Tax Planning - Total Wealth Planning

Tax Planning

What is Tax Planning?

Tax planning typically involves strategies to minimize your income tax liability. For instance, deferring income, maximizing deductions and selecting tax advantaged investments. Contrary to normal tax reduction planning, Total Wealth Planning has, in certain instances,increased taxable income for many of our clients. If you anticipate higher income tax rates or income in the future, then increasing certain types of taxable income in a current year may save significant taxes in future years. This could be accomplished by generating long term capital gains income, or possibly converting a traditional IRA to a Roth IRA.

You must look beyond just the tax preparation to maximize deductions. Proactive tax planning throughout the year is the key to reducing taxes and maximizing your after-tax dollars for wealth accumulation. This is accomplished by applying changing tax laws to your specific situation.

See below to learn more about Asset Location Strategy, Ordinary, Income, Capital Gains and Qualified Dividends, Tax-Exempt and Tax-Deferred Income.

Asset Location Strategy

Understanding which account to hold various asset classes in is important to effective tax planning. Depending on the type of investment, the asset class can produce income as defined by the IRS. It may be considered ordinary, capital gains and qualified dividends, and tax exempt income. We strive to place these asset classes into the accounts with the most favorable tax implications.

Ordinary Income

Investments often produce income that can be subject to different types of tax rates. Interest income from savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock, and certain dividends are subject to ordinary income tax rates. These are based on a taxpayer’s marginal bracket, which is typically much higher than long term capital gains rates.

Capital Gains and Qualified Dividends

Taxpayers in the 15% and 10% marginal brackets will continue to pay 0% on longterm capital gains and qualified dividends. Taxpayers in the 25%-35% marginal brackets will be subject to 15% tax on long term capital gains and qualified dividends. Those taxpayers in the highest 39.6% marginal bracket will be subject to a 20% tax on long term capital gains and qualified dividends. Keep in mind those taxpayers subject to the 20% tax rate will find their net investment income subject to the new 3.8% Medicare surtax.

Tax-Exempt Income

This is income that’s free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.

Tax-Deferred Income

Certain income whose taxation is postponed until some point in the future is referred to as tax-deferred income. For example, in a 401(k) retirement plan, 403b plan, or traditional IRA, earnings are reinvested and taxed only when withdrawals from the plan are made. The income earned in these types of plans is tax deferred.

More times than not after reviewing a new client’s tax returns, it is pretty evident of the lack of tax savings strategies.  Tax planning is not done in April when tax returns are filed.  Tax planning is a process that is done throughout each year.

Here is the latest example:  Client who is retired and working part time had adjusted gross income (AGI) of $7,000 after deductible IRA contributions of $5,500 for each taxpayer and spouse.  After itemized deductions of $40,000 and exemptions of $15,600 their taxable income was negative ($48,000).  This is an example of what we refer to as “wasted” deductions.

This is one of the worst examples of no tax planning and how it cost the client real money. Here’s why: in this particular year, the taxpayer would have qualified for a Roth IRA contribution.  Roth IRA’s are not deductible but all future growth in the Roth IRA can be withdrawn tax free in retirement.  Even by making the Roth IRA contributions instead of deductible IRA contributions, the taxpayer still would have had income of ($38,000), thus no tax impact!

There are number of other tax planning strategies that could have taken place in the year to use up the “wasted” deductions, but go beyond this short blog.

Assume the $10,000 of IRA contributions grows at 8% for 20 years.  Both the regular IRA and the Roth IRA could grow to approximately $46,000.  However, the withdrawals from the Roth IRA are completely tax free, while the withdrawals from the regular IRA are taxable at ordinary income tax rates.  At a 25% tax rate that is $11,500 of taxes that would be unnecessarily paid because of the tax preparer not taking the time to review the tax return and think through the recommendation.

Financial planning and investment management requires the guidance of a trusted and experienced advisor, such as a fee-only Certified Financial Planner™ (CFP®).

Click here to learn more about how these tax planning strategies can save you money, or contact Rob Lemmons, CFP®, CPA, AIF, CEPA at 513-984-6696 or via email.