 2005, by contributing $4,000 to an IRA, the child could have earned $16,300 and paid only $730 of federal income tax!
Recently, we calculated that by making only two IRA contributions of $5,000 each (2006 maximum) at ages 10 and 11, a child would accumulate $1,985,121 at age 65 with a 10 percent annualized return. This compares to only $1,645,197 for a 30-year-old who begins saving and then continues each year to age 65.
If you have several children to employ, you might consider practicing as a limited liability corporation taxable as a sole-proprietorship to avoid having to pay payroll taxes for your employed children under age 18. With the employer-employee FICA tax being 15.3 percent, this savings becomes significant for several children. Unfortunately, the full tax is payable when the doctor is incorporated.
What does the IRS think about employing children? The IRS has indicated that reasonable wages paid to a child are deductible even if wages are used for the child’s own support. The critical factors based upon court cases are that the wages are reasonable based upon the child’s age and the tasks performed, that the services are performed for the business (not chores at home) and that the practice abides by the formalities typically followed when paying unrelated third parties (like keeping track of hours).
Other income-splitting techniques
One of our favorite techniques for shifting income to children over age 13 is using a Sec. 2503(c) trust to lease dental equipment to the practice. The rent payments are deductible to the practice, and the income is effectively shifted to the child’s lower brackets. If the child is in college, the rent money could be used to pay college tuition.
By using either the Hope credit or the lifetime learning college credit, the child could earn nearly $20,000 and pay very little federal tax. This $20,000 of rent could save the doctor $8,000 of income tax in the combined 40 percent federal and state tax brackets. In some states, sales tax is payable for rented equipment. So be sure to check with your tax advisor prior to implementing this technique.
Miscellaneous Hot Topics
Hybrid automobiles
In the words of Road & Track magazine, “Everyone from Cameron Diaz to George W. Bush is talking hybrid cars.” Effective for 2006, purchased new energy-efficient autos will be eligible for direct credits against income tax. The credit is composed of two parts. The first part is a “fuel economy credit” that can range from $400 to $2,400. The second part is a “conservation credit” that can range from $250 to $1,000. It is estimated that a Toyota Prius, for instance, would be eligible for a $3,150 credit against tax if purchased prior to phaseout.
The credit is complicated to calculate, can be disallowed under the AMT rules, and is phased out over four calendar quarters. For more information, go to www.hybridcars.com.
Heavy SUV deductions
Heavy SUVs, when used more than 50 percent for business, still have attractive tax benefits even after the repeal of the $100,000 expensing in October 2004. For example, the first-year deduction for a $40,000 heavy SUV placed in service in 2005 and used 100 percent for business will generally be $28,000 ($25,000 Sec. 179 plus $3,000 MACRS depreciation). Contrast this with the first-year deduction of only $2,960 for a luxury car used 100 percent for business in 2005. For a list of vehicles with gross weights of greater than 6,000 pounds, check www.intellichoice.com or www.edmunds.com.
HSA accounts
Unlike its predecessor (the medical savings account), the recently created health savings account has been popular and fairly easy to implement. It is estimated that, by the end of 2006, 70 percent of midsize and large U.S. companies will offer this benefit. The idea behind an HSA is that, by combining a high-deductible medical insurance policy with tax-deductible employee contributions, medical insurance will become much more affordable to all concerned.
For 2005, an eligible individual’s maximum deductible HSA contribution is limited to the lesser of 1) the insurance deductible amount, which must be at least $1,000 of self-only coverage or $2,000 for family coverage or 2) $2,650 for self-only coverage or $5,950 for family coverage. These amounts will rise with inflation for 2006. For more information on HSAs, visit www.hsainsider.com.
Reasonable compensation in S Corps
Recently, the IRS announced the launch of a study to assess the reporting compliance of S Corporations. The IRS will examine 5,000 S Corporation returns. One of the hot topics is whether a shareholder’s salary has been made artificially low to avoid payroll taxes. After years of indifference, it appears that the IRS is making a concerted effort to curb abuses in the low-compensation area. One publication has mentioned that some IRS Service Centers have their computers programmed to flag S Corporations that report relatively small salaries compared to distributions. We think it is important to keep salaries at approximately $200,000 to optimize deductible retirement plan contributions.
Finally, Mother Goose also said “life ain’t no fairy tale.” Make sure that your tax planning furthers your financial freedom goals and doesn’t become an end in itself. Always make saving and investing your primary goal. Also, remember not to implement these strategies without the assistance of a knowledgeable tax professional.
Improve Your Bottom Line
By Brian Hufford, CPA, CFP®
By Brian Hufford, CPA, CFP®
Editor’s Note: After initial submission of this article by the author, President Bush signed into law May 18, 2006, the Tax Increase Prevention and Reconciliation Act.
This new tax law creates the following changes to the article:
(1) The Kiddie Tax rules have been expanded to include 14- to 17-year-old children. Under the new law, passive income is taxed at the parent’s rates until age 18 instead of age 14.
(2)A two-year extension has been added to Sec. 179 expensing rules, allowing the higher limits set to expire in 2007 an additional two years until 2009.
Brian Hufford CPA, CFP®, is president of Hufford Financial Advisors, an independent, fee-only planning firm dedicated to helping dentists achieve financial peace of mind. Many dentists attend Hufford Financial Advisors’ Financial Breakthrough Workshops. Upcoming workshop dates and locations are listed at www.huffordfinancial.com. Contact him at (888) 470-3064, or at [email protected].
