If you are affluent or will be in the future, taxes are or will become one of your biggest expenses — maybe the biggest. And probably getting bigger, depending on how much of President Biden’s tax plan gets through Congress.
While some people claim they would love the opportunity to pay more to Uncle Sam, I’m betting you are not one of them.
If I’m right, this column is for you. It explains what tax planning really means, and why you should care. Here goes:
What is tax planning?
Tax planning is the art of arranging your financial affairs in ways that postpone or avoid taxes. In the context of this column, I’m talking about federal income taxes. By employing effective tax-planning strategies, you can increase cash flow and have more money to spend, save and invest. I think that’s a good thing.
Put another way, tax planning means deferring and/or avoiding income taxes by taking advantage of beneficial tax-law provisions, increasing and accelerating deductions and credits, and generally making maximum use of tax breaks available under our beloved Internal Revenue Code.
While the federal income-tax rules are now more complicated than ever, the benefits of good tax planning are probably more valuable than ever.
This goes without saying, but let’s say it anyway: You should not change your financial behavior solely to avoid taxes. Truly beneficial tax-planning strategies are those that permit you to do what you want to do while reducing tax bills along the way.
Tax uncertainty adds to the challenge
For 2018 to 2025, the Tax Cuts and Jobs Act (TCJA) cut federal income-tax rates for most individual taxpayers. But with ongoing huge federal budget deficits exacerbated by the pandemic and with Biden’s tax-increase proposals, who knows how long the TCJA rate cuts will last?
While I think some of Biden’s proposed tax increases won’t get through Congress, some might. High-income folks in general, high-income investors, and investment real-estate owners are most likely to be impacted.
What is financial planning?
Financial planning is the art of identifying and implementing strategies that facilitate reaching your financial goals, be they short-term or long-term in nature. While this concept seems simple, its execution can be more complicated.
How do tax planning and financial planning intersect?
Tax planning and financial planning are closely linked, because taxes are such a large expense as you go through life. In fact, if you become really affluent, you will probably find taxes to be your biggest single expense. Therefore, planning to reduce taxes is a critically important piece of the overall financial-planning puzzle.
What happens if you ignore taxes?
I am continually surprised by how many people fail to get the message about the importance of tax planning until they commit an expensive blunder. Then they finally get it! The trick is to avoid learning this lesson the hard way. To illustrate, consider the following fictional examples:
You are a 40-year-old professional. You consider yourself to be financially astute, but are not well-versed on taxes. One day, you meet the love of your life. Shortly thereafter, you get married.
Before the wedding, you sell your home, which has appreciated by $500,000 since you bought it. You intend to move into your new spouse’s home, which is a dump. However, you are a proven genius at remodeling, and you think you can work your magic on the property. Fair enough.
Result without tax planning: For federal income-tax purposes, you have a $250,000 taxable gain on the sale of your home ($500,000 profit minus the $250,000 federal home sale gain exclusion for an unmarried taxpayer).
Result with tax planning: If you had kept your home and lived there with your new spouse for two years before selling, you could have taken advantage of the much-larger $500,000 home-sale gain exclusion for married couples. That would have permanently avoided $250,000 of taxable gain. If necessary, you could have sold your new spouse’s home. Or you could have kept the place and remodeled it while living in your home for the requisite two years after the marriage.
Conclusion: Tax considerations aside, selling your home probably made good sense. However, selling without considering the tax-smart alternative probably cost you at least $50,000, due to a completely avoidable $250,000 gain taxed at an assumed combined federal and state rate of at least 20%. That $50,000 tax hit (maybe more) is a permanent difference, not just a timing difference. Ouch!
The point is, if you ignore taxes, bad things can happen — even with seemingly sensible transactions.
You leave your job to go work for a different company. You have $200,000 in your 401(k) account with the old company. You want to drain the 401(k) account and roll all the money over tax-free into an IRA. That way, you’ll have complete freedom to manage the money as you see fit.
Result without tax planning: You arrange to receive a check from the 401(k) plan made out in your name. When you get the check, you are surprised to discover that it’s for only $160,000 instead of the expected $200,000.
Why? Because 20% was automatically withheld for federal income tax. This is mandatory when the check is made out to you personally. Ugh! Now you cannot accomplish a totally tax-free rollover unless you somehow come up with the “missing” $40,000 and deposit that amount — along with the $160,000 you have in hand — into your rollover IRA within 60 days.
Say you fail to raise the $40,000. As a result, you’re taxed on that amount because it was not rolled over. Plus, you’ll owe the federal 10% early-withdrawal penalty tax on the 401(k) withdrawal if you’re under age 55. In most states, you’ll also owe state income tax.
Assume the total tax hit on the $40,000 that’s not rolled over amounts to $16,400: $40,000 x (24% federal income rate + 10% federal penalty tax + 7% state income tax rate) = $16,400.
Result with tax planning: You arrange to receive a check from the 401(k) plan made out in the name of the trustee for your rollover IRA, or you arrange for an electronic transfer of funds from the 401(k) plan into your rollover IRA.
Either way, you accomplish a so-called trustee-to-trustee rollover. Such rollovers are exempt from the automatic 20% federal income-withholding rule. So your rollover IRA receives the full $200,000, and you successfully accomplish a totally tax-free rollover with no muss and no fuss.
Conclusion: Aside from not knowing about a tax detail that turned out to be important, your rollover made good sense. However, by doing the rollover “the wrong way” instead of “the right way,” you cost yourself $16,400 in completely avoidable taxes. Of that amount, $4,000 is a permanent difference (the 10% penalty tax) and not just a timing difference. Ugh!
Again, the point is that bad things can happen if you ignore taxes — even with seemingly sensible transactions.
The bottom line
Tax planning is important and worth the effort — especially if you have a lot at stake and even more so if tax rates are headed up, which seems almost certain sooner or later.
The preceding examples are very simple situations that you may already know how to handle. Other situations are more complicated, and you may need professional advice to get the best tax results. In any case, we will do our best to help you out with tax-planning strategies in today’s uncertain environment. Please stay tuned.