Taxes: The Tax Planning Process

Let's now dive into the subject of tax planning. As I mentioned before, taxes are the most significant friction you'll probably face in accumulating your wealth for your financial independence. So it is something that you have to tackle from very early on in your career. So throughout retirement. Let's talk about the tax planning process. It is a three step process. And the first step is that you want to project out for the remainder of the year through December 31st, assuming you're a calendar year taxpayer, which most of you are going to be, if not all of you, a calendar year taxpayer. There's really no reason for dentists typically to be anything other than a calendar year taxpayer. So you want to project out through the end of the year, December 31st to determine what are my income, what's my income going to be, what are my expenses going to be, and what's my taxable profit going to be. And typically it's best to do that sometime mid to late second quarter the year, maybe around May or June, because you've already got a healthy sort of trend forming for the year in your practice. And then you want to revisit that in the fourth quarter of the year to make sure that the projection you did earlier in the year is still on track. And if for any reason it's not because you're collecting more or you're collecting less than, then you can make some changes. So maybe around October time period, November time period, you make those final inning changes before you finish out the tax year. There are just some tax planning strategies that once December 31st comes and goes, you cannot do. So I would not expect for you to meet with your CPA in March or April and say, all right, cpa, how can I save my taxes? How can I reduce my taxes? Now? You'll probably end up having that conversation anyways. And the reason why is that most CPAs are historical, they're historians in nature, and their job is to collect your numbers, package them up in the corporate and the personal tax return that we looked at in our prior modules, make sure everything fits where it needs to go, it's compliant with all the tax rules, and then submit that to the tax agencies. That's the primary role of a certified public accountant, or CPA. And some CPAs, to varying degrees, might get into some basic planning around maybe encouraging you to set up a retirement plan, for example, or talking about what you can deduct on travel and that kind of thing. That's going to be different than what we defined as a chief financial officer or a cfo, which is our recommended model. It's the model that we here at Practice CFO provide to our clients, which is the belief that a good tax plan is always made within the broader context of your overall cash flow plan and everything else you're trying to accomplish for that year. And that a good tax plan will always entail a projection within deliberate, we'll say, clinical decision making around your cash flow, what I call traffic, controlling your cash flow, such that by the end of the year you have the most optimal outcome. From a financial perspective, not just tax, tax is one important element, but building your assets, paying down debt, saving in taxes, etc. So a tax plan, the way we do it is that it's always simply baked into or packaged into a broader overall business financial plan and even a personal financial plan as well. So typically doing that second and fourth quarter of the year. Now when you do those, then is the time to say, what tax planning strategies can I be implementing? Now, in a prior module, we talked about the difference between your effective tax rate and your marginal tax rate. And remember, it's the marginal tax rate that matters when you're doing tax planning, because the marginal tax rate is that tier. Remember, there are steps, 10%, 15%, etc. It's the step that you are in that matters because whatever tax planning you do to to reduce your income in that step means you're going to save taxes at that rate. And so when you're doing your tax plan, you might say, okay, I'm in the 24% rate, or I'm in this rate, I'm in the 10% state rate. California might be 9.3% state rate. So you add those two things up and it might be, who knows, might be right around 35% or so. If you're a little bit higher income earner might be closer to 45%, depending on some states. Remember the top bracket, we're looking at 37% plus the state rate, which depending on your state could be as low as zero. But most states, it's going to be around 3 to 6%. And the higher states like California, that's going to be closer to 10%. And so tax planning becomes absolutely essential for everybody, particularly those in the higher tax states, in order to reduce that friction of the IRS taking a good chunk of your money and putting it in to their bank account, we need to reroute that through good tax planning. So as you're doing this tax projection, that's the time to say, okay, what strategies can I be doing to lower my taxes. Now, the one that we emphasize a lot is setting up a properly designed retirement plan. And I emphasize properly design because a lot of financial planners may come and say, hey doctor, you should set up a 401k, and by the way, let me manage that for you. And they don't know anything about your cash flow, they don't know anything about your tax situation, they don't know anything really about the heart of all of your cash, which is your practice. And yet they're giving you advice, a critical advice that relates to your practice and the cash flows. That involves payroll, it involves setting aside a healthy amount of money, it involves certain expenses to manage it. It needs to be set up in connection with your overall context with these 401k and other retirement plans. But if set up and designed right, they are one of the best tax planning strategies you have available to you. And the greatest thing is they're completely legitimate and they're really set up. Or I'll say the type of business that is ideal for a retirement plan is a business where you have an owner or maybe a pair of owners, if it's a partnership and you have relatively few staff, let's say 10 staff or less, nine staff or less, maybe even 12 staff or less. And there's a spread, good spread, between what the owner is paid and what the average staff is paid. And the reason why 401s are, those are a sweet spot for 401ks is that they don't come with whole lot of staff cost. Now, when I say that, it's not that I don't want you to support your staff and take care of them, they matter a lot. But I say that because if it's not that way, then the 401k isn't a viable planning strategy for you. It becomes too expensive. So if you design it correctly, the 401k is the sort of one of the biggest ways to reroute money that would be going to the IRS and putting it to you. And we talk about that more in our retirement planning module. Now, the third step is once you've done your projection, basically taking your P and L and you've projected it out to the end of the year to say, what is my profit and loss statement going to look like at the end of the year? Now I can sort of calculate what my taxes are going to be, or your CPA can do that, let you know you're going to owe $40,000 federal and $10,000 state or $80,000 federal and $30,000 state, whatever that is. And now you have a decent idea. So the next step is now we have to make appropriate tax payments throughout the year. And you do not want to get behind on this. This is one area that causes many dentists to.

Really slow their progress toward financial independence is they get tangled up with the IRS and they get behind. Next thing you know, you got a bunch of tax notices coming in the mail, you got tax penalties, you're having to set up loans or settlements with the IRS and pay an attorney. You want to stay a mile away from that. So if you do your tax projection now, you know what you're in for. And you might only be June, July, August. Now you've got plenty of time to still make that up if you get behind. So now you know what you're going to owe, you know where you are in the year, and now we can make those payments. Now there's two ways to make your tax payments. The first one is through payroll. And most of you, if you follow my advice, are going to be set up as S corporations. And as an S corporation, you are an employee of your own S corporation just like your hygienist, just like your front office and your assistant, et cetera, you are an employee and you have to pay yourself payroll. Now you're not going to pay yourself as an owner, say 30% of production or collections, which you might have been paid as a non owner. Instead as an owner, you pay yourself what makes the most sense from a tax planning standpoint. And if you have a 401k from a 401k planning standpoint. Also, we like to factor in the doctor's budget into payroll as well and designing it so that the whole system is running smoothly around the cash flow in your practice to going out of your practice. And payroll is one of those ways that that happens. The other one is draws, as we discussed in the past, W2 payroll and K1 distributions or draws. Just focusing on payroll right now. Now when you make your payroll, you can deduct in taxes, really whatever you want. Now the IRS wants you to withhold a certain amount, but I'm going to tell you, don't treat yourself like a normal employee and just take zero withholding allowances on your W4. The W4 is what you give to your employer. You give to the payroll company so that they can automatically calculate how much to withdraw from your, from your, from your, from your paycheck. The reason why you don't want to do that is because your tax Your taxes aren't just a function of your W2, they're also a function of what your K1. So you have to look at it globally. And you may need to withhold enough taxes out of your W2 to cover both the the income related to your W2 and your K1. Or if you have a spouse who's earning a high income, it's very likely your payroll company doesn't know that and they're not going to automatically withhold enough. So what happens is at the end of the year when you file your 1040 tax return and your CPA comes and says, hey, Doc, you owe $40,000 and you're all upset and want to fire your CPA, it's because this whole system of tax planning wasn't done and we never withheld enough from our payroll. Now, that's one way withholding from payroll, your federal and your state taxes. The second way is through what are called estimated quarterly tax payments. This is just you writing a check out of your personal account. Some people do it from their business, but this isn't tax deductible expense to go pay your taxes. So theoretically, remember, your corporation does not pay taxes, income taxes. So you would pay this out of a personal account. May mean you need to make a distribution out of your corporation to make that. But you write that check to the to the irs and you write that check to the state government, and you do it four times a year. And that's called your estimated payment. Why is it estimated payment? Because you're estimating what your taxes are going to be. You're dividing that up by four, and you're writing that check every quarter due on April 15, June 15, September 15, and January 15. Now, you may ask, well, Wes, which one should I do? Payroll. Should I just do it all through a payroll withholding or should I do it all through an estimated payment? Well, the answer is, it really depends on your situation. You can do 100% through both. If you do 100% through your W2, your W2 has got to be high enough such that you can deduct all the taxes necessary without going negative on your W2. As at the end of the day, your W2 and your K1 are taxed at the same amount. It all flows into one bucket. And you pay taxes on that income. And the IRS says you can pay us estimated payments or through payroll. Doesn't matter. But there is a benefit to paying through your payroll. And the benefit is that let's say you went through the entire year and you didn't make one single dollar in payment in either of these two options to the irs. So the IRS hasn't seen a dollar come from you to paying taxes. Now, traditionally, the IRS doesn't like that. Not traditionally. In fact, they don't like that. And they're going to penalize you for late tax payments. Except if you run it through payroll. On December 31, you run one big massive payroll for you. Let's say you do $100,000 gross. You have, I don't know, you've got 50,000 go to the federal government and you've got 30,000 or 20,000 go to the state government. And the rest might go to some FICA, maybe a 401k. And then the rest sort of is direct deposited into your personal account. That all goes through the payroll company. Then that money that you just paid to the federal and the state government on December 31 through payroll is treated as if it was made equally throughout the year. And guess what? No late payment on that. No late payment on that. So if you're ever behind, you think, gosh, I don't want to be. I don't want to pay any late payments. Then make sure you catch up through payroll. If you do it through your quarterly estimates, you can't just say, well, the last payment is due on January 15th for the year after, of course, January 15th, I'm just going to write a check for the entire year on that day. Well, guess what? You're going to have a late payment for not making the April 15, the June 15, and the September 15 estimated payments. You're going to have a late payment. I'm not going to go into the details of how to calculate the late payment here. That's beyond the scope. But the point is that you're going to have a late payment and you want to avoid that. So what we typically do here at practice CFO is we run pretty much all of the taxes through payroll and doctor doesn't need to worry or set a reminder to make quarterly estimated payments. But you've got to make sure that your payroll is structured correctly with, with the right gross W2, the amount of withholdings, and all of that is a function of good tax planning. So that is the process of tax planning. In the next module. We're going to talk about some different tax strategies or maybe some things you can run through your practice that will give you healthy tax deductions and help you pay less taxes to the irs.