As year-end approaches, small business owners turn to their accountants and ask one question: “Should I buy X before year-end to lower my tax bill?”
A few years ago, a small business owner I follow asked the same question on her Instagram stories. Like many small business owners, she was worried about her tax bill and wondering whether she should generate some business expenses before the end of the year.
In her story, she mentioned asking her accountant if there was a “sweet spot” for the amount of money she should spend so that she wouldn’t have to pay too much in taxes. According to her story, her accountant answered, “yes, there is a sweet spot, and more expenses are always better.” But the accountant never told her what that sweet spot is.
Perhaps something was lost in translation, but if her recollection of the conversation is accurate, that accountant might need to Google, “Don’t let the tax tail wag the dog.”
That’s an old saying among tax pros and investment advisers. Essentially, it means, don’t let the least important part of something control the more important elements. Read on to learn more about what I think her accountant’s advice was short-sighted.
Should I spend money to lower my tax bill?
In a word: No. To explain my thinking here, let’s consider a fictional client.
Ben is a freelance web developer. He’s had a great year, landed several new clients and nearly doubled his income over the prior year. Understandably, Ben is concerned about his future tax bill, so he wonders whether he should spend some money before year-end to lower his tax bill.
The costs Ben is considering include:
A new car. Ben drives his personal vehicle for business quite often. His current car is fine, but he’s heard about big write-offs for business vehicles.
A new laptop. Ben’s current laptop is a couple of years old. It works well, but that new MacBook Pro sure looks cool.
Office supplies such as ink cartridges for his printer, notebooks, and new business cards.
Registration for an upcoming conference and airfare to travel there.
If Ben came to me with this question, I would answer with a question of my own: “Which of these expenses do you NEED in your business today or will definitely purchase in the near future?”
Based on the information above, I would say Ben should say NO to the new car and laptop. He doesn’t need them, and his only motivation for buying now is to save money on his tax bill.
The office supplies? Well, if Ben is running low on these items and would probably order them sometime soon, AND he has the money available to buy the supplies now, it makes sense to accelerate those expenses into the current year so he can take advantage of the tax deduction now.
Likewise with the conference registration. If it’s one Ben attends every year and makes connections that help propel his business forward, go ahead and buy the tickets.
Tax Deductions Aren’t a Dollar-for-Dollar Reduction in Your Tax Bill
Maybe Ben thought he could buy a $2,500 MacBook Pro, claim the deduction on his taxes, and get a free laptop. But that’s not how tax deductions work.
Let’s say Ben is in the 25% tax bracket. For every $100 he spends, Ben will save about $25 in taxes. The net effect is he’s still spent $2,475. If he NEEDS that laptop for his business, it’s a good use of his money. But if he doesn’t need the MacBook, he’s better off keeping the $2,500 and just paying the tax, don’t you think?
So the next time you’re looking at a record year in your business, don’t start spending money willy-nilly to lower your tax bill. First, celebrate! Then, face the fact that taxes are a cost of doing business. Of course, we all want to do whatever we can (legally) do to reduce the amount we have to pay, but spending money on stuff you don’t need isn’t the solution.
Smart ways to reduce taxable income
If you really want to lower your tax bill, there are a few ways you can spend money to reduce your taxable income while keeping the money in your own pocket. Here are some ideas:
Contribute to a retirement account, such as a Traditional IRA, SEP-IRA or 401(k)
Contribute to a health savings account (HSA)
Make an S-Corp election
If you’re eligible to contribute to an HSA and you haven’t already maxed out your contributions to your retirement account, you may be able to lower your federal income tax while keeping the money. Of course, it won’t be quite as accessible as it is in your business checking account, but it’ll still count toward your net worth. That’s a smart way to lower your tax bill.
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