When thinking about preparing tax returns each year, many taxpayers have a binary view about the outcome that looks something like this:
Owe Tax: BAD
Receive Refund: GOOD
While this may be the case if you are living paycheck-to-paycheck and have not accumulated wealth yet, holding on to this perspective after achieving some measure of financial success may limit your potential over the long term.
If you identify yourself in the thought pattern above, it can be helpful to reframe the topic of taxes and consider their actual impact in the context of your financial plan. After all, taxes (like death) will come one way or another. How we prepare, plan, and respond to them will impact not only our nest eggs but also our experiences.
Therefore, we want to frame the issue of tax planning as one of the tools available to effectively build, preserve, and utilize your wealth. In this context, whether you receive a refund or owe money with your return is neither good nor bad; it is simply the outcome of a complex financial life reconciling with a complex US tax code. With this framework in mind, we can focus on what tax planning can really accomplish.
Goals of Tax Planning
Depending on your financial situation, your tax planning goals may include any of the following:
- Minimize lifetime tax paid
- Build tax-free savings
- Avoid underpayment penalties (Meet Safe Harbor)
- Maximize tax-free and tax-advantaged savings accounts
- Limit impact of surtaxes (IRMAA, NIIT)
- Avoid interest-free loans to the government (pay as late as possible)
Why does this matter? Money saved in taxes is money that can continue working for you and your family. This contributes to greater financial security and more flexibility and control to spend, invest, and give as you see fit.
What should you expect? About 65% of taxpayers received a refund last year. Success breeds complexity. As you build wealth and generate income from a variety of sources, you are more likely to see variations in your annual refunds or balances due. You may more frequently owe money with your tax return. If you are working toward the goals above, owing a balance due should not be a cause for concern. The more complex your financial situation and the more changes you are experiencing, the more likely you may also be to face a surprise.
Common Life Events That Cause Surprises
Any of the following life events can lead to tax surprises:
- Changes in income
- Mid-year job changes
- Children turning 17
- Retirement
- Starting Social Security
- Taking withdrawals from retirement accounts
- Selling long-held stock positions
- Starting a business
- Becoming a shareholder in a small business
- Death of a spouse or loved one (inheritances, income changes, etc.)
- Getting married
- Getting divorced
Avoid Common Pitfalls
There are a few common tax pitfalls that you can try to avoid:
- Under contributing to retirement accounts (401ks, IRAs, Roths)
- Over/under withholding
- Making withdrawals from inefficient sources
- Missing valuable tax credits (education, etc.)
- Lack of tax-minimization strategies during market declines
Tax Strategies to Consider
There are also some strategies you can use to help you make the most of your assets over time:
- Roth conversions
- Tax loss harvesting
- Back Door Roth
- Tax-efficient asset location
Take the Long View When It Comes to Tax Planning
Many of us feel dread or frustration when writing checks to the federal government above and beyond what was already withheld from our incomes throughout the year. This is completely normal. Owing taxes is a side effect of financial success and one that we can work to bring into perspective. When we feel frustration, anger, or other strong emotions during tax season, it can be helpful to review where we are, where we have been, and where we are going in relation to our financial plans.
A large tax liability in dollars may still be a lower percentage of your income in relation to what you are likely to pay in the future. This can seem counterintuitive but it is a positive for your long-term financial plan.
If you have questions about reducing your lifetime tax liability and maximizing your financial plan, our financial advisors and tax team are here to help. Please don’t hesitate to contact us.
