When Should Your Clients Pay Their Income Taxes – 2014 or 2034?

2nd Oct 2014

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The IRS would like your clients to convert income to wealth. Really.

The IRS would like your clients to convert income to wealth. Really.

While some clients view government as an adversary, especially high-income people who have to pay a lot of taxes, the federal government is actually a strong supporter of building net worth. IRS Tax codes covering the majority of IRA, 401k, 403(b) and defined benefit plans encourage wealth accumulation through the deferral of taxes on income.

Self-employed high-income people (HISE), in particular, have some generous options.  They potentially can contribute $100,000 or more annually with tax advantaged retirement programs like our defined benefit plan,  moving that tax obligation off until the money is withdrawn, possibly decades from now. Rather than see their current year tax bill grow, they can build their net worth more rapidly.

If your clients are a high-income, self-employed individuals or couples, the math gets pretty compelling:

2014 Declared Income: $450,000
Marginal Federal  (Top) Tax Rate: 39.6%
2014 Tax Obligation (assuming combined federal and state tax rate of 38%) $171,000
Contribution to Tax-Advantaged DB $150,000
Taxes Deferred $57,000
Revised 2014 Tax Obligation (assuming 38% tax rate) $114,000

 

Some FAs report to us that they get a client’s attention by saying “the government is willing to offer you an interest-free loan of about $40,000, payable during retirement.” (This assumes income and tax rates remain the same.) The extra kicker is: If those future distributions in retirement fall into a lower tax bracket, some of that “interest-free loan” is never paid back because of the lower tax rate!

The only cash flow reason not to take that deal is if your client needs to spend all or some of that final $150,000 in income this year, or they are saving up for a big purchase (a second home or commercial real estate?).

That’s a question we cannot answer. But you can because you know, or can ask about, your clients’ plans.

The greatest value of a high income is the comfort it can provide today, but the second greatest value is the comfort it can build for clients in retirement, especially when the government is pitching in to help.

Is this a positioning you find useful when working with clients to increase the rate at which you can help them convert their income to wealth?

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