Year-End Cash Decisions
Farm Business Management Update, December 1999
By Alex White
At this time of year, a lot of major financial decisions are made. Most of these decisions center on methods of minimizing income taxes. The two most common questions I hear at year end are:
The good news is that these methods typically accomplish the goal of minimizing income taxes this year. However, the problem with these methods is that you must spend money in order to lower your taxes. If you are in the 28 percent marginal tax bracket that means you must spend over $3.50 to reduce your income taxes by $1. I hear the argument, "Well, I need the supplies anyway. Might as well pay for them now and lower my taxes." The problem arises when producers spend money on supplies and equipment they really do not need. They find themselves with unneeded supplies, seldom-used equipment, and a possible shortage of cash, all because they want to pay as little income tax as possible.
Wouldn't it be nice if you could find a way to keep your money and reduce your taxes at the same time? Well, a couple of strategies will allow you to reduce your income taxes without spending money. These strategies involve the use of retirement plans, such as Individual Retirement Accounts (IRAs) and Simplified Employee Pensions (SEPs). While not everyone may benefit from these plans, they are a possible alternative to "tax spending." Retirement plans allow you to reduce your income taxes this year and defer taxes until the future by investing (not spending) your money. How do they work?
Traditional Individual Retirement Accounts (IRAs)
Traditional IRAs have been in existence since 1982. Any taxpayer who is under the age of 70 1/2 is eligible to make contributions to an IRA, as long that he/she has earned income. The maximum annual contribution per person is the lesser of 100 percent of earnings or $2,000. This contribution may be tax-deductible, depending on your adjusted gross income and whether or not you or your spouse participates in a qualified retirement plan. The earnings on your IRA are not taxed until you take the money out of the account. You will pay ordinary income taxes on the amount you withdraw from the account in the year of the withdrawal. For example,
Jack is in the 28 percent tax bracket. He contributes $2,000 to his IRA this year, and the entire amount is tax-deductible. The immediate impact is that Jack has reduced his income taxes by $560 this year. If his IRA earns 8 percent every year until retirement, these earnings are not taxed until Jack withdraws funds from the IRA.
Assume Jack contributes $2,000 to his IRA every year, and the IRA earns an average of 8 percent annually. Jack reduced his income taxes by $560 each year, and at the end of 20 years, the IRA will contain nearly $92,000.
Okay, sounds too good to be true - reduced taxes, tax-deferred earnings, and it is still your money. IRAs have their downside, however. First, your money is "locked up" until you retire (or age 59 1/2). If you withdraw funds from an IRA before you retire, you will pay a 10 percent federal penalty, as well as ordinary income taxes on the amount you withdraw (Note: Certain exceptions exist to the early withdrawal penalty). That means a 38 percent tax bite if you are in the 28 percent tax bracket. Second, if you invest money into the IRA that reduces the amount of cash you can invest back into your farm or business. What you need to look at in this case is the rate of return on the different investments. Compare the after-tax rate of return on equity for your operation to the after-tax rate of return for the investments in your IRA. Third, you can longer make contributions to a traditional IRA after the age of 70 1/2. At this age you must begin to withdraw funds from your IRA. Are you taxed then?
So you might be interested in an IRA -- what next? You can open an IRA with a commercial bank, a credit union, an investment broker, or certain insurance agencies. You choose how your money is invested inside the IRA -- certificates of deposit (CDs), money market accounts, stocks, bonds, and/or mutual funds. You can choose investments with varying levels of risk -- very safe, moderate, high risk. When you are deciding on your investments, remember the old rule of thumb -- High Return typically means High Risk.
Roth IRAs were first started in 1998. These IRAs differ from traditional IRAs in that annual contributions are not tax-deductible, but the earnings of the account are tax-free when withdrawn. The annual contributions (maximum of $2,000/year) are after-tax, so they do not reduce your income taxes each year. However, as long as you have had the account for at least 5 years by the time you retire, all of the earnings of the Roth IRA are tax-free. Other advantages of Roth IRAs are that you can continue to make annual contributions after the age of 70 1/2, and they have no mandatory age for withdrawals. Roth IRAs are great for younger folks and for people who expect to be in a higher tax bracket during their retirement. Unfortunately, no hard and fast rule can be cited as to who will benefit more from a Roth IRA than a traditional IRA. The decision is highly individualized.
Simplified Employee Pensions (SEPs)
SEPs are very powerful IRA-based retirement tools for self-employed people and their employees. They are similar in nature to corporate pension plans for larger firms. A self-employed person may open a SEP for himself/herself and all eligible employees. The IRS has requirements for deciding which employees are eligible to participate in a SEP.
To start a SEP, you open an IRA for yourself and all your eligible employees. You then make annual contributions to each of the IRAs. Because the IRA is in the name of the employee, you have no fiduciary responsibility after you make the annual contribution. The employees are responsible for deciding how the funds are to be invested.
Annual contribution limits are much greater than for IRAs. The maximum annual contribution is the lesser of 15 percent of earnings (or salary) or $24,000. However, the percentage contribution for the owner must be the same as the percentage contribution for all eligible employees. Because the contributions are made to IRAs, the same investment choices apply.
For you, the owner, all of the annual SEP contributions (owner and employee) are tax-deductible, thereby reducing income taxes in the current year. Thus, SEPs are a method to reduce income taxes, provide for retirement, and provide employee benefits.
Summary of Retirement Accounts
Retirement accounts can be powerful tools in tax management, retirement planning, and labor management. Some of the main benefits include
As with any investment, these retirement plans have disadvantages. The main disadvantages are
Are IRAs or SEPs better uses of your cash than year-end tax spending? The answer is, "It depends." Retirement plans may be extremely useful to some producers but not very useful to others. You need to consider your overall goals and the impacts on your operation before making this decision. For more information look for a series of extension-sponsored retirement and estate planning seminars in your area during January and February.
Visit Virginia Cooperative Extension