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Supercharge Your Retirement: How IRAs Can Mean Big Tax Savings for Tax Year 2024!

5/28/2025

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Hello, savvy savers! Are you dreaming of a comfortable retirement but wondering how to make your money work harder and keep more of it away from taxes? You're in the right place! Today, we're unlocking the power of Individual Retirement Accounts (IRAs) – your ticket to potentially significant tax savings while building that nest egg.
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IRAs are special accounts designed to help you save for the future, and their biggest superpower is the tax advantages they offer. Depending on the type you choose, you could lower your tax bill today, watch your investments grow without yearly tax bites, or even take money out completely tax-free in retirement! Let's dive into the different types of IRAs and see how they can fuel your journey to a richer retirement.

Traditional IRAs – Your Partner for Tax Savings Now

Think of a Traditional IRA as the classic way to save for retirement, often giving you an immediate tax break.
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  • The Tax-Saving Scoop: When you contribute to a Traditional IRA, you might be able to deduct that contribution from your taxable income for the year. Less taxable income can mean a smaller tax bill in the current year – woohoo! Your money then grows "tax-deferred," meaning you don't pay taxes on the investment earnings each year. You'll only pay income tax on your deductible contributions and all the earnings when you withdraw the money in retirement. The SECURE Act also brought good news: there's no longer an age limit for making contributions to your Traditional IRA, as long as you have earned income!
  • Who's it For? This can be great if you think you're in a higher tax bracket now than you will be in retirement.
  • Real-World Example: Meet Sarah, a 40-year-old marketing manager. She contributes $7,000 to her Traditional IRA in 2024. If her contribution is fully deductible and she's in the 22% federal tax bracket, she could reduce her current year's taxes by $1,540 ($7,000 x 0.22)! That's extra cash in her pocket today, all while her $7,000 is working towards her retirement.
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Key Traditional IRA Points 
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  • Contribution Limit: Up to $7,000 (or $8,000 if age 50 or older with the $1,000 catch-up).
  • Deductibility: May be limited if you or your spouse are covered by a retirement plan at work and your Modified Adjusted Gross Income (MAGI) exceeds certain levels. For instance, for a single active participant in 2024, the deduction starts to phase out at a MAGI of $77,000.
  • Required Minimum Distributions (RMDs): You generally must start taking RMDs by age 73 (thanks to the SECURE Act 2.0).
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Roth IRAs – The Magic of Tax-Free Retirement Income!
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Imagine pulling money out in retirement and not paying a dime of tax on it. That's the incredible potential of a Roth IRA!
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  • The Tax-Saving Scoop: With a Roth IRA, you contribute money after you've paid taxes on it (so no upfront deduction). But here's the kicker: your investments can grow completely TAX-FREE, and qualified withdrawals in retirement are also 100% TAX-FREE. This means all those lovely earnings over the years can be yours without sending a cut to Uncle Sam, provided you meet the rules (like having the account for 5 years and reaching age 59 ½). Plus, unlike Traditional IRAs, Roth IRA owners don't have to take RMDs during their lifetime. The SECURE Act 2.0 also introduced a cool feature allowing limited tax-free rollovers from long-term §529 education plans to Roth IRAs starting in 2024.
  • Who's it For? This is fantastic if you believe you might be in a similar or higher tax bracket in retirement, or if you just love the idea of tax-free income later on.
  • Real-World Example: Consider David, a 28-year-old software developer. He contributes $7,000 to his Roth IRA. He doesn't get a tax break today, but his investments grow tax-free. If he retires at 65 and has built up a substantial sum, every penny of his qualified withdrawals – including decades of growth – is his to keep, tax-free! This could mean tens or even hundreds of thousands of dollars in tax savings over his retirement.

Key Roth IRA Points
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  • Contribution Limit: Up to $7,000 (or $8,000 if age 50 or older). This is a combined limit with Traditional IRA contributions.
  • Eligibility: There are MAGI limits to contribute. For 2024, a single filer's ability to contribute phases out between $146,000 and $161,000 of MAGI. For those married filing jointly, it's $230,000 to $240,000.
  • No Lifetime RMDs: You're not forced to take money out during your lifetime.

Traditional vs. Roth IRA: Quick Glance​

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IRA Funding – Choosing Your Investment Path
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Once you open an IRA, you need to decide how to invest your money. This chapter is all about your options.
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  • The Tax-Saving Scoop: The IRA itself provides the tax shelter, regardless of the specific investments you choose (as long as they're permitted). This means within your IRA, your chosen investments can grow tax-deferred (Traditional) or tax-free (Roth) without you having to worry about annual taxes on dividends or capital gains from those investments.
  • Investment Choices: You generally have two main ways to fund an IRA: 
    • Trust or Custodial Account: This is very common and lets you invest in a wide array of options like mutual funds, stocks, bonds, and Certificates of Deposit (CDs).
  • What You Can't Invest In: IRAs generally can't hold life insurance contracts or collectibles like antiques or artwork.
  • Real-World Example: Maria has opened a Roth IRA. She decides to use a custodial account at a brokerage firm. Within her Roth IRA, she invests in a mix of index funds and some individual stocks. All the dividends and capital gains her investments generate within the Roth IRA grow tax-free, maximizing her retirement potential.
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Coverdell ESAs – Tax-Smart Savings for Education (A Special Mention)
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While our main focus is retirement, the guide we're drawing from includes a chapter on Coverdell Education Savings Accounts (ESAs). These aren't retirement accounts, but they use a similar tax-advantaged structure to help save for education.
  • The Tax-Saving Scoop: Contributions to Coverdell ESAs are not deductible, but the money grows tax-deferred, and withdrawals are tax-free if used for qualified education expenses (from kindergarten through college).
  • Key Features:
    • Contribution Limit: Up to $2,000 per year per beneficiary (the student).
    • Contributor Income Limits: Apply to those making contributions. For 2024, single filers see a phase-out above $95,000 MAGI ($190,000 for joint filers).
    • Beneficiary Age: Contributions must generally be made for beneficiaries under 18, and funds used by age 30 (unless a special needs beneficiary).
  • Real-World Example: Grandparents, John and Mary, want to help with their granddaughter Emily's future college costs. Their income allows them to contribute. They open a Coverdell ESA for Emily and contribute $2,000 each year. The money they invest grows, and when Emily goes to college, she can use the funds (contributions and earnings) tax-free for her tuition, books, and room and board.
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Simplified Employee Pension (SEP) IRAs – A Big Boost for Small Businesses & Self-Employed
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If you're self-employed or own a small business, a SEP IRA can be a fantastic, simple way to save a substantial amount for retirement with significant tax advantages.
  • The Tax-Saving Scoop:
    • For Employers/Self-Employed: Contributions are tax-deductible for the business.
    • For Employees: Employer contributions (and their earnings) grow tax-deferred and aren't taxed to the employee until withdrawal (unless directed to a newly available SEP Roth IRA, where qualified withdrawals would be tax-free).
  • Higher Contribution Limits: This is a major perk! For 2024, an employer can contribute up to 25% of an employee's compensation, capped at a maximum contribution of $69,000 per employee. This allows for much larger savings than a standard Traditional or Roth IRA.
  • Simplicity: SEPs are much easier and less costly to set up and administer than many other qualified retirement plans.
  • Real-World Example: Alex is a successful freelance graphic designer. He sets up a SEP IRA for himself. In a good year, he can contribute a significant portion of his net self-employment income (up to the limits) to his SEP IRA, getting a valuable tax deduction now and building a hefty retirement fund that grows tax-deferred.
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SIMPLE IRAs – Easy Retirement Savings for Small Employers
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SIMPLE (Savings Incentive Match Plan for Employees) IRAs are another great option for small employers (generally those with 100 or fewer employees) looking to offer retirement benefits without the complexity of traditional 401(k)s.
  • The Tax-Saving Scoop:
    • Employee Contributions (Elective Deferrals): Employees can choose to have money deducted from their paycheck pre-tax (or to a Roth SIMPLE, after-tax starting in 2023), lowering their current taxable income if pre-tax. For 2024, employees can defer up to $16,000 ($19,500 if age 50 or older).
    • Employer Contributions: Employers must contribute, either by matching employee contributions (e.g., dollar-for-dollar up to 3% of pay) or by making a non-elective contribution for all eligible employees (e.g., 2% of pay). These employer contributions are tax-deductible for the business.
  • Vesting: All contributions (employee and employer) are immediately 100% vested – meaning the money is always yours.
  • Real-World Example: "The Corner Bookstore," a small shop with 10 employees, sets up a SIMPLE IRA. Their employee, Maria, elects to contribute 5% of her salary pre-tax. The bookstore matches her contribution up to 3%. Maria gets an immediate tax break on her deferrals, a "free money" match from her employer, and all of it grows tax-deferred for her retirement. 
    • Note on Early Withdrawals: There's a 25% penalty (ouch!) if you withdraw from a SIMPLE IRA in the first two years of participation, dropping to the usual 10% thereafter for pre-59 ½ withdrawals (unless an exception applies).

The Power of Tax-Advantaged Growth: IRA vs. Taxable Account
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Let's see how investing in an IRA can outpace a regular taxable brokerage account over time, thanks to those tax benefits. We'll use the historical annual average return of the S&P 500 index, which has been around 10% (though remember, past performance is not a guarantee of future results!).
Scenario:
  • You invest $7,000 every year.
  • You do this for 30 years.
  • Your investments hypothetically earn an average of 10% per year.
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What This Shows:
  • The Roth IRA is the clear winner here, providing the most spendable cash in retirement because all that growth is completely tax-free!
  • The Traditional IRA still significantly outperforms the taxable account because your money compounds faster without the annual tax bite on growth, even after paying taxes on withdrawal.
  • The Taxable Account lags behind due to the "tax drag" – the effect of paying taxes on your investment gains year after year, which reduces the amount of money left to keep growing.
The difference over decades can be truly astounding!

Your Journey to Tax-Smart Retirement Savings Starts Now!
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IRAs are powerful tools that can help you build a more secure and prosperous retirement by offering significant tax advantages. Whether it's getting a tax deduction today with a Traditional IRA, aiming for tax-free income in retirement with a Roth IRA, or utilizing employer-sponsored IRAs like SEPs and SIMPLEs, the key is to understand your options and get started.
The rules might seem a bit daunting, but the long-term benefits for your financial future are well worth exploring. Consider your current tax situation, your expected income in retirement, and your savings goals.
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Maximizing Your Business Cash Reserves with CDs and Money Market Investments

7/10/2024

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In today’s financial landscape, it's crucial for businesses to make the most of their cash reserves. One effective strategy is investing in Certificates of Deposit (CDs) and money market accounts that offer interest. Let’s explore the benefits of these investment options and how they can help your business grow its cash reserves.

The Power of CDs and Money Markets

Certificates of Deposit (CDs) and money market accounts are secure, low-risk investment vehicles that offer higher interest rates compared to traditional business savings accounts. By investing your business's idle cash in these instruments, you can generate a steady stream of income without exposing your funds to significant risk.

Capitalizing on High CD and Money Market Rates

Currently CDs and money markets are yielding around 5% depending on the maturity.
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CD and money market rates are the highest they’ve been in over a decade, mainly due to rising inflation. Higher inflation leads to increased interest rates as financial institutions try to attract deposits. Historically, interest rates tend to peak right before recessions. Locking in these high rates now can be particularly advantageous. If a recession occurs and interest rates fall, you will continue to earn the higher rate for the duration of your CD’s term, providing a stable and predictable return on your investment.
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Hypothetical Interest Earnings

To illustrate the potential benefits, let’s consider the annual interest earnings on a 5% CD for different investment amounts:

  • $10,000 Investment: $10,000 x 5% = $500 annual interest
  • $100,000 Investment: $100,000 x 5% = $5,000 annual interest
  • $1,000,000 Investment: $1,000,000 x 5% = $50,000 annual interest

As you can see, even modest investments can yield substantial returns, providing your business with additional funds for growth and operations.

FDIC Insurance for Business Accounts

One of the primary concerns when investing business funds is ensuring their safety. The Federal Deposit Insurance Corporation (FDIC) insures CDs and money market accounts held in FDIC-member banks up to $250,000 per depositor, per insured bank, for each account ownership category. For businesses, this means each of your business accounts is insured up to $250,000 at each bank. If your total deposits exceed this limit, consider spreading your funds across multiple banks to fully benefit from FDIC insurance.

Mitigating FDIC Insurance Risk with Brokered CDs

Purchasing brokered CDs can further mitigate the FDIC insurance risk. When you buy brokered CDs through a brokerage account, you have the option to purchase CDs from multiple institutions. This diversification means you can spread your funds across various banks, ensuring that each CD remains within the $250,000 FDIC insurance limit. By doing so, you can protect your entire investment, even if it exceeds the insurance cap for a single bank, thus eliminating the risk of uninsured deposits.

Laddering CD Maturities

Another strategy to maximize the benefits of CDs is laddering their maturities. Laddering involves spreading your investment across multiple CDs with varying maturity dates. For instance, you could invest in CDs with 1-year, 2-year, and 3-year terms. As each CD matures, you reinvest the principal into a new CD with a longer term. This approach provides regular access to your funds, reduces interest rate risk, and ensures that a portion of your investment is always earning the highest available rate.

How to Buy a CD Using a Business Brokerage Account

Purchasing a CD through a business brokerage account is straightforward. Here’s a step-by-step guide:

  1. Open a Business Brokerage Account: If you don’t already have one, choose a reputable brokerage firm and open a business account.
  2. Fund Your Account: Transfer the amount you wish to invest from your business bank account to your brokerage account.
  3. Research CD Options: Use your brokerage platform to research available CDs. Compare interest rates, terms, and FDIC insurance coverage.
  4. Purchase the CD: Select the CD that best fits your business needs and complete the purchase through the brokerage platform.
  5. Monitor Your Investment: Keep track of your CD's performance and interest earnings through your brokerage account dashboard.

It's important to note that CDs can be bought and sold on the open market and do not need to be held to maturity. Their value can fluctuate based on interest rate changes. If interest rates rise, the value of your CD may decrease, and if rates fall, the value may increase. This flexibility can provide additional liquidity options for your business, allowing you to manage your cash flow needs more effectively.

Conclusion

Investing in CDs and money market accounts is a smart way to enhance your business’s financial health. With the potential for higher interest earnings and the security of FDIC insurance, these instruments provide a reliable avenue for growing your cash reserves. 

Investment Disclaimer

The information provided in this newsletter is for educational purposes only and should not be considered as investment, tax, or legal advice. Every business's financial situation is unique, and you should consult with a professional financial advisor, accountant, or attorney before making any investment decisions.

Best regards,
​Daniel Johnson
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Inflation adjustments may lower tax rates for some in 2023

10/19/2022

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Inflation adjustments may lower tax rates for some in 2023

New IRS inflation adjustments for 2023
New IRS inflation Adjustments for 2023
In response to the rising cost of living, the IRS just released a slew of new inflation adjustments that may help taxpayers lower their tax bills in 2023. 
 
Notably, the IRS is shifting the tax brackets by about 7% from 2022 levels, meaning that the taxable income thresholds will increase, easing the burden on taxpayers.  The standard deduction will also increase by about 7%, resulting in bigger tax deductions.
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Below is an exert of what the new IRS Procedure has to say.  Note that these changes won’t take place until tax year 2023.   

From the IRS website....

Highlights of changes in Revenue Procedure 2021-38:
The tax year 2023 adjustments described below generally apply to tax returns filed in 2024.

The tax items for tax year 2023 of greatest interest to most taxpayers include the following dollar amounts:
  • The standard deduction for married couples filing jointly for tax year 2023 rises to $27,700 up $1,800 from the prior year. For single taxpayers and married individuals filing separately, the standard deduction rises to $13,850 for 2023, up $900, and for heads of households, the standard deduction will be $20,800 for tax year 2023, up $1,400 from the amount for tax year 2022.

  • Marginal Rates: For tax year 2023, the top tax rate remains 37% for individual single taxpayers with incomes greater than $578,125 ($693,750 for married couples filing jointly).
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The other rates are:
35% for incomes over $231,250 ($462,500 for married couples filing jointly);
32% for incomes over $182,100 ($364,200 for married couples filing jointly);
24% for incomes over $95,375 ($190,750 for married couples filing jointly);
22% for incomes over $44,725 ($89,450 for married couples filing jointly);
12% for incomes over $11,000 ($22,000 for married couples filing jointly).
The lowest rate is 10% for incomes of single individuals with incomes of $11,000 or less ($22,000 for married couples filing jointly).
 
  • The Alternative Minimum Tax exemption amount for tax year 2023 is $81,300 and begins to phase out at $578,150 ($126,500 for married couples filing jointly for whom the exemption begins to phase out at $1,156,300). The 2022 exemption amount was $75,900 and began to phase out at $539,900 ($118,100 for married couples filing jointly for whom the exemption began to phase out at $1,079,800).

  • The tax year 2023 maximum Earned Income Tax Credit amount is $7,430 for qualifying taxpayers who have three or more qualifying children, up from $6,935 for tax year 2022. The revenue procedure contains a table providing maximum EITC amount for other categories, income thresholds and phase-outs.

  • For tax year 2023, the monthly limitation for the qualified transportation fringe benefit and the monthly limitation for qualified parking increases to $300, up $20 from the limit for 2022.

  • For the taxable years beginning in 2023, the dollar limitation for employee salary reductions for contributions to health flexible spending arrangements increases to $3,050. For cafeteria plans that permit the carryover of unused amounts, the maximum carryover amount is $610, an increase of $40 from taxable years beginning in 2022.

  • For tax year 2023, participants who have self-only coverage in a Medical Savings Account, the plan must have an annual deductible that is not less than $2,650, up $200 from tax year 2022; but not more than $3,950, an increase of $250 from tax year 2022. For self-only coverage, the maximum out-of-pocket expense amount is $5,300, up $350 from 2022. For tax year 2023, for family coverage, the annual deductible is not less than $5,300, up from $4,950 for 2022; however, the deductible cannot be more than $7,900, up $500 from the limit for tax year 2022. For family coverage, the out-of-pocket expense limit is $9,650 for tax year 2023, an increase of $600 from tax year 2022.

  • For tax year 2023, the foreign earned income exclusion is $120,000 up from $112,000 for tax year 2022.

  • Estates of decedents who die during 2023 have a basic exclusion amount of $12,920,000, up from a total of $12,060,000 for estates of decedents who died in 2022.

  • The annual exclusion for gifts increases to $17,000 for calendar year 2023, up from $16,000 for calendar year 2021.

  • The maximum credit allowed for adoptions for tax year 2023 is the amount of qualified adoption expenses up to $15,950, up from $14,890 for 2022
Items unaffected by indexing:
By statute, certain items that were indexed for inflation in the past are currently not adjusted.
  • The personal exemption for tax year 2023 remains at 0, as it was for 2022, this elimination of the personal exemption was a provision in the Tax Cuts and Jobs Act. 

  • For 2023, as in 2022, 2021, 2020, 2019 and 2018, there is no limitation on itemized deductions, as that limitation was eliminated by the Tax Cuts and Jobs Act.

  • The modified adjusted gross income amount used by joint filers to determine the reduction in the Lifetime Learning Credit provided in § 25A(d)(2) is not adjusted for inflation for taxable years beginning after December 31, 2020. The Lifetime Learning Credit is phased out for taxpayers with modified adjusted gross income in excess of $80,000 ($160,000 for joint returns).
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How to pay taxes as a single member LLC

6/20/2022

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Picture how to pay taxes as a single member llc

How to pay taxes with a single member LLC​

When it comes to taxes and the IRS, payroll can be confusing and downright intimidating at first, especially for new entrepreneurs.  But rest assured, paying yourself from a single member LLC is a lot easier than you might think.

What is a single member LLC?

Let’s start with a brief overview of what a single member LLC is.
 
A single member LLC (limited liability company) is a business structure allowed by state statue.
 
This biggest benefit of this structure compared to a sole proprietorship or partnership is that an LLC protects you from personal liability.   In a nutshell, it shields you from getting sued personally from potential liability issues arising during the course of business.   The liability instead falls on your business, shielding your personal assets.
 
LLCs can have more than one member or owner, but in this article, we are focusing on LLCs with one member.

What taxes are you liable for?

As a single member LLC, you will be responsible for paying both federal income taxes and self-employment taxes on your net income. 
 
Federal income taxes range from 10% to 37% in tax year 2022.  
 
In addition to federal income taxes, you must pay self-employment tax.
 
Self-employment tax is a tax consisting of Social Security and Medicare taxes primarily for individuals who work for themselves.  The self-employment tax rate is 15.3%, which consists of two parts: 12.4% for social security and 2.9% for Medicare.  
 
You must pay the 12.4% Social Security tax on the first $147,000 of income in tax year 2022.  Amounts over that amount are not subject to further tax.  However, you must pay the 2.9% Medicare tax on all your net income.
 
Self-employment tax is like the Social Security and Medicare taxes withheld from traditional paychecks for W-2 employees.   As a traditional W-2 employee, the employer pays half (7.65%) and employee pays half (7.65%).  As a self-employed individual, you are responsible for paying the full 15.3%.
 
An additional 0.9% Medicare tax is due on income over $200,000 for single filers and $250,000 for joint filers.
 
Depending on your state, you may be liable for state income taxes as well.

Disregarded Entity

When it comes to taxes, a single member LLC is referred to as a disregarded entity by the IRS by default.
 
What does this mean?
 
A disregarded entity means that for federal tax purposes, your LLC will not be taxed as a separate entity.  Instead, your LLC will report income on your personal 1040 tax return.  This makes filing taxes a lot easier as you only need to file one return with the IRS.

Pay yourself with 4 easy steps

In order to pay yourself, follow these 4 steps.

Step 1:  Obtain an EIN from the IRS

When you form your LLC, you need to sign up for an Employer Identification Number with the IRS, which is referred to as an EIN.  An EIN is used by the IRS to identify a business entity, similar to a social security number.
 
You can apply for an EIN with the IRS for free here.

Step 2:  Register and pay estimated taxes with the IRS

After you obtain an EIN, you will need to register and pay estimated taxes with the IRS.  Estimated taxes are due each quarter on approximately January 15, April 15, June 15, and September 15.  
 
Estimated taxes are similar to withholdings from a traditional paycheck.  However, it eliminates the need for filing traditional payroll forms such as form 941, W-2, and W-4.
 
You can register by visiting this link to the IRS payment portal and filling out Form 1040-es to estimate the taxes you owe each quarter.  Remember that taxes are based on net income, which is revenue minus all your business deductions and expenses.
 
Once signed up, it is super easy to pay your taxes each quarter.  The IRS even has a mobile app to make paying easy.

Step 3:  Pay yourself

This is the easy part.  Either write yourself a check or transfer money from your business checking account to your personal checking account.  It’s a simple as that.
 
When recording the transaction in QuickBooks or another accounting software, remember to classify it as an owners draw or distribution.  Note that the amount you pay yourself is not deductible as an expense.

Step 4:  File your taxes at year end

When it comes time to file taxes at the end of the year, you will file form 1040.  There is no need to file an additional business tax return such as Form 1120 or 1120s for corporations, unless you make the special election to do so.  You can read more about taxation of s-corporations here.  
 
Instead of filling out the W-2 income section on your tax return, you will report the profit or loss from your business on Schedule C of the 1040 tax return.  Taxes are based on the net amount after all business deductions. 
 
And don’t forget to input the quarterly estimated taxes you paid during the course of the year.

Conclusion

A single member LLC is a great business structure for entrepreneurs and paying yourself is easier than it seems.  Just remember to follow these 4 steps:
  1. Obtain an EIN
  2. Register and pay estimated taxes with the IRS
  3. Write yourself a paycheck
  4. File a 1040 tax return at year end
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What are the benefits of single member LLC electing S Corporation Tax Status?

5/23/2022

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S Corporation Election

What are the benefits of single member LLC electing S Corporation Tax Status?
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A single member LLC by default is taxed as a sole proprietorship.  However, LLCs may choose to be taxed as S corporations by filing a from with the IRS, referred to as an “election”.  Read on to find out the potential tax benefits of making this election.

Disregarded Entities

The IRS refers to single member LLCs as “disregarded entities” for taxation purposes.  
 
This means that the profits and losses from an LLC are reported on schedule C of a 1040 individual tax return. This makes filing taxes easier, because single member LLCs taxed as disregarded entities do not have to file separate business tax returns like corporations and partnerships.
 
Although the tax filing is easier, it doesn’t mean it’s the most tax efficient way to file.

What is an S Corporation?

An S corporation isn’t a type of legal business entity like an LLC, corporation, or partnership.  Instead, an S corporation is a tax status recognized by the IRS.
 
When an LLC makes the election with the IRS to be treated as an S corporation, the legal status of the LLC doesn’t change.  The business structure is still an LLC.  The S corporation election with the IRS only affects the LLC’s tax filing requirements.

What are Self-Employment Taxes

Self-employment taxes consist of Social Security and Medicare taxes on your wages.  Income treated as dividends is generally not subject to self-employment taxes.  We will see why this matters below.
 
The self-employment tax rate is 15.3%, which consists of two parts: 12.4% for Social Security and 2.9% for Medicare.  For 2022, only the first $147,000 of wages are subject to the 12.4% Social Security tax while the Medicare tax has no limit, meaning all your wages are subject to the 2.9% tax.
 
With an S corporation, only amounts paid as W-2 income are subject to self-employment taxes, whereas with a single member LLC, your entire income is subject to self-employment taxes.   
 
S corporation earnings not paid as W-2 income are treated as shareholder dividends reported on Schedule K-1, which generally are not subject to self-employment taxes.  This allows an S corporation owner to take money out of the business and not be subject to the 15.3% self-employment taxes.
 
Note that self-employment taxes are taxes on wages, which are in addition to Federal income taxes.  All business are liable for Federal income taxes on earnings while self-employment taxes are only levied on amounts paid as wages. 

The Reasonable Salary Requirement by the IRS

S corporation income can either be salary (W-2 income) or dividends (K-1 income).  The salary portion is what is subject to self-employment taxes of 15.3%.
 
An owner/employee of an S corporation must pay themselves a “reasonable salary”, meaning that all the business income cannot be considered dividends.
 
For example, if you own a landscaping company that earns $100,000 in net profit, you cannot pay yourself a $100,000 “dividend” and avoid paying self-employment taxes on the entire amount.  You must pay yourself a reasonable salary or the IRS will come knocking.
 
There are no specific IRS guidelines for what constitutes a reasonable salary.  Instead, various courts have ruled on this issue.  Some factors considered by the courts in determining reasonable compensation include:
  •  Training and experience 
  •  Duties and responsibilities 
  •  Time and effort devoted to the business 
  •  Dividend history 
  •  Payments to non-shareholder employees 
  •  Timing and manner of paying bonuses to key people 
  •  What comparable businesses pay for similar services
  •  Compensation agreements 
  •  The use of a formula to determine compensation 

LLC vs S Corporation Tax Benefits

By default, a single member LLC it is treated as a sole proprietorship for tax purposes.  This means it will report all income on schedule C of an individual 1040 tax return and be subject to self-employment taxes on the full amount of income.
 
On the other hand, the amount of self-employment tax an S corporation must pay is based on the amount it pays as W-2 income.
 
For example, let’s assume your LLC earns $100,000.
 
When taxed as a sole proprietorship, an LLC is responsible for paying $15,300 in self-employment taxes. ($100,000 times 15.3%)
 
On the other hand, if an S corporation pays its owner $60,000 as a “reasonable salary”, it is only liable for $9,180 in self-employment taxes. ($60,000 times 15.3%)
 
This results in a savings of $6,120 in total self-employment taxes paid.
LLC vs S Corporation Self-Employment Tax Comparison
LLC vs S Corporation Self-Employment Tax Comparison

​Note that the entire $100,000 is subject to Federal income taxes regardless of LLC or S Corporation status. 
 
The remaining $40,000 can either be kept in the business or paid out as a dividend.  Any amounts paid as a dividend will not be subject to the 15.3% self-employment tax.

How an LLC makes an S Corporation Election?

For a single member LLC to be taxed as an S corporation, an election with the IRS must be made.  This is done by filling out Form 2553, Election by a Small Business Corporation.  
IRS Form 2553 S Corporation Election
IRS Form 2553
Your business may qualify only if it has:
  • No more than 100 shareholders
  • No nonresident alien shareholders 
  • Only one class of stock
 
There are further instructions and requirements which can be read here.

Additional Costs of S Corporation Election

Electing S corporation tax status may come with additional costs and tasks including:
 
  • Payroll provider, tax filings, etc.
  • Additional tax return (1120s)
  • Additional bookkeeping costs
 
It is important to weigh these additional costs when determining if S corporation status is right for you.
 
If you have any additional questions, please contact me here.
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Need help choosing the right QuickBooks Online plan?

5/16/2022

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Picture

Choosing the right QuickBooks subscription

Are you thinking of signing up with QuickBooks Online but are having a tough time deciding which plan is right for you?  If so, you’ve come to the right place.
 
In this article, we are going to compare the types of plans that QuickBooks Online has to offer.
 
The great thing about QuickBooks Online is that it operates through your web browser.  There is no software to install and getting started only takes a few minutes.  QuickBooks Online uses cloud-based software which means that you can work from anywhere on the go.  You can use QuickBooks on your PC, Mac, iPad or phone.
 
Now let’s look at which subscription is right for you.
Comparing QuickBooks Online plans
Comparing QuickBooks Online subscriptions

Types of QuickBooks subscriptions​

QuickBooks Online offers 5 types of subscriptions which are billed monthly.
 
There are no contracts or commitments, and you can upgrade, downgrade, or cancel your subscription at any time.  The five types of plans to choose from are:
 
  1. Self Employed - $15 per month
  2. Simple Start - $25 per month
  3. Essentials - $50 per month
  4. Plus - $80 per month
  5. Advanced - $180 per month
 
Now let’s dive into the features among the plans.

QuickBooks Self Employed

The least expensive QuickBooks plan is Self Employed which costs $15 per month.
 
It may be a good starting point if you are a freelancer that strictly uses cash accounting.
 
  • Self Employed only allows 1 user and 1 accountant.  
  • It only allows you to do simple invoices, so if you need to email invoices, this plan won’t be a good choice.
  • You can have both personal and business bank accounts.
  • Self Employed doesn’t allow accounts receivable, accounts payable, or payroll.
  • It doesn’t allow for receipt capture using the mobile app.

QuickBooks Simple Start

The next plan up is Simple Start.
 
At $25 a month, Simple Start is great for new businesses just starting out.
 
It’s also great for service-based business requiring accounts receivable, payroll, sales taxes, and financial reporting.
 
Simple Start offers:
  • Full general ledger 
  • Allows for accounts receivable
  • Multiple sources of income
  • You can have 1 user & 2 accountants
  • Custom invoices
  • Sales receipts
  • Product & service items
  • Estimates
  • Sales tax
  • Financial Statements
  • It allows you to convert easily from QuickBooks Desktop.
  • You can import lists from Excel.
  • Simple Start allows you to integrate apps.
  • You can pay bills electronically.
  • You can print checks.
  • Simple Start allows you to run payroll
  • Prepare and file 1099s
  • It allows for progress invoicing which is great if you collect deposits on your estimates and invoices.
  • It allows for receipt and bill capture from your phone, making tracking expenses a breeze.

QuickBooks Essentials

​One step up from Simple Start is Essentials at $50 per month.  You get all the benefits from Simple Start plus more.
 
Why might you need to upgrade to essentials?
 
Essentials allows for: 
  • Accounts payable
  • Custom fields
  • Recurring transactions
  • Multicurrency
  • It allows for delayed charges.   So, if you bill a lot of work for a client during the month, but like to invoice them on a single invoice, delayed charges make keeping track of the work very easy.
  • Essentials also allows time tracking which you can then use to create billable hours which is great for attorneys or anyone who bills clients by the hour.
  • Finally, Essentials lets you have 3 users and 2 accountants 
 
One of the features I love about essentials is recurring transactions.  If you are a business such as a lawn service that invoices monthly, recurring invoicing will allow you to automatically send invoices via email to your customers.  It’s a huge time saver.  Imagine individually creating 100 invoices every month by hand.  Recurring invoicing can save you hours of work each month.

QuickBooks Plus

After essentials comes the Plus plan for $80 per month.
 
Why might you need plus?  For me, the two biggest benefits of the Plus plan are:
 
  1. The ability to track multiple revenue streams and/or departments or locations using class and location tracking.
  2. The ability to track inventory.
  3. Price rules to automate categorization.
 
If you need to track inventory, plus is the plan you want.  Plus also allows you to create budgets and allows for advanced reporting such as the ability to track profitability by class or location.
 
Plus allows all the features of Essentials as well as:
  • The ability to track expenses by customer.
  • Plus allows you to bill expenses to customers. 
  • You can enable class and location tracking of income and expenses.
  • You can create budgets.
  • Track inventory using the first in first out FIFO method.
  • You can create price rules to speed up expense categorization.
  • You can create projects and track their profitability. 
  • It allows purchase orders.
  • You can have 5 users, 2 accountants and make “reports only” users.

QuickBooks Advanced

The highest tier plan in QuickBooks Online is the Advanced plan at $180 per month.  If you are a growing business, this may be the plan for you.
 
Advanced allows for:
  • Unlimited accounts, classes, locations, and tag groups.  Other plans have limits.
  • It has an advanced import and batch entry features.
  • QuickBooks gives you a dedicated account team & on-demand training and premium 24/7 technical support.
  • You can have 25 users & 2 accountants with custom user permissions, which is great for accounting departments that may need to limit user access.
  • There are custom reporting fields.
  • You can import invoices and budgets.
  • You can batch enter invoices, checks, bills, or deposits.
  • Finally, Advanced allows you to automate approvals and reminders.

Conclusion

Below is a detailed spreadsheet comparing each QuickBooks Online subscription.
QuickBooks Online plan comparison
QuickBooks Online plan comparison
I hope you found this article helpful when deciding which QuickBooks Online plan to choose from.  If you have any additional questions or comments, feel free to contact us here!
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How to track profitability by location or product division in QuickBooks Online...Location vs Class Tracking

5/12/2022

1 Comment

 
How to use class and location tracking in QuickBooks Online
Class and location tracking in QuickBooks Online.

Class and Location Tracking

Are you a business with multiple locations or storefronts?  Or perhaps your company has different divisions or product lines?  Wouldn’t it be nice to see which store is most profitable?  Or which product line is generating the most sales?
 
In this article, we will discuss how to track profitability using locations and classes using QuickBooks Online.

Why would you want to use location or class tracking?

QuickBooks Online lets you track the income, expenses, and net profit of different segments of your company such as storefronts, product lines, departments, geographic locations, or projects.  Class tracking and location tracking are two QuickBooks features that allow you to do this.
 
For example, if you are a construction company, class tracking can allow you to track both residential and commercial operations.  Or track each job individually.
QuickBooks class tracking
QuickBooks Online class tracking
Or if you own multiple retail stores or restaurants, location tracking can help you track the profitability of each.
QuickBooks Online location and class tracking
QuickBooks Online class and location tracking

Which QuickBooks Online subscription will you need to track classes or locations?

Not all QuickBooks subscriptions support class and location tracking.
 
Class and location tracking are only available with QuickBooks Online Plus and Advanced subscriptions.  You may need to upgrade your plan if you are currently using Simple Start or Essentials.

How to enable and setup class tracking

To enable class tracking:
 
  1. Select the Gear icon and then Account and settings.
  2. Select the Advanced tab on the left.
  3. In the Categories section, use the Track classes slider to enable class tracking.
  4. Turning on Class tracking brings up an option to activate a Warn me when a transaction isn’t assigned a class feature. When there are unclassified transactions, you may not know if that represents a mistake or if it means the transaction needs to be split among multiple classes at a later date.  So it’s best to turn this feature on.
  5. Now choose whether you want to assign the class to the entire transaction or each row in the transaction. I recommend  selecting “One to each row in transaction” as it gives you more flexible to breakdown your transactions by line item.  Clicking “entire transaction” will not allow you to break out transactions by line item.  
  6. ​Next, select Save and then Done.
How to assign classes in QuickBooks Online
Class tracking "one to each row in transaction"
How to assign classes in QuickBooks Online
Class tracking "entire transaction"
Once enabled, to add classes:
  1. Click the Gear icon and All Lists.
  2. Select Classes. ( You can also add locations by selecting Locations.)
  3. Click the New button.
  4. Add the name of the class or location and click Save.

How to enable and setup location tracking

To turn on locations:
  1. Click the Gear icon  then select Account and settings.
  2. Select Advanced.
  3. In the Categories section, select the Edit  icon.
  4. Select the checkbox to track locations.
  5. Select Save, then Done.
 
To add a location:
  1. Click the Gear icon  then select All lists.
  2. Select Locations.
  3. Select New, then add the Name of the location you want to track.
  4. Select Save and close.
 
Once class tracking and location tracking are turned on and set up, you will be able to assign them to transactions such as invoices and expenses.

When to use location vs class tracking?

If you are having trouble deciding between location and class tracking, consider the following:
 
If you need to put more than one category on a transaction, use class tracking.  Location tracking only allows you to assign one location per transaction, whereas class tracking allows you to assign a different class for each line item.
How to assign class and location tracking in QuickBooks Online
QuickBooks Online location and class tracking
The ability to add classes to each line item is especially important if you are creating expenses that need to be broken out.  For example, let’s say you own two retail stores, but purchase supplies for both stores on one expense transaction.  Location tracking won’t let you assign each line item a location, but class tracking will. 
 
If you need to run a balance sheet by category report, use location tracking.
 
If you want to be reminded to categorize a transaction, use class tracking.  Location reminders are not available.
 
You may decide that using both locations and classes is the sweet spot.  For example, if you have two retail stores, you can assign each storefront a location, then setup up classes for your different product lines.  This would allow you to run a profit and loss report by location to see the profitability of each store.  It would also allow you to run profit and loss by class report to see how each product line is performing from both locations.

Running Reports with classes and locations

  • Profit and loss by class 
QuickBooks Online profit and loss by class report
Profit and loss by class report
  • Profit and loss by location
QuickBooks Online profit and loss by location report
Profit and loss by location report
There are two ways to run these reports.  You can either run them directly from the reports page, or click display columns by “class” or “location” on a standard profit and loss report.
How to run QuickBooks Online profit and loss by class and location report
Run profit and loss by class directly from the reports page
How to run a QuickBooks Online profit and loss by class and location report
Filter by "display columns by"
  • Custom balance sheet by class or location. Unlike Profit and Loss, there are no default Balance Sheet by Location or Class Reports. However, you can customize a Balance Sheet to show locations or classes by choosing from the Display columns by dropdown.
How to run a QuickBooks balance sheet by class and location
Balance sheet by class and location report

Transactions that can be used with class tracking

Remember that you can assign classes to each line item of a transaction.  QuickBooks allows you to assign a class to the following transactions:
  • Invoice
  • Sales receipt
  • Estimate
  • Sales order
  • Statement Charges
  • Refunds and credits
  • Check
  • Credit card charges
  • Bill
  • Purchase order
  • Paycheck

Transactions that don’t support location fields

On the other hand, location related transactions have some limitations.
 
The following transaction types don’t support a Location field:
 
  • Transfers (instead, use a Deposit or an Expense transaction to indicate the funds being transferred from the “from account” to the “to account”)
  • Receiving payments
  • Prepayments from customers entered in the Receive Payment window
  • Sales tax payments and sales tax
  • Journal entries with unbalanced locations
  • Invoices with billable expenses with no location or different locations
  • Paychecks allocated to multiple locations
  • Payroll liability payments
  • Pay bills with Bill Credit with a different location
  • Paying bills
  • Pay bills where bills entered for the same vendor have different locations
  • Payments for invoices for the same customer where the invoices have different locations
  • Transferred funds between locations
  • Discounts entered in the Receive Payment window
  • Discounts entered in the Pay Bills window
  • Inventory quantity on hand adjustments

Conclusion

In summary, class and location tracking are great ways to gain better financial insights into how your business is performing.  
 
If you have any further questions or are having trouble which feature to use,  please contact us here.
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6 Financial Philosophies to Live By

5/9/2022

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Financial philosophies by Daniel Johnson Financial Services LLC
Financial Philosophies

6 Financial Philosophies to Live By

​I’m a believer that minimalism in general leads to less stress.  The less material possessions enslaving your wallet, mind, and time the better.  Below I lay out 6 simple personal financial philosophies to live by, which can increase your happiness in life and lead you towards financial independence.
 
1. Avoid DEBT
2. Save, Save, Save
3. Understand the power of compound interest
4. Diversify your income sources...get side hustles!
5. Don’t stress over timing the market
6. Invest in yourself...skills and education

Financial Philosophy 1: Avoid DEBT

Understand that taking on debt is a form of voluntary slavery.  There are exceptions such as debt used for necessities, for instance, a mortgage.
 
Debt is a trap that can suck the happiness from your soul.  More debt often means more stress.  Let’s face it, if you have a lot of debt, you’re probably living outside your means.  
 
For me free time is the ultimate form of wealth.  Freedom to do what I want.  Freedom to sleep in.  Freedom to not be trapped in a job I hate.  Freedom to travel.  Freedom to live life on my terms.  Having to work to make debt payments eats into my free time.  This is why I AVOID debt.
 
Ask yourself this.  How many hours a week do you have to work to afford that $500 new car payment?    Let’s say you make $15 an hour and work 40 hours a week, you are bringing in $600 a week before tax.  For simplicity, figure you take home about $500 a week after tax.  Is it really worth working a full week every month to pay for your vehicle?
 
Unfortunately, debt is unavoidable in some cases.  I had to take out a mortgage when I bought my house.  Some of us have to take on debt to survive.  Outside of debt used for survival, debt should be avoided at all costs.
 
If you have outstanding debt, first pay off high interest credit cards.  Next pay off car loans, unless you were lucky to get a 0% APR loan, just make sure that the debt doesn’t accrue and balloon at the end of the term.  Once all high interest debt is paid off, start tackling your mortgage.
​
Do you own your possessions or do they own you?
 
Do you own your possessions or do they own you?  Material possessions can turn into money traps.  

  • Vacation home?  It’s going to need upkeep.  
  • RV?  It’s going to need maintenance.
  • Boat?  Bring On Another Thousand.
  • Designer clothes?  They’re going to go out of style.
 
Sometimes less is better.  Minimalism can lead to happiness for some, but for most, simply living within your means and not overextending yourself can be a huge stress relief.
 
Corporate America is here to suck you in and make you a voluntary slave to the system.  They want you to spend money, even if it’s money you don’t have.  Just borrow it they say.
 
However the key to understand is that most debt is voluntary.  You have a choice to break the mold and live life on your terms.  The pursuit of happiness is the ultimate goal for most humans outside of survival.  It’s up to you to decide what you value more.  Debt shouldn’t be used to buy happiness.  

Financial Philosophy 2:  Save, Save, Save

My next philosophy is save, save, save!  Outside of a huge windfall of money, decreasing your spending and or increasing your income is the only way to add to your wealth.  
 
First save up an emergency fund.
 
The first step in savings is to establish an emergency fund.
 
How much should you have in an emergency fund?  Three to six months of expenses is considered adequate by most financial planners.  However, I prefer to have a year's worth of expenses set aside in a savings account for added flexibility in case of hardship, such as a job loss.
 
Next,  reduce your spending.
 
After you get an emergency fund set up, find ways to reduce your spending.  Use your savings to start investing.  Find ways to cut your expenses such as:

  • Reduce or eliminate your cable bill
  • Cancel gym memberships (work out for free at a park, pushups, pullups, etc.)
  • Drive less, instead walk or bike more (get in shape and cut your gas bill)
  • Eat out less, meal prep instead
  • Lower your cellphone bill or go on a family plan with others
  • Stop drinking at bars
  • Consolidate your debt to a better interest rate (better yet eliminate DEBT)
 
You get the idea.  The key is to make expense cutting fun.  Focus on the benefits and stress reduction aspects of doing so.  
 
The problem most of us fall into is that when they get a raise or find a better paying job, they often increase their spending in stride.  If you get a $1,000 a month raise but immediately purchase a new house, boat, or new car, how much ahead are you really?  
 
In the example above regarding the $500 a month car payment, consider this.  What if instead of paying $500 on a car payment, you found a way to save $500 a month?
 
Assume you earned 7% per year in a well balanced mutual fund and contributed $500 per month.

  • At the end of 5 years, you would have $35,796.
  • At the end of 10 years, you would have $86,542.
  • At the end of 20 years, you would have $260,463.

Financial Philosophy 3:  Understand the power of compound interest

There is a reason bankers are rich.  It’s because they are earning interest from debt you are paying them.  If you are in debt, you are doing yourself a disservice.  It’s time to flip the script on the bankers and start earning instead of paying.
 
When I originally purchased my $120,000 home in 2010, I took out a $96,000 mortgage at 5.25% interest rate equating to a monthly payment of $530.  I decided to do the math and found out that if I made the $530 payment for 30 years, I would end up paying $94,841 in interest alone.  My $120,000 house would really have cost me $214,841.
 
I decided that I needed to pay the house off as soon as possible.  It took me several years to pay off the house, but I still ended up paying almost $20,000 in interest.  It’s better than $94,841, but still, that $20,000 that could have been in my wallet.
 
When you earn interest, it’s just the opposite.   Here’s a quick example of how compound money works.
 
Think of every dollar you have saved as like an employee who is working for you. The more dollars or employees you have working for you, the more money you can potentially earn.
 
Let’s assume your investments earn 8% per year.  Below is an example showing how compounding works.
 
Year 1:  $1,000,000 x 8% = $80,000 earned for the year
Year 2:  $1,080,000 x 8% = $86,400 earned for the year
Year 3:  $1,166,400 x 8% = $93,312 earned for the year
Year 4:  $1,259,712 x 8% = $100,777 earned for the year
Year 5:  $1,360,489 x 8% = $108,839 earned for the year
 
At the end of the year 5 your money would have grown to $1,469,328.  In year 10, you would have more than doubled your money to $2,158,925.  By year 20, your $1,000,000 would have grown to $4,660,957.
 
You can see how these numbers can really grow as your next egg builds.  The more money or employees you have working for you, the more money you will earn.

Financial Philosophy 4:  Diversify your income sources...get side hustles!

Treat your employment as you would an investment strategy and diversify your income sources.  Having as many side hustles as possible will help spread out the risk in your earning potential in case of a job loss.  This may not be feasible for everyone, but even a few extra hundred dollars a month can make a difference.
 
Nobody likes to be dependent on a job.  Losing your job can lead to a lot of stress, especially if you’re strapped with debt.  The more sources of income you have, the more peace of mind you have if you lose one of them.
 
In my 20s, I worked Monday through Friday for a financial consulting firm 8:30am to 5:30pm.  When I got home at 5:45pm, I would hook up a trailer to my truck and proceed to mow 1 or 2 lawns per evening until sunlight ran out.  I did this for 10 years.  
 
The benefits of this were that I developed a steady source of income and got in really good physical shape from all the physical work.  Mowing lawns was my gym membership.  The main drawback was that it really ate into my personal social life.  I didn’t have a steady girlfriend.  I missed a lot of concerts, sporting events, and late nights at the local bar with friends.  But the sacrifice paid off in the long run.
 
Mowing lawns also led to more opportunities like laying sod and small landscape renovations.  On some occasions I would clear $500 working for 4 hours on Saturday morning.  This side hustle helped me pay off my mortgage early.
 
The real trick to  a side hustle is to focus on the benefits and block the negatives out of your mind.  Having negative thoughts in your mind leads to nothing but unhappiness and loss of focus.
 
The problem with side hustles is that most of us are limited by time.  Finding a side hustle that can make you money in your sleep would be ideal, but it’s not realistic for everyone.  
 
One of the biggest things to look for in a side hustle is flexibility of time commitments. 

  • Get a part-time job (most obvious and probably least flexible)
  • Rent a room in your house on AirBnB
  • Drive for Uber or Lyft
  • Rent your car out on Turo
  • If you’re in a big city, deliver for PostMates
  • Sell products on Etsy
  • Find freelance work on sites like Fiverr.com or upwork.com
  • Teach a language online on a site like VIPkid.com
  • Sell items are EBay, Craigslist or OfferUp
  • Start a blog or youtube channel
  • Clean houses, mow lawns, be a part-time handy person

Financial Philosophy 5:  Don’t stress over timing the market

When investing in the stock and bond markets, my philosophy is this:  You can’t control the market, so why stress about it?  Market timing is a waste of time for 99% of people.   Why try to beat the market ups and downs? Nobody has a crystal ball.  What the 1% of people that have temporarily timed the market successfully aren’t telling you is the ten times they failed and lost their shirt.  
 
Let’s face it.  The stock market is sort of like a giant casino.  The allure of making a 10 to 1 or 100 to 1 home run investment can be exciting.  
 
But thinking about and studying the market won’t change its direction.  Yes you can analyze undervalued companies by combing through financial statements and valuation metrics.  But market pricing is so efficient now that it’s like finding a needle in a haystack.  Your time and energy is probably better spent on side hustles and making more money to invest.
 
Instead of market timing, focus on asset allocation.  Asset allocation means dividing your investments to assets that are negatively correlated.  This means that their values will move in opposite directions during bull and bear markets.
 
A properly allocated portfolio will minimize the risk of losing the value of your investments when markets decline.  Everyone’s risk tolerance is different and there is no right or wrong answer.  Historically, stock and bonds values have moved in opposite directions.  When stocks decline, bond values have tended to go up in price and vice versa.  This is why investors choose allocations like:

  • 90% stocks, 10% bonds
  • 70% stocks, 30% bonds
  • 50% stocks, 50% bonds
 
You get the idea.  I have ignored real estate, cash and other assets in the above scenario for simplicity.  It’s important to remember that there is no guarantee that the past will predict the future, but we can use the past to anticipate and prepare for the future.

Financial Philosophy #6:  Invest in yourself

Saving the best for last.  Perhaps the best financial philosophy is to invest in yourself.  
 
What do I mean by, “invest in yourself?”  I mean investing the time to learn new skills and further your education.  
 
Investing in yourself is also about developing daily habits and routines that make you a better person.  
 
Reach out to people in your community or on social media offering to work for them for free in order to gain real life experience in whatever interests you.  If you like photography, ask a well established wedding photographer if you can hold their camera bag during a few of their bookings.  If you like accounting, ask a local CPA if you can shadow them.   If you want to be a chef, ask a local restaurant if you can clean the kitchen while observing.  You’d be surprised how many people would find this flattering and willing to help. You’d also be surprised how much and how fast you learn a skill that interests you.  This also builds what I call social capital.  
 
The way employers are hiring is changing.  The days of paper or PDF resumes are dying.  Employers want to see real life skills. 
 
Taking action is the first step.  It’s as simple as that.  Baby steps are ok.
 
Investing in yourself in the best recession proof thing you can do.

Conclusion

Strengthen your mindset and make your journey to financial independence a fun one.  
 
1. Avoid DEBT
2. Save, Save, Save
3. Understand the power of compound interest
4. Diversify your income sources...Get side hustles!
5. Don’t stress over timing the market
6. Invest in yourself...skills and education
1 Comment

The 4% Rule:  How much do you need to retire?

5/9/2022

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The 4 percent rule for retirement
The 4% rule for retirement

What is the 4 percent rule?

Are you a millennial looking to FIRE?  Or perhaps a baby boomer looking to quit the rat race?  How much money will you need in your nest egg to make the dream a reality?  The 4 percent rule just might be your answer.

The 4 percent rule is a guideline used to determine the amount of money a person should have accumulated in their nest egg to live on indefinitely.  It was developed by three finance professors at Trinity University in the late 1990s.  The goal of the 4 percent rule is to provide a safe income stream without ever running out of money, even during the worst economic crises.  

Sound too good to be true?  In this article, I’ll dive into the math behind the 4 percent rule, discuss some potential problems, and illustrate some examples using actual market returns.

How much money will you need to retire under the 4 percent rule?  The multiple of 25

How much money will you need in your nest egg?  The easy answer is to multiply your annual expenses by 25.  Under the 4 percent rule, this should be enough to live on indefinitely.   But, life is never easy, so let’s dig in a little deeper.
​
First, figure out your annual expenses.   Add up everything that you spend money on, and I mean everything.  Housing, food, phone bill, vacations...you get the idea.

Once you figure out your annual expenses, multiply the number by 25.  The result will be your target nest egg needed to retire.  For example:
  • If you have $30,000 in expenses, $750,000 should be your target.
  • If you have $40,000 in expenses, $1,000,000 should be your target.
  • If you have $50,000 in expenses, $1,250,000 should be your target.
  • If you have $80,000 in expenses, $2,000,000 should be your target.

These are target goals for your nest egg.  However, I will discuss some drawbacks to this method further down.

You may have other sources of income during retirement, such as Social Security, a pension, 401k, or part time job.  These additional sources of income can help reduce the amount that you ultimately need in your nest egg.

Expense tracking apps

Having trouble calculating your annual expenses?

Apps like mint.com can track your annual expenses automatically if you are willing to sync your credit card or banking account information.

I personally like to charge all my expenses on my credit card, then pay off the balance in full each month.  Most credit card companies have some form of expense tracking software that will break down your expenses and summarize them by category, making it very easy to track your annual spending.  

Let’s assume you’ve reached your target nest egg...What asset allocation should you use during retirement with the 4 percent rule?

Asset allocation is a personal choice based on risk tolerance.  Generally speaking, most people prefer a conservative allocation during retirement to prevent against wild price fluctuations in the market.

Your risk tolerance is up to you.  

Some may prefer the safety of FDIC insured savings accounts and CDs, but don’t expect high returns.  In fact, the 4 percent rule probably even work if you use this method, unless your FDIC insured investments happen to earn over 4%, which hasn’t happened in a long time.

Others may prefer to take on more risk and allocate their investments into stocks and bonds.  Since stocks and bonds tend to move in opposite directions, including both in your portfolio can protect your nest egg during bear markets.   For simplicity, let’s take a look a pretty sensible allocation of 50% stocks and 50% bonds and see what kind of returns you might expect based on past performance and see if the 4 percent rule holds up.

Below is a table showing a hypothetical allocation of 50% stocks and 50% bonds derived from historical total returns from the S&P 500 Index and the 10 year Treasury bond from 2000 to 2018.  Total returns include both price appreciation and dividends/interest. 
Historic stock and bond returns, S&P 500, 10 year treasury yield
Historical S&P 500 and 10 year yield returns
Out of the 19 years shown, there were 7 years in which the market didn’t earn at least 4 percent.  This means that your nest egg would have taken a hit in 7 out of those 19 years.

This brings us to the next question.

Will I run out of money if I follow the 4 percent rule?

The short answer is probably not.  As long as markets continue to perform at historical benchmark, you should be fine.  But historical performance is merely a guideline, not a guarantee.  Anything could happen out of your control.

  • The next great recession could hit and markets crash.
  • Inflation could turn to hyperinflation and prices go through the roof like in Venezuela.
  • A serious medical bill may hit you unexpectedly.
  • You may need a major home repair.
  • A meteor could destroy the earth....you get the idea.

Some of these problems can be mitigated, but problems with the economy are largely out of your control.  So, stressing over future unknowns that are out of your control is really a wasted worry.  Instead, focus on what you can control, like properly allocating your nest egg.

Also, the question of whether you will run out of money depends on what you invest in.  If you have your money sitting in an FDIC insured savings account earning 2% or less each year and withdraw 4%, you run a high risk of running out of money.  Since you would be withdrawing more than you earn, your nest egg would start to diminish.

What are some problems with the 4 percent rule?

Two potential problems with the 4 percent rule are:

1. The 4 percent rule doesn’t account for inflation.  Or does it?
2. Withdrawal amounts may fluctuate with market performance.

Potential problem #1:  Inflation and the 4 percent rule

This first potential problem with the 4 percent rule is inflation.

In short, inflation means rising prices.  Unfortunately for us, the prices of basic needs like food, healthcare, education and housing seems to be going through the roof.  While prices of luxury goods like computers, 4K TVs, and other discretionary purchases are falling.   

If the cost of living rises and prices skyrocket, you may be tempted or even forced to withdraw more than 4 percent.  Doing this poses a real risk of depleting your nest egg.

However, the good news is that any inflation should show up in stock prices.   See, just like food, healthcare, and other living expenses, stock prices go up in value too.  If inflation is going up, so should stock prices.  

Think of it this way, if your portfolio earns 7% per year and inflation runs 2%, your “real” net gain for the year is 5%.  So, assuming you withdraw 4%, your “real” net gain would be 1%.  But, that may not be enough cushion for most.

Below is a table showing inflation rates since 2000.  For each year, you would have to earn at least the inflation rate plus your 4% annual withdrawal just to stay even with rising prices.  For example, in 2007 when inflation was 4.1%, you would have to earn at least 8.1% to stay even (4% withdrawal plus 4.1% inflation).
Historical inflation rates, consumer price index, CPI
Historic inflation CPI rates
Potential problem #2:  Withdrawals and the 4 percent rule 

Another problem with the 4 percent rule is that withdrawals during down years may yield you less income.

Let’s say you started with $1,000,000 in the first year.  For simplicity, let’s say you earned 4% which equates to $40,000.  Under the 4 percent rule, you would withdraw $40,000 at year end.  The net result is that you still have your $1,000,000 at year end.  

Now, assume the market declines by 4% the following year.  Your year end investment is now worth $960,00.  A 4% withdraw from $960,000 equals $38,400, which is short of your $40,000 anticipated withdraw form the previous year.  For those without other sources of income outside of your nest egg, this can cause a real strain, especially if inflation causes a rise in living expenses.

However, the opposite can happen when the market is up.  If the market were to increase the following year by 8%. Then your $960,000 grows to $1,036,800.  A 4% withdraw on this amount would be $41,472.   These fluctuations tend to average out over time.

Historically since 1928, the weighted geometric average of a portfolio invested 50% in the S&P 500 and 50% in 10 year Treasury bonds has yielded around 7%.  Assuming a 4% withdrawal rate, this would theoretically leave you 3% wiggle room for inflation. 

What happens if I retire right before a financial downturn?  Will the 4 percent rule hold true?

As mentioned above, stocks can fluctuate year by year.  What would happen if you decided to retire right before a market crash?  Does the 4 percent rule pose a threat?

Let’s look back to 2000 when the dot com bubble burst and 9/11 caused worldwide financial turmoil followed by a 6 year recovery, then another financial crash in 2008 fueled by the subprime mortgage and banking meltdown.

Where would a hypothetical portfolio of 50% stocks and 50% bonds be today using a 4 percent annual withdrawal rate?  Below is a table showing what would happen if you invested $1,000,000 right before the crash of 2000 and withdrew 4 percent each year throughout the market ups and downs.
4 percent rule for retirement
The 4% withdrawal rate
As you can see from 2000 to 2006, it took 7 years for your nest egg to recoup the losses and recross the original $1,000,000 threshold.  Also, take note of the fluctuations in withdrawal amounts year by year.  

By the end of 2018 your nest egg would have grown to $1,301,931.

Summary

Here’s a quick summary of the 4 percent rule:
  1. Determine your nest egg needed for retirement by multiplying your annual expenses by 25.
  2. Find an asset allocation matches your risk tolerance.
  3. Use 4 percent as a maximum annual withdrawal rate.
  4. Stay flexible and adapt to potential difficulties like inflation and market fluctuations.

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    Daniel is a CFP® with over 15 years of accounting, tax, and financial planning experience.

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