A few weeks ago we were speaking to one of our business clients about their tax planning needs for the upcoming year. During this session, we got to talking about how spending money yields a “tax rate” reduction of one’s taxes for every dollar they spend. This then prompted the analysis of spending to save on taxes versus to generate revenue. Let us elaborate.
How Income Taxes Work. A while back, we wrote about how the income tax system works with regards to refunds and balances due in this post. The short version is that for each $1 you earn, you have to pay an associated amount of taxes based on your marginal tax bracket. Conversely, for each $1 you spend on a deductible expense, it reduces your associated taxes by the tax rate applicable to your highest marginal tax bracket.
Spending To Save On Taxes. One of the things we always try to convey to clients is to spend money on what makes financial, life or business sense. Don’t spend money to save on taxes; if you receive an associated tax benefit, that’s just icing on the cake. Why? Let us illustrate.
Let’s say that Ricky lives in his mothers basement. She doesn’t charge him any rent, but he gets this “idea” of buying a house so he can get a tax deduction. So he goes and gets a mortgage and spends $10,000 on mortgage interest, which is tax deductible. To keep things simple, we’ll assume that all of the mortgage interest is reflected on his return and that his last marginal tax bracket is 25%. Based on this, he can expect to see his tax liability drop by $2,500. But let’s look at it another way…
Ricky wasn’t paying anything to live in the basement. Zero, zip, zilch! But to get a $2,500 tax deduction, he went out and spent $10,000 on mortgage interest? In the world of Finance we go by two rules:
- Cash now is better than cash later – due to inflation $1 today is worth more than $1 in the future so give me the money NOW!
- You only “save” money when you spend $0 – spending money is just that, an expenditure (no matter how big of a discount; sorry discount shoppers).
Using these two rules, it’s pretty clear that Ricky is in violation of the second.
Spending to Generate Revenue. Thus, if you are faced with a decision to spend money, we usually recommend that you do so to generate more revenue (especially if you are in business). Why? There are numerous reasons but some include:
- You won’t see as big of a tax reduction as you would hope for by spending it on deductible expenses (see the example above).
- Increased revenue will allow you to spend on more beneficial expenses (e.g. increased payroll for yourself).
- Who doesn’t like more money? Oh yeah, the Capital One Baby!
So let’s change things up and assume that Ricky owns his own delivery business. He files his business income and expenses on a Schedule C so any profit from his business shows up on his personal return and is taxed at his marginal tax rate (25%). For this tax year thus far, he has $50,000 in profit (income less expenses) from his business.
Instead of buying a house, he decides to spend $10,000 on some billboard advertising. Now his profit is only $40,000 because the advertising expense is tax deductible. But those ads generate $25,000 of new business. Way to go Ricky! So his profit then becomes $65,000. Sure, he will have to pay $3,750 more in taxes ($65K – $50K = $15K x 25%) then he would have had to if he didn’t run the advertisements. But the flip side is that he will be left with $11,250 in more cash.
Now, if Ricky has a smart tax accountant on his team (like us), they might tell him to open a SEP IRA where he could put almost all of that additional $15K above his original $50,000 profit towards his retirement savings. Best thing about that is 1) it’s deductible on his tax return and 2) he’s funding the day he can park that delivery van for good!
Need some help with your tax planning? Want to brainstorm on how you can best spend your money? Give us a call or shoot us an email and we’d be happy to chat with you!
Until next time…