The Truth About Deductions – You Keep What You Don’t Spend

Courtesy of Tax TimeI still receive a good amount of advice from colleagues, friends, and family that it’s okay to buy a service or product because I can deduct it as a business expense.

Business deductions are great if you own a business. Small business owners have a great deal of flexibility in terms of deductions. Essentially any purchase or expense related to the business can be included: mileage driven to work, desks, computers, postage, utilities, rent…etc. The purpose of deductions is essentially a tax credit against your profits.

A simple example is that if you earn $100 but incurred costs of $80 in order to earn that $100, you only have a tax liability of $20. This amount is quite huge if your marginal tax rates are high, which is typically the case for most high earning individuals. The U.S. tax laws are quite generous to small business owners and allow many options for a business to succeed. For expensive equipment, you can opt for a Section 179 to depreciate items over a number of years. If you are going to spend the money anyway, you might as well take advantage of these benefits.

 

 

Deductions are not for everyone.

Unfortunately, the majority of doctors are shifting towards salaried positions, which means that we receive our income through W-2 payments. As an employee, your ability to deduct your expenses is dramatically less than that of a business owner. Expenses for employees can only be itemized if they exceed 2% of your annual gross salary! Even then, you can only expense the amount that exceeds 2% of your income. For an employed physician who grosses $200,000 a year, you can only deduct the amount over $4,000. Let’s say that you went to one CME meeting and spent $5,000 on all expenses, and that your marginal federal tax burden is 35%. Essentially, the government will consider that you made $1,000 less in income, thereby “saving” you $350 in taxes. Okay, by spending $5,000, you “saved” $350 in taxes.

The math is better than having no deductions, but does that impact your spending decisions? Did you have to attend that particular meeting? What if you spent only $3,000 at the same meeting (stayed at a less fancy hotel, and ate cheaper food)? At a gross salary of $200,000, you don’t meet the 2% minimum requirement for deductions. However, you spent $2,000 less than you could have otherwise and also paid tax on the amount that you kept.

In scenario #1 ($5,000 meeting), you spent $5,000 and paid taxes (likely marginal) on $4,000 (the amount less than 2% of your income) of it.

In scenario #2 ($3,000 meeting), you spent $3,000 and paid taxes on $3,000 of it. However, you are “ahead” $2,000 from the amount that you didn’t spend. At a 35% marginal tax bracket, you still end up with an extra $1,300 to spend on other things.

Understand your goals.

Everyone is going to have different goals. If spending only $3,000 at a meeting would make you miserable, then you might as well spend $5,000 to enjoy your hard-earned money. Otherwise, you might be better off roughing it with $3,000 at the meeting, and putting the $1,300 you save towards your kids school tuition or a nice vacation.

What are your thoughts on deductions?

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(Photo courtesy of Tax Time)

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