What’s the Ben Franklin quote? Nothing is certain but death and taxes? Granted, the quote seems a bit morbid, but the reality is that when it comes to taxes, many people simply think, “it is what it is.” They are obligated to report their earnings to state and federal governments but often don’t think about tax planning beyond that. And this is unfortunate, because U.S. taxpayers will surrender an average of 34.49% of what they earn over a lifetime to taxes. For context, that’s about $470,168 of an average lifetime earning of $1,363,203.
Even those who understand the basics of income tax might not realize just how much planning can be done in order to lower tax rates and maximize deductions, as well as the impact that saved money can have on retirement, philanthropy, and other life goals.
But that doesn’t have to be you. Let’s go over what you need to know about taxes, how tax planning can impact your family’s financial plan, and how you can manage your taxes to protect your family’s finances.
Why Tax Planning Is Important for You and Your Family
Tax planning matters, and careful attention to future taxes can either benefit your family’s net worth or significantly damage it. For example, I once had a new client who waited to sell their former home until several years after moving into a new one. They rented the house off and on, which helped cover their expenses, but they were slow to put it on the market. Unfortunately, because they did not think through the tax implications, they ultimately sold outside of the window when the $500,000 home gain exclusion would have applied. As a result, they ended up paying almost $160,000 in taxes that they wouldn’t have needed to pay had they sold the property earlier.
Another time, I had a new client who had donated a large amount of stock that had previously been restricted to charity but falsely believed that the original grant date of the restricted stock started the holding period. When I began helping with their financial planning, I discovered that it was actually short-term stock, which ultimately saved them about $200,000 in taxes. So again, tax planning matters: You can either pay attention to taxes now or potentially pay dearly down the road.
Managing Tax Liability and Protecting Your Net Worth
Now that we’ve covered why tax planning is important, let’s go over some tips that you can implement into your tax planning strategy so you can better manage your tax liability and protect your family’s finances:
1. Watch out for taxes on retirement accounts
First, consider the tax implications of retirement plan options such as 401(k)s and Roth IRAs. Though many people are savvy about saving for retirement, they do not know the most tax-efficient methods to draw from retirement accounts and the planning that can be done in the interim, like Roth conversions or other marginal rate tax planning.
2. Don’t let taxes drain your stock values.
Taxes can also have a major impact on equity compensation planning and non-qualified deferred compensation planning. Pay attention to alternative minimum tax planning (for incentive stock options), and work to determine the optimal exercise time for your options. With all stock acquired through equity compensation grants, deciding when to sell stock can be a complex decision. So, make sure you include tax planning and diversification considerations in your strategy.
3. Protect your home equity against excessive taxes.
Determining how and when to purchase a home (both primary and vacation homes) is a planning item at the top of many people’s lists but often doesn’t get enough attention. Make sure you understand the actual deductibility of real estate taxes and home mortgage interest — and that the loan is structured correctly — so that you know the true cost of home ownership. Additionally, avoid being like the late-selling clients I mentioned above and maximize the home gain exclusion when selling your home.
4. Lower your taxes with generosity.
Studies indicate that Americans are very generous (charitable giving has recently hit record levels), but many people don’t understand how to make charitable gifts in the most tax-efficient way. If you have a high-earning year, “bunching” gifts through the use of a donor-advised fund can ensure maximum deductibility.
If your family might be subject to the estate tax, understand how to gift using various strategies such as leveraging the annual exclusion, considering gifts of securities rather than cash for donees in lower tax brackets, and using more complex estate planning strategies.
5. Understand the big picture.
One of the most common ways taxes can cause a family’s finances to derail is simply a lack of cash flow planning and understanding of the full tax picture. For example, employment bonuses are generally subject to a federal flat withholding rate of 22%. But those who receive them are often in much higher tax brackets, leaving taxes due with the tax return and even leading to penalties and interest.
Additionally, if you have investment income that is not subject to withholding, it’s essential to consider if estimated tax payments are required to protect you from interest and penalties — and to avoid surprises.
A Less Taxing Ending
Taxes can be frustrating and, even in some cases, disastrous. But they don’t have to be. Careful financial planning can protect you and your family’s financial legacy from excessive taxes. Here’s a story with a happier ending: One of my clients was expecting a large loss due to accelerated depreciation being taken at an entity he and several of his irrevocable trusts owned. Much of the depreciation was being allocated to a trust with no other income (and wouldn’t have additional income for several years). The happy ending? We were able to make an election for the trust to allow the loss to flow to the client’s own individual tax return, saving him $500,000 in federal and state income taxes.
Tax planning is just as critical as your overall financial planning. If you don’t understand the ins and outs of taxes, you can unintentionally hurt yourself in the long run. However, by following these tips, you will be in a better position to determine your tax liability, manage your financial planning strategies and goals, and protect your family’s net worth.
This guest post was authored by Susan Jones
Susan Jones is senior wealth manager at Plancorp, a full-service wealth management company serving families in 44 states. She is a licensed attorney and CFP who has passionately provided wealth management services to individuals, families, fiduciaries, and private foundations and their related entities with a focus on sophisticated income, gift and estate tax consulting and compliance, proactive executive compensation planning, and succession planning for more than 20 years. Susan understands the many facets involved in creating a successful multi-generational family legacy and uses a forward-looking approach to help clients grow and preserve assets, reduce taxes, and realize both their financial and non-financial goals.
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