Last month I discussed how farmers with excess money could reduce their taxes by giving money to their children and grandchildren with cash or grain gifts.
• Before investing off-farm, consider your working capital needs.
• Use retirement plans to gain financial diversification as well as tax advantages.
• HSAs and 529 plans are tax-advantaged investment vehicles for nonfarm funds.
Over the last few weeks, I have been asked by producers about other ways to make use of extra funds. Many farmers are fortunate to be in a low-debt situation. They have upgraded their machinery line and storage facilities, and they have extra money to put to good use outside of their farming operation.
When formulating a plan to put excess cash to work, the first step is to determine how much excess cash can safely be taken out of the farming operation.
In order to do this, farmers need to make a determination of how much working capital they need to balance their risk from a drop in income.
Working capital is defined as the difference between current assets, which are cash or those assets that will be converted into cash within 12 months, and current liabilities, which are those debts that need to be paid in the next12 months.
Current assets include grain, livestock held for sale, growing crops, and accounts receivable and prepaid expenses.
Current liabilities include operating debt, accounts payable, and those payments to be made in the next year on long-term debt.
Probably the best way to measure working capital needs is to compare working capital to annual gross income. Most financial analysts recommend $1 of working capital for every $4 of gross sales.
Thus, farmers with a working capital that is lower than 25% of gross sales probably should reconsider pulling money out of their farming operation.
One good option for use of excess cash is funding a retirement plan.
IRAs are the most well-known retirement plans. Traditional IRAs provide a tax reduction in the tax year they are funded and are taxable when they are withdrawn.
SEP IRAs and Simple IRAs are flavors of the IRA family, and they are especially designed for farms and small businesses.
All types of IRAs have different limits on annual funding, as well as different requirements for employee contributions.
Roth IRAs are another well-known retirement plan.
Roth IRAs differ from traditional IRAs because they are funded with after-tax money. However, the income earned by the Roth IRA compounds tax free, and no tax is due at withdrawal.
For 2010, Roth IRAs are permitted for single taxpayers with adjusted gross incomes less than $120,000 and married folks with earnings below $177,000.
Farmers who are ineligible because of high incomes should probably consider deductible retirement plans.
Health savings accounts
Health savings accounts have become very popular.
The owner of an HSA is allowed to deposit funds in an income-earning account and deduct the contribution from his or her tax return.
Although these funds can be used to pay out-of-pocket medical expenses tax free, the account balance can also be carried forward into retirement years when income is not quite so plentiful.
In 2011, a taxpayer with family insurance coverage can set aside $6,150 in an HSA, $7,150 if the owner is age 55 or older.
Saving for college with 529 plans
In previous columns I have explained the advantages of 529 plans, which are established to provide college funding for children or grandchildren.
Although they are funded with after-tax dollars, the accounts grow tax free and distributions are tax free if the beneficiary uses the distributions for college expenses.
Contributions are considered gifts, and, therefore, are limited to $11,000 per year. Excess gifts are exposed to gift tax. However, 529 plans allow up to five annual gifts to be made in one year, effectively allowing a one-time gift of $55,000 to each account.
If the 529 plan is owned by a grandparent, the plan’s assets do not reduce eligibility for the grandchild to receive financial aid. However, distributions from the plan will need to be counted by the student as income when applying for financial aid.
As always, consult with an experienced tax adviser before proceeding.
Anderson is a farm financial management consultant in Redwood Falls. E-mail him at email@example.com.