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Better in My Pocket: Tax Breaks to Consider

As featured in The Journal of the Medical Dental Association.

As in the game of football, the actions you take in the “fourth quarter” of the year can mean the difference between winning or losing – especially when it comes to tax planning. Here are some tax tips you can use at year end, and all year long.

It’s common knowledge in football that the fourth quarter mean the end of the game is near, and unless the score is hopelessly lopsided, anything can happen. Your team could still win or lose.

In my profession—although we advise our clients all year around—the fourth quarter means helping businesses claim all legitimate tax breaks before time runs out, so they can pay less of their annual profit to Uncle Sam and keep more for themselves.

What are some of those tax breaks? At the top of my list the best tax planning tool for small business owners—which naturally includes dentists—is a qualified retirement plan. So let’s start with that and then move on to some other tax breaks you should consider.

Why a Qualified Retirement Plan?

There’s no question in my mind that a qualified retirement plan brings the biggest bang for your buck. Most commonly, it’s in the form of a 401k profit-sharing plan—an employer-sponsored plan that covers you as well as your employees.

Contributions made by the practice to the plan are tax deductible, which means more earnings stay in your pocket. It’s one thing to create tax deductions by paying somebody else for services or merchandise. But while that saves on taxes, you lose the whole dollar in the transaction. With a retirement plan, on the other hand, the money you contribute is a deduction that’s also going into your account. In other words, it’s still your money, and you’re just switching pockets, so to speak.

When you offer an employer-sponsored qualified retirement plan, you’ll naturally cover your eligible employees which means there’s a cost you can’t retain. The money you pay into their accounts is theirs. (Keep in mind, though, that this is a form of compensation, so maybe you’re able to manage your staff’s hourly rates—or raises—differently because you’re adding a fringe benefit).

When considering a qualified retirement plan as a tax planning tool, it’s a no-brainer if 80 percent or more of the total contribution will go into your own account. Here’s an example:  Say the profits in your practice enable you to put $50,000 into a qualified retirement plan for both you and your staff. You take $10,000 of that and divide it among your staffs’ accounts. Your account gets the remaining $40,000. Sure, you’ve put $10,000 into other pockets, but kept $40,000 in yours. At roughly a 40 percent combined tax rate, you’ve saved $20,000 in taxes—and that goes a long way toward funding the $50,000 you have to come up with.

The 60-to-80 Percent Ratio

Alternatively, if the contribution ratio is below 60 percent, then the benefit of having a qualified retirement plan is questionable. Say you have that same $50,000 that you can save in the same way. If your eligible staff—the number of employees you have plus the wages they earn—requires that you put $20,000 or more of that $50,000 into their accounts, that leaves you with $30,000 or less for your own account. To me, that’s a marginal benefit and you may want to look at other alternatives to save on taxes.

Here’s another way to look at it: The $50,000 deduction you get for putting the money into a retirement plan will save $20,000 in taxes. But if you choose to take $50,000 as taxable profit instead, you’ll pay $20,000 in taxes and be left with $30,000. So, you’d be in the same position as not having the plan at all. Either way, you get the $30,000. However, you may also want to consider the direct benefit to your staff of paying that $20,000 in retirement contributions and taking that as a tax deduction, rather than giving it to Uncle Sam to spend.

Clearly, receiving 80 percent of the benefit from a qualified retirement plan is ideal; 60 percent, not so much. Between 60 and 80 percent is more of a judgment call. If you can contribute $15,000 to your staff’s retirement plan and keep $35,000 for your own account, you might consider the resulting employee goodwill to be a solid return on your investment.

A 401k profit-sharing plan is just one of the possibilities. There are other retirement plan options with provisions that can skew the dollars in favor of the business owner. You may also consider a little less complex approach such as a Simple IRA. The contribution level is more limited than the 401k profit-sharing plan, but the rules are less complicated (as the name implies). As always, it’s best to obtain the advice of your business or tax advisor.

Of course, there’s no requirement to offer a 401k or other retirement plan in your dental practice. But it usually makes sense when you consider how you’re saving for your own retirement. Including your staff adds cost but also the aforementioned goodwill benefit.

Your consultant can also discuss the provisions or rules of qualified retirement plans with you. In each of these, you can be less restrictive than what the rules say but you have to meet the minimum requirements. For example, if you offer a 401k plan to your staff, you can’t require that they work more than 1,000 hours in a year to be eligible. But you could set fewer hours—say 500— for them to be eligible if you want.

The Tax Planning Benefits of a Roth IRA

Now, what happens when you put the maximum allowed into a qualified retirement plan and you still have available cash or profits that can be taxed? One option is to set aside some of that in a personal IRA plan that’s most likely non-deductible. Almost immediately after doing that, you then take funds from it and convert them to a Roth IRA. Why? Because you never pay tax on distributions from a Roth as you would on a non-deductible IRA.

Previously, if your income was above a certain level—as is true for most dentists—you’d be unable to convert a non-deductible IRA into a Roth IRA. Even though that rule has been relaxed, it still requires a two-step process that entails putting funds into a non-deductible IRA and quickly converting it to a Roth. (I recommend doing it almost simultaneously. Open your non-deductible IRA one day and convert it the next day, because if the IRA grows before you convert, you’ll pay taxes on the growth).

Under Roth IRA rules right now, you’re only allowed to put a maximum of $5,500—or $6,500 if you’re 50 or older—into an account. So you could create one for you and one for your spouse.

Something else to consider: If you can employ your spouse in your practice, he or she can become eligible for the qualified retirement plan you offer. The 401k aspect of the plan allows you—and your spouse—to defer $17,500 of salary into the plan. At age 50 and over, you can put in an additional $5,500. Withholding that salary and putting it into a retirement account will benefit both you and your spouse in the future.

In fact, at age 50 and over, the amount that can be put into a qualified retirement plan (the employer contribution plus the income deferred into the 401k) is capped at $57,500 for 2014. A spouse working in the practice is not likely reach $57,500, however you can pay him or her $25,000 and the spouse can defer $23,000 (if age 50 or over) in the 401k. In addition, there’s going to be an employer contribution on the $25,000 that the spouse earns, and while that’s negligible, it increases your tax deduction as well as ratio (60 to 80 percent discussed earlier).

You’re saving more tax dollars with money you’re going to accumulate for retirement anyway, and you’re keeping Uncle Sam at bay for a longer period of time.

Deduct Your Child’s College Education

Yet another tax planning tool is to employ your children, though in case of an audit you’ll have to document the services they provide to your practice. You might put them on the payroll for roughly $6,000 each, because that’s level where you maximize the tax deduction, since the first $6,200 is subject to zero federal tax. You get to deduct that $6,000 in wages to an employee of your practice, and at the same time contribute another $6,000 to your family’s worth.

Your children can earn such wages in a variety of ways. For example, tech-savvy older kids might research dental supply costs on the Internet to find the best deals for a parent’s practice, or keep its social media presence up-to-date. Some are also paid modeling fees for appearing in promotional materials for their mom or dad’s practice.

The question is, what do you do with that payment to your children? One option is putting it into a “uniform gift to minors account,” where you or your spouse serves as custodian until the child reaches age 18.

Another option is contributing $5,500 of that $6,000 to a Roth IRA. The attraction of this option is that funds in a Roth IRA may be used without penalty for education.

Let’s also do the math on leaving the contributions untouched: If your child works in your practice from age 10 to 22, and you make the maximum contribution each year, then $70,000 or so accumulates in the account. Imagine what that number might grow to by the time your child is age 65 and ready to retire. At just 4 percent per year the total accumulation will be more than $500,000. What a great way to pass along an inheritance.

That’s a form of overall tax planning which gets some money out of your estate and grows it in theirs. And it can be any invested any way you want—say in a mutual fund or a single stock.

Some Minor Tax Breaks to Ponder

Aside from estate planning and sheltering income, there are some other things to think about before the end of the year. Since 2013, a new Medicare surcharge under the Affordable Care Act (ACA) has been instituted on wages of $250,000 or more on a joint return. If you can keep the joint return wages below that figure, you save the new 0.9 percent surcharge. Last year, one dentist I advised was so irritated by the new surcharge—even though it’s minor—that he asked me to help set his practice production schedule at a level where he’d earn precisely $249,999. He preferred to take more time off rather than pay a higher rate of the additional income to the government.

Some dentists also look to create home office deductions. With this, the IRS looks for both “exclusivity” and a “qualified business purpose” for compliance. The question is how do you make them fit your circumstances? Your tax advisor can help you with that. However, there is a new simplified approach called a “safe harbor” for a home office deduction that factors in square footage used by $5 per square foot. The maximum amount of space that qualifies is 300 square feet, giving you about a $1,500 deduction.

Another tax break allows a taxpayer to not to report income from the rental of their home for up to 14 days. Any more than that and you must report the income. Let’s say you have a vacation home and have a legitimate business purpose that can be documented, such as a staff retreat for strategic planning or a conference with fellow dentists to discuss best practices. Your practice can cut a check to you for fair market rent, and as long as the 14 days aren’t exceeded, that rental income doesn’t have to be reported.


As always, one of the best things you can do for yourself and your practice is to work with your advisor or consultant to regularly monitor your tax position during the year. That way, you can tweak things here and there to take advantage of all your tax-break opportunities, and keep more practice profit in your pocket. That’s better than waiting until the fourth quarter and trying to throw a “Hail Mary” pass in hopes of winning the game.

 

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