Financial and tax planning can feel a bit ambiguous at times. There are quite a few assumptions that need to be made about your financial future. What will your income and expenses be in retirement? What growth rate can you assume in your portfolio? How much of your income will social security really replace?
While you may not be able to control everything about your financial situation, there is one area where you can take charge immediately.
Taxes.
Proactive tax planning can instantly elevate your overall financial plan.
Here’s how.
Tax Preparation vs. Tax Planning
It is very common for people to believe that filing a tax return is the same as tax planning. In reality, they couldn’t be more different.
Think about it this way. When you visit your CPA during tax time each year, what are the conversations like?
This process often consists of providing your accountant with information about the past (W-2s, 1099s, 401(k) contributions, mortgage interest, property taxes, etc.). There is only so much your accountant can do to reduce your tax burden at this stage. In practice, their job is mostly to ensure that you file properly and don’t get dinged by the various taxing authorities.
When we say “tax planning”, we mean taking proactive steps to manage your tax burden not just throughout the year, but for your lifetime. Quality tax planning will consider ways to limit your tax liability now and in the future.
This is not a one-time meeting or pile of papers. Tax planning is an ongoing process that is deeply integrated with your overall financial planning strategy.
Invest with Taxes in Mind
When it comes to investing, you have some options for how you want to manage your tax burden.
- Pre-Tax Accounts: In their simplest form, these accounts allow you to contribute pre-tax money to an account and earnings will grow tax-free until distribution. Examples include traditional 401(k)s and traditional IRAs. When you withdraw from these accounts in retirement, all contributions and earnings will be taxed as income. The advantage is decades of tax-deferred growth. As a bonus, if your employer offers a matching program, their tax-deferred contributions will help cover your tax bill when you retire.
- Post-Tax Accounts: Often referred to as “Roth”, these accounts allow you to contribute after-tax money to an account and let it grow tax-free forever! Examples include Roth 401(k)s and Roth IRAs. Qualified withdrawals aren’t taxable in retirement or included in your AGI, which can bring more flexibility to your distribution plan.
- Taxable Brokerage Accounts: Finally, there’s a typical brokerage account. Unlike most retirement accounts, you can withdraw from these accounts at any time without a penalty. They are subject to more preferential tax rates and have the ability to offset gains and losses. The brokerage account offers advantages when passing assets to your heirs. Your benefactors will get a ‘step-up’ in basis to the value at the date of death and can be sold with NO tax consequences.
So how do you decide which buckets to invest in? Unfortunately, there is no short, or one-size-fits-all answer. This decision is unique to you and you will want to consider your overall investment strategy in conjunction with the tax implications.
Tax Planning Tips to Consider
Here are a few things to think about:
- Is your income much higher or lower today than it will be in the future?
- If you know your income will drop significantly down the line, it may be advisable to contribute more to traditional tax-deferred accounts. The opposite is true if you believe your income will be much higher in the future. If that is the case, you may want to focus on Roth contributions.
- How much do you value access to your money?
- For most retirement accounts, you can not access your funds without penalty until after age 59.5. If you have an early retirement goal, taxable brokerage accounts may be the way to go.
- Having flexibility in the future is a major benefit.
- If you have a combination of traditional, Roth, and taxable brokerage accounts, you will always be able to efficiently manage your tax burden. Having the ability to manage your bracket, control your “income”, and stay dynamic as the tax scene changes will be a strength in your plan.
Level Up Your Investment Strategy With A Tax Plan (Now & In Retirement)
Now that you have the basics down, what are some of the other strategies you can use to reduce your tax burden?
- Tax Loss Harvesting: This is the process of selling certain investments in a taxable brokerage account at a loss to offset a current or future capital gain. This can be a tricky process to implement and you need to be sure that you stay within the legal guidelines to avoid wash sale rules. If done properly, this will help you manage your tax bill when it comes time to take profits.
- Flexible Retirement Contributions: Deciding between traditional and Roth contributions is not a set it and forget it decision. For example, maybe your income is much lower this year because you took some time off. In this scenario, you may want to contribute more to a Roth account (pay taxes now instead of in the future). On the other hand, you may realize that your spouse is about to retire early and your future income will be much lower. If that is the case, contributing to a traditional account may be advisable (reduce your tax burden today and pay taxes in the future).
- Flexible Withdrawal Strategies: As we discussed earlier, having a flexible strategy during retirement can be critical. The ability to choose from a mix of taxable, tax-deferred, and tax-free income sources can have a significant impact on your taxes. Phase-out rules, benefit premiums, deductions, and credits are all affected. Tax rates and laws are changing constantly and having multiple options will help you navigate ever-changing policies and insulate your plan against dramatic changes.
Tax Planning Can Help You Avoid Costly Mistakes
Quality tax planning balances the implementation of proactive strategies and helps you avoid costly mistakes. Consider these costly tax planning mistakes:
- Timing the Sale of Appreciated Securities: Taxable brokerage accounts are taxed based on capital gains rates. If you sell an investment with a large gain, you are going to owe taxes based on short-term (for securities held for less than 1 year) or long-term (for securities held for more than 1 year) capital gains rates. It is important to understand these implications before making a sale.
- Missing RMD Requirements: Traditional IRAs and 401(k)s have required minimum distribution (RMD) obligations while in retirement (based on your age). If you fail to take the proper RMD, you could owe as much as a 50% penalty!
- Improper Withholding: If you are not withholding the proper amount of taxes throughout the year, you may have a substantial liability when tax season rolls around. For employees, this is typically reconciled via your W-4 elections. For self-employed individuals, you may have to pay tax estimates throughout the year.
- Not Considering your Estate Plan: Tax planning and estate planning go hand-in-hand. It is critical to understand how all of your accounts relate to your Will or Trust. Not all accounts are treated the same when it comes to transferring assets to your heirs.
The Bottom Line
As you may have noticed, there are quite a few things to consider when it comes to proactively manage your tax situation.
Which investment accounts should you use? How can you manage your taxes in a taxable brokerage account? How much is your RMD? Are you withholding enough throughout the year? What types of accounts are best for transferring wealth to your family?
At Bienvenue Wealth, tax planning is at the forefront of our financial planning process. We have decades of experience helping our clients reduce their tax burden now and in the future. Don’t let a lack of tax planning derail your financial future. Schedule a time to talk with our team and learn how we can help.