Real Wealth Leadership

888-CAMARDA (888-226-2732)

Tax mistake - not maxing out tax-deductible retirement plans

  • This one’s pretty simple, and you probably know it even if you don’t do it. Money you contribute to a 401k, 403b, TSP, or other deductible plan at work comes right of the top of your gross income, meaning you save the income tax, and your share of the FICA (Social Security and Medicare) and other applicable taxes. FICA runs at around 7%, so if you are in a 25% income tax bracket, you save at least 32% right now (if in the highest 39.6% bracket, you save nearly 47%!). Do if you don’t contribute $10,000, you take home maybe $6,800. If you invest instead, the whole $10,000 goes to work for you. And while you will ultimately have to pay tax on withdrawals, you will benefit because:

    1. Chances are the savings discipline will make you wealthier down the road than not mending your earn-it and spend-it ways;
    2. You can use tax arbitrage as explained in Mistake #2 to sharply reduce or even eliminate the tax.

Tax strategy creativity is critical

  • The Internal Revenue Code is one of the most complex, convoluted, and internally contradictory documents ever created—and it keeps changing almost by the week. Various studies conclude that even IRS employees only understand between 55% and 83% of basic tax facts. As of 2006, the Federal tax rules totaled over 13,000 pages—and the rules have grown more complex since. Many of these rules exist to try to counter the tax reduction strategies that the most proactive taxpayers (and their advisors) keep coming up with to legally keep wealth in their families’ pockets, instead of the IRS’s. But for IRS, it can be a game of catch up, with the best advisors finding new opportunities faster than IRS can close old ones. Great complexity can breed great opportunity, and it’s been said that “sophisticated taxpayers take advantage of the complexity to find loopholes that lower their tax liability.” Tax avoidance is perfectly legal, and often remarkably easy, if you know where to look.

    Too many taxpayers (and their tax advisors) believe in “death and taxes” inevitably, that you “gotta pay what you gotta pay.” The truth is, it is perfectly legitimate to use the portions of the tax code that support the reasonable position that results in the least tax—or no tax at all! This is a key concept; tax liability is a function of code interpretation, and astute advisors mine the complexity of the code to build the most favorable positions for taxpayer clients.

    The opportunities to legitimately save enormous dollars can be profound, if you know where to look. Unfortunately, some tax preparation professionals may not be the right place. According to a Money magazine study cited in an MIT book, not one tax prep professional was able to produce a correct return! Often, even the most basic tactics, like controlling taxable investment income, or maximizing tax deductions, are completely missed. Good tax advisors are worth their weight in gold, but can be very hard to find, especially if you don’t know how to tell the difference.

    If you own a business, are a high income professional, or have significant investment accounts (whether you are retired or not), you may be leaving way too much money on the table, and this report may be worth a lot of money to you. I hope it is!

Taxes on annuities – higher than other investments

  • Annuities are taxed kind of as a hybrid between “qualified” retirement plans and IRAs and regular taxable investments. For annuities inside such plans like IRAs, 401ks, TSA/403bs, etc., the IRA tax treatment controls, and the entire value of the annuity—initial investment and all the growth—will be taxed as ordinary income in the year you take it out, which means you will pay your highest tax bracket on the distributions. In other words, they are treated just like any other investment in such an IRA for tax purposes. The same is generally true for ROTHs —tax-free treatment once the ROTH criteria have been satisfied—but check with your tax advisor to be sure.

    Annuities outside of retirement plans—so-called “non-qualified” annuities, those you buy with after tax money— “enjoy” their own rather quirky tax treatment, which can prove rather oppressive. For one thing, the tax treatment is ordinary income (again, read your highest marginal tax rate), which can be double the rate on capital gains, generally applied to stocks and much mutual funds growth. This is worth underscoring: annuities’ growth is generally taxed at up to double the rates on other types of investments. This can be a real damper on the wealth value for consumers who can only consume what’s left after taxes. And while the gains on non-qualified annuities are deferred (which means you don’t pay tax until you actually pull money out of the contract) the same sort of 10% penalty as for IRAs applies to pre-59 ½ distributions. In that case, you pay your highest marginal tax rate (and the distribution can easily put you into a higher bracket), plus 10% of the taxable distribution. This is quite different from capital gains treatment on things like stocks, which are also deferred until you choose to recognize the gain, and come with no pre 59 ½ 10% additional excise penalty, besides having a top tax rate about half of the top ordinary income tax rate. Finally, annuities are subject to last-in- last-out (“LIFO”) rules, which mean you have to pay the tax on all of the gain before getting your initial investment back tax-free. This treatment can bunch taxable events, accelerate taxation, and drive higher rates, all of which can reduce the amount left for you and your family. This is also quite different than the rules for capital gains, which can be much more flexible in letting you and your tax advisor pick your tax shots, reducing tax recognition and better controlling rates to yield more for you.

    In many ways, non-qualified annuities are saddled with some of the worst tax rules for investors, and this should give many investors pause.

    On the other hand, losses on annuities are “ordinary losses” and can be deducted against other sources of income, like wages, without limit—a big advantage over capital losses. Those who are down should consider the wisdom of this exit ramp, especially during down market cycles where this applies. This can be a big value tax strategy for those “stuck” in annuities. Finally, those with gains should consider “1035” (the number refers to an Internal Revenue Code section permitting this technique) exchanges, which allow tax-deferred “rollovers” between annuities. This can be a big help in getting out of expensive, poorly-managed annuities and into low-cost, no-load products while avoiding current taxation.

The danger of having no strategy or ignoring tax efficient investing strategies

  • This is without question the most fundamental mistake made by taxpayers and their tax advisors/preparers. For some reason, this industry is almost hopelessly re-active. Most clients and preparers don’t even look at the fact patterns until after the first of the year, when nearly all potential strategies are impotent, except the old “well, you could put some more into your IRA.”

    The reason this is so important is the tax “game” has four quarters and they all end on December 31 st . After that, the score is mostly set in stone; it just is not visible until your preparer does the tax accounting.

    In order to win the tax game, you need to play the game before it is over. Unlike the vast majority who don’t “plan” until after the end of the tax year, the smartest taxpayers and best tax advisors begin before the tax year begins, or at worst by summer of the tax year. Start planning much later than that, and even the best tax mind is a Monday morning quarterback.

    As you accumulate wealth, taxes on investment returns become more and more important. Mutual funds with a lot of turnover are particularly tax inefficient since taxpayers are forced to pay tax on any gains or income the fund recognizes during the tax year, regardless of whether or not the investor themselves takes any income or recognized any gain. This has been widely viewed as unfair since implemented the late 1980s as part of tax reform, but widely ignored by taxpayers for decades, causing many to overpay. ETFs and single stocks are much more efficient in this regard. Deferred annuities are some of the most highly taxed products around—with really vicious LIFO and ordinary income tax treatment—but widely sold and swallowed as being tax shelters! Bond and CD income gets taxed at your highest bracket, but dividend income from stock sources enjoys a lower capital gains-type rate. Making stock changes at high market levels needlessly can exacerbate capital gains, and too many people still don’t do tax loss harvesting each year, which can save tens of thousands or more. All of the preceding has to do with non-qualified (non-IRA- like money), but there are lots of smart strategies for IRAs beyond the arbitrage discussed above. For instance, it is smart to put ordinary income rate (top marginal rate) assets like bonds in IRAs, but capital gains rate assets outside where they will enjoy the lower rate. Otherwise, in the worst cases, you can effectively pay about double the available tax rate! Worse yet, if the capital gains asset is one you might pass on at death, you may wind up paying the highest marginal rate instead of zero tax by way of the at death basis step up!

The high tax cost of being an employee instead of self-employed

  • For those of you who can make this choice, being self-employed is a no-brainer. You can deduct a lot of legitimate expenses, set up your own deductible retirement plan, and use numerous, creative, complete above-board ways to cut taxes and build your own wealth more rapidly.

    Shy of starting your own company, the independent contractor route is the most feasible for the average reader. Here, your pay is shown on a 1099 instead of a W2. The pay number on the 1099 is the beginning line on the business return you will file against which expenses are deducted to arrive at taxable income (a number usually much, much lower than where you wind up as an employee, even if you try to deduct the same items as “employee business expenses”). I won’t get into the technical detail here, but, trust me, the difference can be huge, as most CPAs will probably tell you. If you do this, you can file as a sole proprietor (using the Schedule C on your regular 1040 tax return) or actually set up a corporation or LLC (LLC is preferred—see my report on asset protection), and then file the appropriate business return (usually an 1120S, but possibly 1065), which dovetails into your personal return. While filing a business return can seem a bit of a bother (but is usually fairly simple and cheap), running your independent contractor work through your own company can yield many benefits, including asset protection and a much lower audit profile.

    While I appreciate that many readers can not avail themselves of 1099 status without changing jobs, if there is any possibility at all, you should explore it. There are probably significant tax and other savings to your employer as well, so it is worth exploring with your owner, manager or HR. If the nature of your work meets the various IRS tests and can qualify, the wealth opportunity is significant for all concerned (except IRS, which is why it is not a fan of 1099 work!).

Why to use a medical reimbursement plan if you own a business

  • Medical reimbursement plans are really one of the great unsung heroes of the tax control saga. As most of us painfully remember, medical expenses are barely deductible, and ONLY IF we itemize instead of taking the standard deduction, and ONLY IF such personal deductions are not phased out because of our income or chiseled down by the AMT rules, and ONLY IF they survive all that and still amount to more than 7.5% of our adjusted gross (not bottom-line taxable) income. This smoke-and- mirrors calculation really epitomizes the fetid feint-and- bloat of the early 21 st century U.S. tax system, but I wax political, and don’t want to be misconstrued, especially since I reverently believe in Health Care, especially my own. For a family with $200K in AGI, this means the 1 st fifteen grand of medical expenses will never be deductible, even if one manages to leap through the previous hoops. And fifteen grand is a pretty high bar, so unless someone’s really sick, it does not even pay to add up the receipts, which is probably why you stopped doing this long ago, if you ever did.

    Still, if you are like most of us, you spend substantial sums on this industry, between insurance premiums, deductibles, vitamins and Band-Aids, and other health-maintenance items, which one could argue even include gym dues, crystal-gazing, massage, and aroma therapy. (Hair and nail care might prove a tad aggressive.)

    Medical Reimbursement Plans (or MRPs, authorized under section 105 of the Internal Revenue Code, a colossus pushing 10,000 sections, and growing) give us the opportunity, in the right setting, to run all this stuff on a fully-tax- deductible basis (meaning a $1.00 Band-Aid only costs $0.60 after taxes and $18,000 in insurance premiums “only” $10.800).

    In the worst cases, these savings can be worthwhile, and in the best, they are phenomenal. If you have one, make sure it’s tuned up; if you don’t, better check on your options before losing another hand to Uncle Sam. (Yes, you can call us, we know all about them.)

Load up on tax-free vehicles, like 529s and (sspecially) ROTHS

  • Even for those who have develop advanced strategies to sharply reduce taxes from professional or business income and developed estate plans that allow significant wealth to pass tax free from generation to generation, basic tools like 529s and ROTHS can be extremely powerful. Though each has restrictions on free access, when used in accordance with the rules (which are actually pretty livable), their tax-free nature can really supercharge your wealth creation. To use a simple example, let’s say we invest $100,000 for 20 years at 10% net return. We will assume a blended tax rate of 30%, which is about halfway between the top income and long-term capital gains rates. In simple terms, a tax-free investment compounds at the full 10%, but the taxable one would only compound at 7% (10%-30% tax). In 20 years, the tax-free account is worth $672K, the taxable one is worth $386K (only about half a much). This is a super example of the power of tax control in building wealth. The difference in results is huge, but can be completely obscured unless you actually crunch the numbers!

Beware the AMT - be sure to have an Alternative Minimum Tax plan

  • The Alternative Minimum Tax has been around since 1970 and was designed as a way to force fat cats with smart advisors to pay at least some tax instead of avoiding it via the numerous complicated loopholes that existed at the time (of course, the smart guys just found other loopholes.) These days, it mostly ensnares middle income or higher income people who don’t (or whose advisors don’t) know enough or take the time to plan around it. All admit this is very unfair, but it continues because a) the tax code is broken and there is not the political gumption to fix it, and b) the Federal government spends far more than it takes in and really needs the money.

    Increasing contributions to your deductible retirement plan, making investments more efficiency, and timing large, deductible items like property taxes into favorable years are a few ways to avoid this tax. There are a lot of other smart things you can do to plan around this tax, but the technical complexity of this particular nastily not-so- little tax precludes discussion here. Get the knowledge or find a really smart tax advisor, and most of all, plan before December 31—once the New Year’s ball drops, many planning options evaporate!

Can tax savings really supercharge your wealth?

  • Feel like your wealth’s being taxed to death? Feel like you’re making plenty but not keeping enough? For many people, taxes are the single biggest obstacle to building wealth faster, which stands to reason since a huge percentage of annual income, that could be saved and invested, often evaporates to taxes instead.

    Unlike much else in life, with taxes it’s not who you know, but what you know! And there’s a lot to know – so much that various studies conclude that even IRS employees only understand between 55% and 83% of basic tax facts. As of 2006, the Federal tax rules totaled over 13,000 pages – and the rules have grown more complex since. Many of these rules exist to try to counter the tax reduction strategies that the most proactive taxpayers – and their advisors – keep coming up with to legally keep wealth in their families’ pockets, instead of the IRS’s. But for IRS it can be a game of catch up, with the best advisors finding new opportunities faster than IRS can close old ones. Great complexity can breed great opportunity, and “sophisticated taxpayers take advantage of the complexity to find loopholes that lower their tax liability.”*

    It’s like the old saw, “What’s the difference between tax avoidance and tax evasion? Twenty years in Leavenworth!” The point, of course, is that tax avoidance is perfectly legal, and often remarkably easy, if you know where to look. For instance tax arbitrage – using the differences between tax rates applicable to different kinds of entities (C vs. S corporations, for instance) or different individuals (you and your children for instance) – can save some people a real bundle.

    The opportunities to legitimately save enormous dollars can be profound, if you know where to look. Unfortunately, some tax preparation professionals may not be the right place. According to a Money magazine study cited in the MIT book, not one tax prep professional was able to produce a correct return! Often, even the most basic tactics, like controlling taxable investment income, or maximizing tax deductions, are completely missed. Good tax advisors are worth their weight in gold, but can be very hard to find, especially if you don’t know how to tell the difference.

    If you own a business, are a high income professional, or have significant investment accounts (whether you are retired or not) you may be leaving way too much money on the table.

    *Joel Slemrod, Harvard PhD and Economics Professor University of Michigan (UM), and Jon Bakija UM PhD and Economics Professor Williams College, from the book Taxing Ourselves, MIT Press.

How sloppy books can waste big tax dollars

  • While obvious, this is really too common and important not to mention. If you keep sloppy books (or don’t keep books at all), invariably errors will creep in, expenses will be missed, and needless tax will wallop you. We have seen instances where non-taxable loan proceeds (a couple hundred grand in one case) were carelessly added to the income statement instead of the balance sheet, overstating taxable profit by a huge amount. If we had not been called in to clean up the books and tax position on this case—because the owner got finally fed up at the poor service he suspected he was receiving—he would have paid something like $100K in extra tax, and no one (neither he or his previous high-dollar advisor) might ever have known. It does not matter who does the books, you, your staff, or a paid outside accountant; unless they really know what they are doing, you can be really getting soaked even if your frustration never rises to the “fed up” level. What really matters is you are sure you have someone that really knows the craft and truly cares about getting you an accurate and tax-controlled result. Also, remember that tax accounting and “regular” financial accounting can have very different rules, and it can be better to run a set of tax books along with the regular books you use to steer the business the whole year rather than trying to “pull them together” months after the fact, when your tax preparer is swamped and can’t give it the time it needs, even if he wanted to. Doing it right the first time usually costs less time, money, and tax than letting things pile up to the fermentation point. Did I mention we do books?

If selling a business be sure to negotiate from tax savings strength

  • When you negotiate to sell a business, you and the buyer are at cross-purposes when it comes to tax treatment. You want as much value allocated to goodwill, personal goodwill, and going concern value since this shifts more taxable value to lower-rate capital gains treatment, and less to highest rate ordinary income/earned income treatment. This is especially important to avoid since the business sale itself will probably push you into the highest bracket, if you are not already there. Under current law, this is something like 40-46%, and very likely going up, vs. 20% for capital gains (also probably going up). That’s a difference of 400 grand on a $2M sale, not exactly chicken feed no matter who you are. The buyer is going to want to shunt value to “earn-out” things like a personal consulting contract for you, fast depreciation period assets, and so on, to accelerate write-offs and manage their own tax position.

    The important thing to remember is that you need good tax counsel as part of the negotiation process, since, like the buyer, you want to protect your own tax position; once a deal is cut it is much harder to finesse the tax angles. The less tax they pay, the less you actually receive. Higher taxes mean a much lower net on the business sale, and you want to pay your cards from an after- tax in-your- pocket perspective, instead of getting infatuated with deal heat, only to lament at leisure later.

    Did I mention we do buy/sell transaction structure and business brokerage consulting?

Load up on tax-free vehicles, like 529s and (especially) ROTHS

  • Even for those who have develop advanced strategies to sharply reduce taxes from professional or business income and developed estate plans that allow significant wealth to pass tax free from generation to generation, basic tools like 529s and ROTHS can be extremely powerful. Though each has restrictions on free access, when used in accordance with the rules (which are actually pretty livable), their tax-free nature can really supercharge your wealth creation. To use a simple example, let’s say we invest $100,000 for 20 years at 10% net return. We will assume a blended tax rate of 30%, which is about halfway between the top income and long-term capital gains rates. In simple terms, a tax-free investment compounds at the full 10%, but the taxable one would only compound at 7% (10%-30% tax). In 20 years, the tax-free account is worth $672K, the taxable one is worth $386K (only about half a much). This is a super example of the power of tax control in building wealth. The difference in results is huge, but can be completely obscured unless you actually crunch the numbers!

Missing deductions for legitimate business expenses

  • This is really one of my pet peeves. Far too many business people (largely on the advice of their too-conservative, too-uninformed, or too-work- adverse tax advisors) simply do not write off perfectly legitimate expenses and wind up essentially doubling their costs for these overlooked business items. I am firmly convinced that many tax preparers would rather see clients pay excess tax than face the bother of possibly having to explain their methodology (or lack thereof) of tax accounting! Commonly missed areas are business use of personal autos, travel and entertainment where at least some business/work is conducted, fuel, business items purchased on personal checks or credit cards (set up dedicated business account and cards and use them religiously!), and so on. An important point is that it be arguably deductible because of reasonable business purpose. Don’t be afraid (or let your tax adviser convince you to be afraid) to take legitimate deductions. You would be amazed at some of the extremely aggressive positions that I have seen pass muster on audit. A good way to start this is to go through your personal check registers and credit card statements (all of them) and categorize expenses that reasonably should be including on the business books. (Guess who can help!)

Modern tax shelters – the continuing power of real estate tax breaks

  • “Tax reform”, back in 1986, killed the real estate tax breaks so soundly that most of us don’t even remember how sweet they were anymore. Many taxpayers (and their advisors) incredibly still don’t know about the “real estate professional” loophole that opened up in the early 1990s, and that’s a darn shame for those of us that have amassed a bit of a real estate portfolio, whether business property, or commercial or residential rentals. In the right fact pattern—you have a spouse who has the time to spend, say 15 hours a week ostensibly looking after the real estate (keeping books, checking ads, painting or directing the painters, whatever) and is not doing much else occupationally—you get most of the old real estate write-offs back and can net them against your other income, possibly saving a huge slug of tax. If you have real estate besides your home, are frustrated by the post-1986 “passive loss” rules, and have a willing and able spouse, you really need to get a second opinion on this (Camarda has an endless supply of them).

    And make no mistake, what you have heard about real estate investing being responsible for more millionaires in the U.S. is probably true. If you are careful, patient, and willing to spend some time, it can be a very effective and tax advantaged way to build wealth and ongoing income.

Split income with kids to lower tax rates for business owners

  • This is a great boon to families, a way to give meaningful “gifts” to your kids on a tax deductible basis. Find a way to employ your children (they really need to do something you can document, but rocket science is not required, making copies and carrying out the [business] trash will suffice). The benefits? You get to shunt your high-bracket income to your kids’ low/no bracket rates, which can save the family thousands or tens of thousands given the current “progressive” tax structure which makes tax-free lower levels of income and even subsidizes it with de facto-welfare tax “refunds,” even when no tax has been paid. Your kids have the right to file their own returns, and their earned income (as opposed to the radioactive “Kiddie Tax” investment income) is taxed at very low rates and can generate valuable deductions as well. This is tax planning 101, and if you have not been encouraged to do it by your tax advisor, you might want to consider why. If you need help, we can give you some very good ideas on this, as you probably surmised.

Super-accelerated business depreciation— section 179

  • We shouldn’t have to mention this, but we see this slam-dunk missed often enough in our tax planning that we feel duty bound to remind you of it. Instead of having to stretch the write off of asset purchases over several to many years, which, essentially, is what depreciation does, most businesses can now write off up to $250K per year of qualifying purchases and save the tax now. In a 40% bracket, that’s a cool $100K of tax savings in your pocket. Again, this is such a basic technique that I am almost ashamed bringing it up, but the oversight pops up often enough that you should be sure you are taking advantage of it. (We can tell by taking a quick look at your return.)

Tax Arbitrage - using the Internal Revenue Code to lower tax rates

  • Arbitrage just means taking advantage of different prices for the same thing in different markets. If you can buy gold for $1500/oz in London and sell it for $1700 in Dubai, you can make a riskless $200/oz—that’s arbitrage.

    For instance, tax arbitrage—using the differences between tax rates applicable to different kinds of entities (C vs. S corporations, for instance) or different individuals (you and your children, for instance)—can save some people a real bundle. Another way to apply this concept is doing IRA ROTH conversions (paying the tax on the IRA in exchange for the remainder to grow tax free) in years when you are in a low tax bracket because you may have business losses, lost a job, or high deductions from medical expenses, for instance. Ditto for postponing IRA distributions until after retirement when earned income (and hence your tax bracket) is lower or absent. A great example of arbitrage is the so-called corporate inversion, a super “loophole” (now closed due to ongoing rules updates) that basically let corporations swap high U.S. tax rates for near-zero ones in places like Ireland; this was perfectly legally under the law before it was changed—and still legal for the companies that had the foresight to seize the opportunity ahead of the curve. Such opportunities abound, if you have a creative tax strategy.

Tax dangers of having the wrong business buy/sell plan

  • In some cases, “stock redemption” style buy/sell plans (as opposed to “cross purchase” types) can result in needless taxation when one partner dies and the survivor(s) buy them out. Here’s why: with a cross purchase, the tax-free life insurance proceeds are paid to a partner, who then takes them and buys the dead partner’s stock; this purchase increases the surviving partner’s tax basis, so when eventually sells his share, capital gains are smaller and more of the sale proceeds are a tax-free return of basis. With the stock redemption style, the insurance money goes directly to the company, wasting the tax-free benefit of the insurance and keeping the survivor’s tax basis the same. If you have a buy/sell, getting a second opinion and update review could save you a bundle. This would also be a good time for a cost/benefit analysis on the life insurance, to see if you could get more benefit for less money. Camarda provides the services discussed here, too.