Tax planning is an essential but often overlooked part of any financial plan and can play a significant role in wealth accumulation over time, especially for high-income earners. We use several proven strategies with our clients to minimize their taxes over time, maximize their savings and investment growth, and help them reach their financial goals.
What is Tax Planning?
Tax planning is the tailored analysis of your personal income situation to minimize taxes paid over your lifetime. Tax planning considers many variables: your investments, the timing of your income, major purchases, cash flow events, and much more.
Additionally, tax planning is an underrated tool to use when planning for financial independence in retirement. Through efficient and comprehensive efforts between your CPA and financial advisor, designing a financial strategy to optimize your tax scenarios can increase the ability to contribute to retirement plans while lowering the tax burden your financial situation bears.
When we develop or optimize our clients' financial plans, we start with the tax brackets they find themselves in today to uncover financial growth opportunities and look for ways we can lower the overall tax liability in the future.
Benefits of Working With a Financial Advisor Who Offers Tax Planning
Lifetime tax planning allows you to reinvest into yourself to achieve your financial goals. To maximize this opportunity, our team of financial advisors at WJA and in-house tax team intimately familiarize themselves with our client's financial goals and collaborate for a complete picture of each client. Depending on your situation, we can use different strategies to achieve your long-term financial goals:
- Tax Loss Harvesting: minimizes the capital gains tax by selling investments at a loss to shrink taxable income and offset your capital gains. This strategically places you in a position to pay less in taxes.
- Using tax deduction credits like foreign income credit, child tax credit, etc.
- Calculating tax projections: minimizes the chances of a penalty targeted at high-income earners.
- Timing of cash flow movements: investing in Traditional IRA's in your higher tax years and converting IRA'S into Roth IRA's during your low-income tax years
- Asset allocation in your portfolio: minimizes the loss of investment to high tax assets
Proactive Tax Planning Saves Money Over Your Lifetime
When it comes to taxes, most taxpayers try to avoid thinking about the topic until W-2s hit their mailbox. Unfortunately, this approach can be costly over time and can feel like your efforts are taking two steps forward and one step back.
Let's consider a typical example we see. In February, after W-2s have arrived and you start to calculate your tax estimates, you may wonder, "how can I lower this tax bill? Is there anything left I can do?" Unfortunately, the answer is no in many cases because the appropriate deadlines have passed. As you realize this, you may be frustrated and vow to get it right next tax season, but as life gets busy, the cycle continues.
Instead, let's say you want to take a more proactive approach. You may start considering your annual tax picture in May, knowing that you still have seven months to make appropriate distributions and decisions before the end of the year. If you start this process by assessing your income, you may realize you're nearing the 401(k) income limits and choose to frontload or max out pre-tax contributions to your 401(k) to minimize your taxable income for the year. You could also start looking into options for charitable giving and charitable bundling to take a larger deduction in the next tax year. Perhaps you even look at your investments and capital gains to determine if there's a tax-loss harvesting opportunity. Many of these strategies can effectively lower taxes over your lifetime, but they all require proper planning and execution to see results.
Utilizing Strategies Such as Roth Conversions to Maximize Tax-Free Savings
When trying to be tax-efficient over an individual's lifetime, many advisors like to recommend strategies such as Roth conversions to clients. Roth conversions can be a great strategy to utilize in years of low-tax rates both before and after retirement.
What is a Roth Conversion?
A Roth conversion transfers funds from a pre-tax retirement account (like an IRA or 401k) to a post-tax Roth IRA. The converted funds originate from a pre-tax retirement account, meaning there were no taxes paid on the IRA (or 401k) contribution, so when the pre-tax funds move to a post-tax Roth IRA, there are taxes due on the conversion. This is why it is beneficial to utilize this tool during lower income years.
What are the Benefits of a Roth IRA?
The most significant value of a Roth IRA is having the assets in the account grow tax-free. You can also utilize the backdoor Roth IRA strategy to transfer the assets of your non-deductible IRA into a Roth IRA if your income is too high to contribute directly to a Roth IRA. By doing proper tax planning, you can optimize the timing of Roth conversions or a backdoor Roth to allow your investment to compound tax-free until you need the funds. How much value can this add over time? Let's consider an example.
Mark is a 60-year-old retired mechanical engineer. His only income for the year is from an investment account and his wife's pension, which brings his modified adjusted gross income to $191,516. As a Texas resident, he pays no state or local income taxes. For the 2021 tax year, Mark pays $32,858 in total income taxes.
| Tax Type | Marginal Tax Rate | Effective Tax Rate | 2021 Taxes* |
| Federal Income Tax | 24% | 17% | $30,946 |
| Capital Gains Tax | 15% | 17% | $1,912 |
| Total Income Taxes | 17% | $32,858 | |
| Income After Taxes | $158,658 | ||
| Take-Home Pay | $158,658 |
Knowing that he'll likely be in a higher tax bracket later in retirement, Mark considers converting $85,000 from his IRA to a Roth IRA.
If Mark converts $85,000 to a Roth IRA today, he'll pay ordinary income tax on the conversion alongside his existing income, which pushes his effective tax rate to 19% and raises his tax bill to $53,258. At first, you may think, "that's an increase of $20,400, so it's not a wise choice!" However, like many things in life, it's not so simple.
| Tax Type | Marginal Tax Rate | Effective Tax Rate | 2021 Taxes* |
| Federal Income Tax | 24% | 19% | $51,346 |
| Capital Gains Tax | 15% | 19% | $1,912 |
| Total Income Taxes | 19% | $53,258 | |
| Income After Taxes | $223,258 | ||
| Take-Home Pay | $138,258 |
If he chooses to convert that $85,000 to a Roth IRA, those funds will grow tax-free until withdrawal. If we assume that Mark makes no other contributions to his Roth IRA and gets an 8% return each year, his Roth IRA will grow to $146,630 net after-tax in ten years. However, if he leaves the funds in a regular IRA with the same 8% returns each year, its value would only grow to $119,281 net after-tax in the same ten years.
That's a difference of over $27,300 by simply executing a Roth conversion during a low tax year!
If he chose to leave the funds within the IRA, he would pay taxes on them at withdrawal in the tax bracket of his retirement income, which may be higher than his current tax bracket. By utilizing a Roth conversion and paying taxes in a lower tax year, Mark earns the freedom of compounding growth and tax-free cash outflow when he's in retirement and ready to use the funds.
Better Optimization of Investment Strategy and Tactics
While Roth conversions are a common tax optimization strategy, they are one of many at a financial professional's disposal to use within a financial plan under various circumstances. A few of the strategies we discuss with clients frequently are:
- Tax Loss Harvesting,
- Clumping of Charitable Gifts,
- Asset Location, and
- Backdoor Roth contributions.
But, knowing how to use these strategies for clients isn't enough. Working with a team of tax and financial professionals who know when to pull certain strategic levers versus others within a thorough discussion of each strategy's benefits and costs can substantially impact an individual's portfolio over time.
Audit Risk Reduction
1 in 4 Americans fears they'll be audited by the IRS, and it's a valid fear considering the common outcome of an IRS audit: paying more taxes. However, if the IRS does reach out to you, it's essential to be prepared to tackle the intensive steps required to navigate an audit effectively.
Many audits stem from improper or insufficient documentation regarding various financial strategies, investment choices, or benefit plan options. When your CPA works alongside your financial planning team, they can proactively spot scenarios where additional documentation or information may be necessary to help minimize your chances of being audited.
If the event you receive a notice of an audit by the IRS, having a tax professional such as a CPA or EA on your side can be similar to having a qualified medical professional at your side before major surgery. With their years of experience and subject matter expertise, having a team of trusted financial partners can give you the confidence and peace of mind needed to navigate the stresses of an audit.
Minimize Tax Drag Across Various Areas such as Real Estate, Investments, Income Taxes, and More
Each year that you file taxes, many factors, such as your tax bracket and tax deductions, affect your tax due. Timing your income to fall within years of lower taxes and your expenses in years of higher taxes can help save you money on your taxes by ensuring you are minimizing your tax bracket burden.
Consider an example highlighting the value tax planning can offer within a retiree's financial plan.
Jill is 64 years old and is married to her wonderful husband, Thom. She is set to retire this year and wants to sell her rental property so she can use the funds from the sale to enjoy a stress-free retirement. Jill has worked for a wonderful company for most of her career and is expecting a big non-qualified benefit plan payout this year for retirement that will push her and Thom into the 32% Married Filing Jointly ordinary income tax bracket.
Let's suppose that the house Jill wants to sell has appreciated over time, is fully depreciated, and is currently valued at $600,000, generating a $250,000 gain at the time of sale. If Jill sells this rental property, the gain on the sale will push her to the 37% tax bracket, and her $250,000 gain on the home will be taxed at a 37% rate, ultimately resulting in approximately $92,500 of additional tax liability.
Now let's look at an alternative scenario where Jill's financial advisor works alongside a CPA to create a more tax-efficient plan. The first step Jill's team recommended is to hold onto the property for a year after she retires to avoid the gain on the sale in the same year as her high-value benefit plan payouts. This collaborative team also recommends that Jill refrains from pulling out any cash from her retirement accounts in the year she sells the home. So what does this mean for Jill's retirement cash flow?
By taking the steps recommended by her financial and tax planning team, Jill can live off of the $250,000 gained from the sale of her rental property with no additional retirement income needed for the year of sale. With only the gain on sale for income and using the lower income tax bracket of 24%, Jill and Thom will only pay taxes of about $48,000. By making just two simple adjustments suggested by the tax and financial planning team, Jill and Thom would save about $44,500 in taxes!
How Many Financial Firms & Wealth Management Firms Offer Tax Planning
According to the 2021 Investment News Pricing & Profitability Study, only 9% of financial firms offer income tax preparation. For the hundreds, if not thousands, of families utilizing the other 91% of firms, they leave money on the table by failing to capture tax savings opportunities to maximize their financial growth.
Financial advisors who neglect to offer tax planning and preparation services often only look at your portfolio and investments from one perspective. However, when only focusing on portfolio growth, a financial advisor may miss out on tax-savings opportunities or make investment decisions with costly tax consequences from realizing excessive gains in a high-income year.
Choosing the right financial advisor for your family ensures that your retirement and financial goals are looked at from a holistic perspective. This perspective, achieved through collaboration with in-house CPAs alongside financial advisors, allows your portfolio to evolve without fear of giving over too much of your investment returns and income to the IRS.
Working with a Firm that Offers Both Tax Planning & Financial Planning
Tax planning is time-consuming; it takes research and thorough knowledge of current and proposed tax laws to understand what applies to your unique financial situation. Allowing a CPA and CFP® to familiarize themselves with your situation gives them the chance to tailor a tax-efficient game plan that works for you, especially when planning for retirement.
At Willis Johnson & Associates, we look at your overall financial picture and build your priorities into a long-term plan that's uniquely yours. Our fiduciary commitment ensures that our choices align with your goals. By simplifying your journey to a successful retirement with a minimized tax burden and a maximized savings plan, we do everything to help you achieve your goals.
