Having Money In The Wrong Tax BucketsIn 1954 and 1974, Congress created a path to help small business owners succeed. Their goal was to support and encourage American entrepreneurship and strengthen the tax base by providing small business owners specific tax incentives. The pathway has four simple goals, to:
provide a secure income for you, your family and your employees
protect widows and retirees
protect against the failure of your business and stock market loss
Follow the path and you’ll achieve maximum tax savings. Wander off the path, get out of order, or out of balance, and you’ll pay more than your fair share of taxes. It’s that simple.
For small business owners, the key is in today’s modern tax code.
By employing tax strategies for small business owners, you can decrease your income taxes, self-employment taxes, or both, and redirect the tax savings to build wealth faster and safer than what you’ve been taught.
Most small business owners use just one tax path to build wealth. We call it the default plan. It is the least tax-effective option, and it yields the highest tax rates. But you don’t have to settle. There’s a better way.
Your money can only get taxed one of four ways. We call these the four tax buckets. Each bucket has its proper place and purpose. But understanding how much and when to put money into each bucket is absolutely key in proper tax strategy.
Bucket one is the lifestyle bucket. We pay taxes on all the money going into this bucket. The more you put in bucket one, the higher your tax rate.
Bucket two money is the least tax-efficient of all because it is taxed twice! Once when we put it in, and once again on the growth. This bucket is usually comprised of savings and after-tax investments, including money invested in your business.
Bucket three is the most tax-efficient because we get a tax break for every dollar we put in, and we can pick up other tax deductions the more we put in this bucket. It can also receive favored tax treatment when it comes out. This bucket holds assets within defined benefit plans.One of the most powerful strategies for the self-employed is a properly designed defined benefit or pension plan. These types of plans allow business owners to make much larger tax-deductible contributions to a qualified account than to defined contribution plans such as SEP IRAs and 401(k)s. It’s not uncommon for our clients to reduce their taxable income by $50,000, $100,000, or $200,000 every year.
Bucket four money gets a tax break going in, but we pay more in taxes than bucket three when it comes out. This bucket is referred to as defined contribution plans such as 401(k)s, IRAs, SEP IRAs, and similar plans.
Understanding these tax buckets is vital.For example, if a 50-year-old puts $50,000 per year into bucket two and three, and both buckets earn identical rates of return over the same time period, bucket three will provide nearly twice the amount of income at retirement.
When it comes to building wealth, understanding how your money is taxed is one of the most important things you can learn…perhaps even more important than rate of return.