Keep It. You Earned It.

If you’re like most business owners and professionals, you think of every dollar as being the same as every other dollar. In truth, there are two kinds of dollars – before-tax dollars and after-tax dollars.
After-tax dollars are real dollars; when you spend them, each is worth 100 cents. Before-tax dollars are different. While they may look the same on paper, a before-tax dollar is an illusion; it’s worth less than 100 cents. How much less depends on your tax bracket – and how well you do your homework.
While there is no practical way to escape taxes entirely, there are some simple approaches to investing that can help you to increase those valuable after-tax dollars in 2009.

1. Maximize your tax-deferred retirement account early. Don’t wait until tax filing time to fund your retirement account. If you have the cash, making the maximum allowable deposit into your 401(k) or IRA as early in the year as possible not only reduces your tax load, it also adds months to the tax-deferred compounding of your investment.

If you haven’t yet set up a retirement account, now is the time to take action. The latest increases in allowed contributions to pension plans offer important tax advantages. The 401(k) contribution limit was raised to $16,500 for 2009.

The “catch up” provision has also been increased. Anyone past the age of 50 is allowed the $16,500 plus a “catch up” of $5,500 for a total contribution of $22,000. 
If you can’t make the maximum contribution, make the highest contribution your finances permit.

2. Allocate your assets correctly. It’s important to make sure you hold the right kinds of investments in each of those accounts. Some types of assets can be classified as tax-inefficient, others are tax-efficient. It makes sense to allocate your tax-inefficient assets to tax-deferred accounts such as your 401(k) or IRA, thus deferring taxes as long as possible. Tax-efficient assets are best held in regular taxable accounts.

Some examples of tax-inefficient assets are corporate bonds, which produce fully taxable income, and the typical actively managed equity mutual fund.

Prominent among tax-efficient investments are municipal bonds. Also, some mutual funds are specifically managed to be tax-efficient; they will usually be promoted as such. Examples would include most index funds, specifically broad-market and large-cap index funds. These funds tend to have less turnover of the equities within the funds and thus generate less taxable capital gains.

3. Put the kids to work. By putting your children to work in your business, you convert their personal allowance into deductible compensation. And it gets better: If your children are under 18 and work for your unincorporated business or professional practice, you need pay no Social Security or Medicare taxes on their earnings. You can pay them $4,400 each and then make Roth IRA contributions for them in the same amount.

Since you’re giving the kids an allowance anyway, putting them to work in the business allows Uncle Sam to help fund that expense. Obviously, the work done must be reasonable for the business, but it doesn’t have to be technical or professional in nature.

These are just a few examples of opportunities to reduce your income tax obligation. Maximizing those precious after-tax dollars requires a little early planning and effort on your part, but the time you spend chipping away at your income taxes may be the most profitable investment you make this year.

The author is a freelance writer based in Abington, Pa., with 40 years of experience in business management and personal and business financing.