Two or Three Heads are Better Than One When it Comes to Tax Planning

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A man in a suit looking at financial documents with a man and a woman to resemble tax planning.Superior tax planning is about generating the required current cash flow with the least tax cost, maximizing future wealth and financial flexibility, and maintaining acceptable risk. Tax planning success requires specifics, starting with a comprehensive net worth statement and a complete understanding of your future earning potential and career desires. Other important details include a definition of one’s financial goals to support one’s current lifestyle into retirement, and finally, an idea of any assets or legacy you want to pass on to others at death. Because these objectives often change over time, exploring them during the planning process is vital.

Much of your tax planning should focus on income tax planning with an understanding of how it fits into a personal financial plan if you expect to die without a taxable estate. Taxable estates add complexity and are not discussed here. At a minimum, your estate plan should define what you want to leave to others and tips to avoid probate.

Saving and long-term investing are two of the most important elements for accumulating wealth. Positive investment returns are necessary but not as important as being a consistent saver and avoiding panic moves and unsuitable investments. Combining the three will result in a portfolio supporting your desired retirement lifestyle and legacy once your full-time career has run its course.

Over the long term, average stock market returns and smart real estate investing have beaten inflation and provided real returns (net of inflation) to investors (net of income taxes). Bonds and other forms of fixed-income investing generally do not beat inflation after-tax. Taxable bonds are usually less tax-efficient than real estate or stocks. Annuities and insurance products are complex contracts. The best insurance contracts provide longevity protection that an investment portfolio cannot because a portfolio is always subject to complex risks. (This article is not intended to offer investment advice.)

One essential element to achieve tax flexibility is ensuring your portfolio is spread over the three most common types of accounts, known as tax location diversification:

  1. Taxable accounts allow you to generate long-term capital gains and qualified dividends taxed at lower rates, generate tax losses, and use high-tax basis securities to reduce the current taxes. You can also borrow against your taxable securities without incurring current taxes. However, your broker will charge you interest, generally known as a pledged asset line. Real estate investments also have tax and financing advantages, including tax-free exchanges and depreciation that stocks and bonds do not offer.
  2. Tax Deferred Accounts are your standard 401K, IRA, SEP IRA, or qualified retirement plans and provide a current tax deduction to help you finance the annual contribution. These accounts also accumulate tax-free income in the account. However, the government payback for these accounts is that all proceeds are withdrawn at ordinary income rates. Also, Required Minimum Distributions (RMDs) require you to drain the account (reduce it to almost zero) and pay income taxes on the distributions during your lifetime unless you die early. Even worse, if the account balance is given to your children, they must drain the account over a ten-year period, which may coincide with their highest earnings years, driving them into high-income tax brackets.
  3. ROTH accounts do not give you an upfront tax deduction, but you get tax-free accumulation and tax-free qualified withdrawals. These are outstanding accounts for capital appreciation and to generate tax-free cash flow in retirement.

Your state of residence also impacts your total income tax bill and tax complexity. California, for example, has high tax rates, no preferential tax rates for capital gains, and significant non-conformity to Federal tax rules. If you live in California, tax planning is even more important.

The tax system is progressive. Marginal tax rates increase with income. In addition, several tax breaks are limited to people not considered “rich” by the governments. These common tax “breaks” are for funding education, retirement, clean energy, supporting low-income housing, etc. Additional complexity results from blocker rules that prevent “passive” losses and “excess business losses” from offsetting other forms of taxable income (i.e., wages). Additionally, some tax breaks like Muni-Bonds only make sense for those taxpayers at the highest marginal tax rates.

Ironically, your best opportunity to take advantage of the complex tax law may come during personal distraction. Your income may be temporarily reduced due to a voluntary or involuntary break from the labor market. You could be getting married or divorced. You might be returning to school, considering a big move, or recently inherited a large sum of money. Planning for a marriage penalty may not be the most romantic thing you think about before your wedding, but it could pay for the ceremony and your honeymoon.

Tax law is complex. It can be difficult for individuals to know what opportunities are available. Tax planners cannot know your comprehensive financial position, goals, or objectives by only reviewing your tax return. They can make assumptions and offer suggestions, but it takes more information to provide the best advice, leading to the best tax-efficient financial moves.

Working with a Certified Financial Planner (CFP) can help you meet your financial goals, and they generally have solid tax knowledge, especially in investment management. However, they are typically not comprehensive tax experts.

For the best results in tax planning, a CFP will need the following:

  1. Your financial plan from your financial planner and your investment policy statement (if you have them)
  2. A comprehensive Net Worth statement
  3. Four years of tax returns. (Many CFPs will perform a tax physical during the planning process to determine if you have any prior year opportunities or risks)
  4. Earnings history (your social security statement is a great source) and an approximate projection of your lifestyle expenses
  5. Your current year earnings and withholdings to date and your current year estimated tax payments;
  6. A complete discussion of your financial and personal goals and objectives and your tolerance for financial and tax risk. This is likely the most important item on the list.

Without each piece of information, you risk missing something important.

We’re Here to Help

A publicly held company has an army of MBAs, tax specialists, and attorneys working on financial planning and analysis Your lifetime income is significant, and consulting with experts to ensure you get the most out of your assets, savings, and investment returns is key. “Failing to plan is planning to fail.” We all need to pay our taxes, but no rule requires you to pay more than the law allows. Generating net cash flow by paying more taxes just means you have to work harder and longer.

If you have questions about personal tax planning and decreasing your tax liability, JLK Rosenberger can help. For more information, call us at 949-860-9893 or click here to contact us. We look forward to speaking with you soon.