If you’ve ever been hit with a large tax bill, you’ve probably found yourself looking for ways to pay less taxes. In part one of this blog post we dove into the three types of income you’ll see on your tax return as a business owner and how they affect your tax liability. If you haven’t read that post, make sure to check it out – we’ve included some bonus tax tips that will help you work smarter, not harder.
There are different approaches to the question of how to optimize tax liability depending on your situation, but one possibility many overlook is to diversify their income sources. Instead of relying solely on business and W2 income, which are taxed at higher rates, learning how and why diversified income sources are beneficial is a great place to start.
Reduce Your Earned Income through Retirement Account Investments
Between W-2 income from your S Corp and/or business income, ”earned income” is likely a major chunk of your overall taxable income as a business owner. One of the best ways to reduce your earned income is to make contributions to a retirement account. There are lots of different retirement accounts that you may be able to use to offset your business income, and you could get a deduction of up to $69,000 in 2024, saving you up to $20,000 in taxes!
Keep in mind that taking a deduction in the current year to reduce your tax bill may not be the best choice for you in the long run. If you’re in a low tax bracket, then you may be better off making a Roth contribution to your retirement accounts. This won’t give you a tax break in the current year, but your distributions in retirement will be tax-free!
Take Advantage of Tax Deductions for Business Owners
One mistake we see with lots of clients new to Young and Co is not taking advantage of all the available tax deductions available to business owners.
We aren’t fans of buying things just to get a tax deduction – even though the advice to spend all your money at the end of the year to offset your taxable income is really common! We believe in spending money on things that you actually need for your business. At the same time, there are some deductions that business owners are already spending money on that they frequently miss claiming on their tax returns. A few examples are mileage deductions, using your cell phone for business, business travel, business meals, and home office reimbursements. These expenses can sometimes add up to thousands of dollars in missed deductions.
Another opportunity that often goes unused is the ability to contribute to a Health Savings Account (HSA) if you have a high deductible health plan. This deduction isn’t specific to small business owners, but a lot of business owners have health plans that qualify for HSA contributions.
Not only do HSA contributions allow you to receive a tax deduction for the money you put into the HSA, but here’s the kicker – you can actually invest that money into index funds, just like you would in a retirement account. This means your HSA can potentially grow over time, providing you with additional funds for qualified medical expenses. And the best part? When you withdraw the money for qualified medical expenses, it’s completely tax-free. The HSA truly is a remarkable tool that can help you manage your healthcare costs effectively.
Make Sure You Have the Best Entity Structure
When you partner with a proactive and strategic CPA, they should be one step ahead in guiding you into selecting (or reclassifying) into a tax standing that most benefits you. One alternative method to decrease your earned income is by considering an S-Corporation (“S-Corp”) election at the appropriate time. At our firm, we assess entity structure as part of our initial onboarding process, and usually recommend making an S-Corp election when you cross $50-75K in annual profit from your business.
S-Corps are great for lots of reasons. First, they can significantly lower the payroll taxes you are required to pay on your business income, which is where the majority of your tax savings come from. Additionally, S-Corps can also benefit from an additional deduction on their federal return through state pass-through entity tax elections, which are a relatively newer deduction that many states have implemented in recent years.
Invest in Assets That Give You a Depreciation Deduction
Another great approach to reducing your earned income is to invest in assets that offer depreciation deductions. Depreciation is a deduction you can take on long-term assets like real estate, equipment, automobiles, and furniture to expense the use of the asset over time. There are also special accelerated depreciation options for certain types of assets (like equipment, furniture, and automobiles) that allow you to take a deduction for the full value of the asset in the year of purchase, even if you purchased it with a loan.
One of the great things about depreciation is that it offsets your earned income, either reducing your business income if you purchase an asset in your business, or offsetting your income with a loss from a new acquisition. While we’ve already discussed the advantages of real estate in our previous blog post, there are other options worth exploring.
- Purchasing another business. A new business can provide you with the opportunity to take advantage of bonus depreciation. When you acquire a business and its assets, you can typically take a depreciation deduction on almost everything, excluding real estate. This means that you can significantly reduce your taxable income in the year of purchase by depreciating any equipment or furniture that you acquire.
- Equipment and asset depreciation deductions. You don’t have to buy real estate or an entire business to take advantage of depreciation. You might buy equipment and other similar assets in your existing business that can provide you with the opportunity to take depreciation deductions. This holds true even if you finance the acquisition. Let’s say you decide to buy a vending machine for $30,000. Instead of paying the full amount upfront, you opt for a loan and make a down payment of $3,000. In the year of purchase, you can generally deduct the full $30,000 purchase price from your tax return, drastically reducing your earned income. This depreciation strategy, especially when combined with financing, can result in substantial tax savings and a net positive impact on your cash flow after taxes.
Building a Lasting Legacy By Hiring Your Kids
Few entrepreneurs start their businesses with the end in mind – and we’re here to help with that! Whether your goal is to position your business to be sold or if you have grand visions of it becoming a multi-generational operation, there are strategies worth considering to reduce your taxable income while getting your kids involved.
One great tax strategy is to hire your kids. You can give your kids age-appropriate tasks to do in your business and pay them a fair wage, just like any other employee you’d have in your business. Your business gets a tax deduction for what you pay them, and your kids get an income that they can use to either invest in a Roth IRA or other retirement account or to pay some of their expenses.
We highly recommend working with a tax accountant to implement this strategy for maximum deductions, as there are specific ways to set up your kids’ payroll to optimize both income tax and payroll tax.
It’s important to have a clear understanding of the different tax strategies available to you as a business owner, even if you hire a tax accountant to help you implement these strategies
Keep exploring our blog posts as we delve into the intricacies of finances and guide you towards the financial independence that each and every one of us deserves, and schedule a free financial assessment with us where we’ll review your tax returns to identify potential areas of opportunity to save on your taxes!
Young and Co empowers service-based business owners to make an impact in their world through strategic financial services.
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