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Small Business Financial Article

Small Business Financial Article
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

For Business Owners, Tax Diversification is Key to Financial Success

For Business Owners, Tax Diversification is Key to Financial Success

The bottom-line in retirement income planning is that, while the deferred taxation you enjoy from qualified retirement plans is great for capital accumulation, it can have an adverse impact on how much you can actually draw from it in retirement. Of course, a lot depends on your tax situation in both the accumulation and distribution phase of your retirement plan: But, assuming that, as a business owner, you do well in accumulating retirement capital, you will likely find yourself in a similar tax environment when you’re ready to convert it to income. And, because it’s too late to do anything about it when you retire, you need to take action now to ensure your retirement is less taxing.

It helps to think of all of your investment options as different tax buckets. There can be a tax-free bucket consisting of tax-exempt bonds or a Roth IRA; there’s a tax-deferred bucket that would include your 401k or a Traditional IRA; and there’s a taxable bucket that would include any investment or savings vehicle that is currently taxed – either at ordinary income tax rates or capital gains tax rates.

A tax-diversified investment strategy includes a mix of all three buckets – and here’s why:

With tax-free vehicles, what you receive as income is what you get. You don’t pay any taxes when it is received. However, you also didn’t benefit from any tax deductions when you contribute to the investment. For instance, with a Roth IRA, your investments grow tax deferred, and, after age 59 ½, they can be withdrawn tax-free; however, your contributions were made with after-tax dollars.

With the tax-deferred vehicles, such as a 401k or a Traditional IRA, you were able to deduct your contributions from your income, saving you money at the time, but, upon withdrawal, your funds will be taxed at your ordinary tax rate.

With taxable vehicles, you receive no tax deduction and, depending on the type of investment, you pay taxes on interest or on capital gains as they were earned. Interest income is taxed at ordinary tax rates, while long-term capital gains are taxed at 25 percent. Of course, you don’t pay any taxes on unrealized capital gains, so, in essence, your investment portfolio can also be a tax-deferred vehicle if you never sell your stocks. But even when you do, you can use losses in your portfolio to offset the gain and reduce your tax.

As you can see, with some vehicles you can generate significant tax savings currently which can be invested. With some vehicles you forgo current tax savings in order to reap tax savings later. And with some, you may have to pay taxes as you go or when you draw from them in retirement, but it’s at a more favorable tax rate.

Tax Diversification Distribution Strategies

Assuming you’ve done well, and you find yourself in one of the higher tax brackets, you now have some choices and flexibility in how you take your income from your three- tax buckets:

One strategy is to draw equally from all three allowing you to average your tax rate down through a combination of tax-free, taxable (at ordinary tax rates) and tax-favored (capital gains rate).

In years when you have a greater need for income, you could emphasize the tax-free or tax-favored account; and in years when you need less income, with the possibility of falling to a lower tax bracket, you could emphasize your taxable income.

Remember, when you do draw from your tax-favored (capital gains) account, you can manage your tax liability by “harvesting” losses from your portfolio.

There is a major caveat: While there is the temptation to defer taxes from your qualified retirement accounts as long as possible, you need to be aware of the Required Minimum Distribution (RMD) rule which requires you to withdraw a certain percentage of your income by age 70½ If you have too much remaining in your accounts at that time, you could be forced to take out more than you need which could force you into a higher tax bracket. There is no RMD with a Roth IRA, so, for that reason, you may want to consider reallocating more of your contributions from the tax-deferred bucket to the tax free bucket, specifically, to your Roth IRA.

There’s another important caveat, and that is that the tax code is very fluid – things can change; and certainly your own tax situation can change. But that is all the more reason why you should have a diversified tax strategy as it offers the greatest amount of flexibility and opportunity to control your income in retirement.


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