I know, I know, we just finished the worst season of the year – Tax Season, but it’s never too early to start planning for next year’s taxes.
Tax planning is a crucial part of any financial plan, yet it is surprisingly often overlooked. Especially when we meet new clients, we often find that they’ve hardly spent the time necessary to properly prepare for taxes.
What most people don’t realize is that over your lifetime, Uncle Sam will be your biggest expense. You’ll pay more to him than to the bank for your mortgage, than to any car company, or to any university your children might attend.
In some cases, it could be $1 million or more that you pay to Uncle Sam, your state, and your locality over a lifetime. No wonder tax planning is important.
The first part of any tax planning is to understand how taxes actually work – they aren’t just something that you deal with once a year.
They influence many aspects of your financial plan:
- How you invest
- When you sell
- How you structure income
- And most importantly, how much you keep.
Let’s get into how your taxes work.
- Not all your income is taxed the same –
Our tax system is progressive. Just because you reach a higher tax bracket doesn’t mean that higher rate is the rate that you’ll pay on all your income.
Your first dollars are taxed at lower rates; only income that exceeds the tax bracket threshold is taxed at higher rates.
Here’s an example:
If you move into a 24% bracket, only the income above that threshold is taxed at 24%. The 24% rate doesn’t apply to every dollar of income you earn.
It’s like climbing a staircase.
If you earn $100,000, your income is taxed in layers:
- First portion at 10%
- Next at 12%
- Next at 22%
- Next at 24% and so on
- The importance of time and taxes –
The more time you own your investments in your mid-term bucket (i.e., a taxable brokerage account), the less you’ll pay in taxes.
Example:
- Own your investment for less than 12 months? You’ll be subject to Short-term capital gains (STCG) on any profits. STCG is taxed as ordinary income (the rate that you pay on your income)
- Own your investments for longer than 12 months? Then you’ll pay Long-term capital gains (LTCG) (at a typical rate of 15%) on any profits.
Same investment, different outcome.
Patience isn’t just a virtue – it’s a tax strategy.
- Tax Deductions and Tax Credits DO NOT work the same.
Probably the most understood aspect of our tax system.
- A deduction is a dollar-for-dollar reduction of your taxable income.
- A tax credit is a dollar-for-dollar reduction on your tax bill.
A $10,000 deduction might save you $2,400 if you’re in the 24% tax bracket.
A $10,000 credit saves you the full $10,000.
That’s a big difference!
- Look beyond this year.
Sometimes the best tax strategy isn’t about saving taxes today, but rather mitigating future tax liabilities that could see you pay significantly more taxes in the future.
Let’s take two investors, we’ll call them Tom and Jane. Tom and Jane each earn $150,000/year:
- Tom uses a pre-tax account to save on his taxes today.
- Jane prefers to use after-tax accounts (i.e., Roth accounts) and pays taxes now.
Years later, if Jane’s income is higher and if tax rates increase, then Jane may come out ahead of Tom because of her tax-free Roth distributions.
It’s not a question of saving taxes right now, but rather of maximizing our tax savings over the next 10, 20, or 30 years.
I see this one a lot with small business owners.
Spending money because they can “write it off” their taxes.
Let’s say a business owner buys a new car for their business:
- Buy an $80,000 vehicle.
- Write it off as an expense of the business.
Yes, you save $25,000 in taxes, but you’re still out $55,000.
Yes, write-offs help, but they aren’t the tax panacea that everyone makes them out to be.
- In most cases, using the standard deduction makes the most sense.
Most taxpayers don’t realize that in 2018, the standard deduction nearly doubled overnight because of the Tax Cuts and Jobs Act.
Because today’s standard deduction is so much higher, the benefits of itemizing for things like mortgage interest, charitable contributions, or SALT (State and Local taxes) have been reduced.
Itemizing today isn’t likely to have the kind of impact as in previous years.
The bottom line here is that taxes matter. Ignore them at your peril, and risk paying thousands (if not tens or even hundreds of thousands) more than what you are legally obligated to pay.
Uncle Sam will be more than happy to tell you what you owe, but don’t expect him to go out of his way to help you reduce your tax bill.
That’s up to you.
Stay the course, my friends.