If taxes were a common household game, what would they be?
While your mind may instantly go to something maddeningly random like “go fish” or intensely competitive like poker, it’s really much more of an ongoing and ingenious dance, like chess.
In chess, players function strategically within a complex set of pre-existing rules and parameters—sounds a lot like the tax code, doesn’t it?
Here’s the thing about your taxes, they aren’t a one-and-done sort of financial chore, though that’s how they may appear on the surface. Like chess, there are thousands of different “games” and “boards” that can occur depending on the player’s choices—the same is true for your taxes.
What creative tax choices can you make throughout the year to better your financial situation?
Cue tax planning.
What Is Tax Planning?
You may be wondering what we’re talking about when we say “tax planning.”
Contrary to popular belief, tax planning is not filing your tax return every year in April. Tax planning is a comprehensive long-term process that reduces your total tax liability throughout your life.
When done correctly, this practice can add depth and breadth to your financial picture by helping you pay less in taxes and keep more of your hard-earned money.
So, tax planning is far different from tax preparation.
For starters tax preparation is a reactive process; there is not a whole lot you can do in April of 2022 to impact your tax burden from 2021.
On the other hand, tax planning is forward-thinking and proactive. A good financial planner will guide you through a comprehensive, continuous, and proactive tax planning strategy.
Tax Planning And Investing
Proactive tax planning can impact a significant area of your financial plan, your investments. There are three primary investment “buckets” to understand.
- Pre-Tax Accounts, such as Traditional 401ks and IRAs allow you to contribute pre-tax money that grows tax-free and is taxable upon withdrawal in retirement.
- After-Tax Accounts, such as Roth 401ks and Roth IRAs have you contribute after-tax money that grows tax-free and is tax-free when you withdraw the funds in retirement.
- Taxable Accounts: Unlike their tax-efficient counterparts, these accounts, like a taxable brokerage account, consist of after-tax contributions that will incur additional taxes on realized gains in the account. What you lose in tax efficiency, you gain in flexibility with these investments.
By investing in a mix of all three account types, you expose your portfolio to varying tax treatments, which ultimately brings diversification and flexibility to your financial plan now and in retirement.
Let’s put these ideas in context.
We’ll start with the short-term planning opportunity.
Early in your career, you contributed the maximum amount to your traditional (pre-tax) accounts and put whatever funds leftover into your Roth (after-tax) accounts. Noticing the imbalance, you’ve been concentrating on building up your Roth investments.
Suddenly, you get an unexpected bonus in January that exceeds your expectations. In this case, you may want to reprioritize your pre-tax contributions to lower your taxable income for the current year.
How can these tax buckets help you out in retirement? Take a look at a possible scenario.
Say you have an equal amount of money in each tax bucket when you reach retirement age. The first few years of retirement are busy checking off boxes on your dream to-do list, but after those are complete, you decide you want to work part-time consulting for your previous company.
The income you get from your part-time job pushes you into a higher tax bracket. But you still need to withdraw a couple of thousand dollars a month from your accounts to maintain your standard of living. What can you do?
One option is to withdraw funds from your Roth account. Since the withdrawals are tax-free, doing so gives you the income you need without further increasing your tax burden.
Keep in mind that everyone’s withdrawal strategy will be different and will likely change as you move throughout retirement. The point is that by saving in multiple avenues, you have options and flexibility to make choices that will be optimal for your situation at the time.
How Tax Planning Strategies Can Lower Your Tax Bill
Diversifying your accounts is just the beginning of a high-quality tax planning process. There are several other tax planning tips that can help you as you progress through your life and career.
Here are some of the big ones.
- Adjust W-4 Withholdings: Your W-4 informs your employer about how much they should withhold in federal and state taxes from your paychecks throughout the year. You want to try and match your withholding with your actual tax burden or get as close as possible. You don’t want to pay a massive bill come tax time, but you also don’t want to give an interest-free loan to the government.
- Deploy A Tax Loss Harvesting Strategy: Remember, when you sell investments for a profit in a taxable brokerage account, you’ll have to pay taxes on that amount. Luckily, you can use realized losses to offset those gains. Tax-loss harvesting is selling investments at a loss and using the proceeds to purchase similar, but not identical, investments (while operating within wash sale rule guidelines). Doing so allows you to maintain a similar asset allocation while reducing your tax liability.
- Utilize HSAs and FSAs: Health Savings Accounts, Healthcare Flexible Spending Accounts, and Dependent Care Flexible Spending Accounts allow you to contribute pre-tax money to an account that can be withdrawn tax-free for specific health-related expenses.
- Fund 529 Plans: You fund 529 plans with after-tax dollars. Your contributions grow tax-free and withdrawals remain tax-free for qualified education expenses like tuition, books, and room and board. If you contribute to your state’s 529 plan, you may also be eligible for a state income tax deduction. Some states, like Kansas and Missouri, even give you a deduction if you contribute to another state’s 529 plan.
- Consider A Roth Conversion: A Roth conversion allows you to convert funds from a traditional IRA into a Roth IRA. You will pay taxes on the amount you convert but won’t have to worry about taxes upon withdrawal in retirement. This strategy is great for investors who anticipate being in a higher tax bracket in retirement and/or are in a lower tax bracket than usual in the year of the conversion.
Work With A Professional
Let’s be honest, taxes can feel like a black box—mysterious, complex, and seemingly continuous.
There are endless nuances and intricacies within the tax code, and after a while, you may just want to throw your hands in the air and give up. Far too many people take an “it is what it is” approach to their taxes, which can mean leaving a lot of money on the table every year.
Sure, taxes aren’t the most glamorous thing on your financial to-do list, but strategic planning now may make your life a bit more star-studded come retirement.
At Chladek Wealth, we’re passionate about comprehensive financial planning. We consider your decisions and options from multiple vantage points, including a tax perspective. Unlike other firms, we proactively review our client’s tax returns to identify potential strategies and opportunities.
Are you ready to take your tax game to the next level?
Schedule a call with us today.
The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article. All investment and financial planning strategies involve the risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.