“In this world nothing can be said to be certain except death and taxes.” – Benjamin Franklin
Everyone gripes about taxes. Rich, poor, or middle class- nobody wants to pay them. But what I’ve noticed during the process of building hundreds of ﬁnancial plans is that for most people, tax planning really doesn’t go beyond looking for easy current tax deductions and potentially opening a tax-advantaged account.
My opinion is that tax planning is one of the most overlooked components of building wealth, but before I go into some strategies we have to get through the basics.
One of the most valuable things to understand about taxation on earned income is that we have a marginal tax system. This might seem elementary, but you’d be surprised how many times I’ve been told by someone that “I make less money the more I work”. This just simply isn’t true. Our tax system means that before any deductions, personal situations, or strategies are taken into consideration, everyone pays the exact same amount in taxes on their ﬁrst $10,000 whether they make $100,000 or $1,000,000 per year. Where progressive tax brackets come into play is when the additional money you earn causes your next dollar to be taxed at a higher rate than the last one you earned. For example, if you pick up a $100 job that moves you from the 25% tax bracket into the 28% tax bracket, it means you’re paying $28 of tax on that $100 instead of $25. It has nothing to do with any of your dollars earned while you were in the 25% tax bracket.
This is very important to understand when it comes to tax planning because tax deductions are applied to your highest taxed dollars. This means that the higher your tax bracket, the more valuable each deduction is because tax deductions can move you down a bracket by eliminating your higher bracket income. For example, if the last $1,000 you earned put you into the 28% tax bracket, putting another $1,000 into your 401(k) or IRA would eliminate that income in the eyes of the IRS saving you that $280 in taxes you’d otherwise owe on that money.
Another valuable thing to understand about taxes is that all income/growth is taxed equally. One of the most common things I see is people focusing on trying to get their money to grow (investing) without paying attention to how that money is taxed. The reason why understanding that you can control how you’re taxed is important is because it can mean significantly more in your pocket for the same initial investment.
Many people try to minimize tax diversiﬁcation to retirement accounts and never really get beyond that. It’s become a decision about whether to invest in a Roth 401(k) versus a 401(k) or any other tax-free versus tax-deferred retirement account, * and once it’s made most people never look back. But that kind of oversimpliﬁcation when it comes to diversiﬁcation for taxes can really cost you. Really, there are so many different levels of tax diversiﬁcation that can happen in your ﬁnancial life from incorporating real estate into your investment strategy to buying stocks in a brokerage account to hold long-term to using the cash value of a life insurance contract as an asset. Which is the best thing to use? Often, the answer can be all of them to different degrees. The Roth 401K and Roth IRA offer tax deferral on any earnings in the account. Withdrawals from the account may be tax-free, as long as they are considered qualified. Limitations and restrictions apply. Withdrawals prior to age 59 or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth 401Ks and IRAs. Their tax treatment may change.
Tax-deferred account withdrawals, such as traditional 401K and IRA, are subject to income taxes, and if made prior to age 59 1/2, a 10% penalty tax may apply.
The key in what types of accounts to use and what types of investments to use (both traditional and non-traditional) based on your goals, your risk tolerance, your lifestyle, and your tax bracket. Even changing how you receive income as an entrepreneur can determine how much money you keep in your pocket for the same revenue.
The bottom line is that taxes eat away your returns both on your time at work (or in your business) and on your investments. It doesn’t matter how much money you make or how high the returns on your investment are- this is a fact. Even worse, the more money you make and the bigger your returns, the bigger your tax bill if you aren’t maximizing your tax planning.
Taking a good hard look at opportunities to incorporating smart tax strategies into your planning isn’t just important because on the surface you have extra dollars in your pocket (although more money to spend is pretty awesome). Saving money on taxes by being strategic about how you’re earning money and how you’re investing it means you could have more to invest, which means more compounding and potential for growth, which means your money working harder for you while you’re sleeping.
In my experience, many CPAs and accountants don’t go in-depth enough with tax planning for individuals and very small businesses because they’re not getting paid to. They’re getting paid to ﬁle your tax returns and help you understand what you can currently deduct. Some accountants might suggest a client consider making retirement contributions or open a retirement account if they notice during the ﬁling of the returns that there are no contributions to report. They might even suggest an entrepreneur who starts making more money change their business status to save money on taxes. Many of my clients have never had their accountants make these suggestions, and I’ve had several in my years in business who never initiated these conversations- I had to.
The truth is, if the extent of the overall tax advice you’re getting is to put some money in a retirement account or change your business status- you’re likely missing out on money. This doesn’t mean you should ﬁre your accountant-after all, they are probably not being paid to be your tax advisor, they are just filing your returns. But, it does mean you probably need a ﬁnancial planner who incorporates tax strategies, and who will be having some crucial conversations with you. Now might be a good time to reach out to your accountant and to your financial planner and ask each of them if there are any tax opportunities you two haven’t discussed that you should consider. If you don’t have these people in place, you likely should.
Investing involves risk including loss of principal. No strategy assures success or protects against loss, and investments and strategies mentioned may not be suitable for all investors. Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual, nor intended to be a substitute for specific individualized tax advice.
Money Basics Series
Although there are certain basic financial rules of thumb that many people can agree make sense at face value (like “a house is always good investment”, “you should try to save as much money as you can for retirement”, and “you should always spend less than you make”), making financial decisions solely based on these rules of thumb is probably not going to help you maximize your money and can actually cost you big time long term if this advice isn’t in line with your personal goals and values.
That being said, after working with hundreds of clients, we realize that there are certain beliefs and fundamental principles we operate off of at Peterkin Financial that color the way we look at planning and consequently the way we advise our clients. Client goals and values followed by data and numbers always trump general rules of thumb, but we feel it is important to share them just the same. So we’ve decided to create a blog post series of what we’ve coined “Money Basics” so you can better understand our perspective as a planning team.