If you imagine your life as a journey, then you might think of a financial plan as a roadmap – or, if you’re a sailor, as a course to plot – designed to get you from where you are today to where you want to be in the future. During your journey you’ll encounter lots of opportunities, but also some obstacles and challenges. It’s important to incorporate tax planning into your financial plan.
What a Financial Plan Includes
A robust financial plan will address all of the following areas of your financial life:
- Cashflow planning
- Risk management and insurance
- Investment management
- Retirement planning
- College planning
- Estate planning
A number of these areas of your financial plan are particularly affected by tax planning.
Tax Planning and Investing
Asset location is a strategy that’s based on the fact that different types of investments receive different tax treatment. How the income you receive from an investment will be taxed should determine the type of account in which you own it. For example, because stocks generate most of their return from capital appreciation (the price going up), and because capital gains are taxed at lower rates than ordinary income, it’s generally better to own stocks in a taxable account, like a brokerage account. Similarly, because bonds and real estate (REITs) produce regular income, holding them in a tax-deferred account like an IRA or 401(k) allows you to shelter this income from tax until you begin taking distributions.
Tax Planning and Saving for College
Aside from buying a home, paying for college is one of the biggest expenses most people will face. The fact that the cost of college has been rising faster than the overall rate of inflation for decades has made saving even more important. Fortunately, there’s a tax-smart way to do so.
A 529 plan is an education savings plan that offers important tax benefits. While 529 plans can be used to save for K-12 expenses, too, they’re still primarily used for saving for college. There are two types of 529 plans: college savings plans and prepaid tuition plans. Almost every state has at least one 529 plan. While you can invest in any state’s plan, over 30 states offer their residents a state income tax deduction or a tax credit for investing in their home state’s plan.
These plans are attractive because they offer tax-free earnings growth and tax-free withdrawals when the funds are used to pay for “qualified education expenses”. For college, this includes tuition, fees, books, supplies, equipment, computers and sometimes room and board.
Want to learn more about financial planning? Contact our team at Springwater Wealth today to learn how we can help you develop a plan for your financial future.
Tax Planning and Retirement
Depending on your age, retirement can seem either very, very far away, or right around the corner. But regardless of your horizon, tax planning is a crucial part of getting ready for your ideal retirement.
For most Americans, a Social Security benefit won’t be enough to meet their income needs in retirement. And because defined benefit pensions are now the exception and not the rule, saving for your own retirement is essential.
The American tax code includes benefits to incentivize saving for retirement. To understand these benefits, you need to understand the difference between taxable, tax-deferred and tax-free accounts.
A brokerage, checking or savings account is a taxable account. Simply put, this means that any income generated in the account will be taxed at the appropriate rate in the year it’s earned. Capital gains in a brokerage investment account will be taxed at preferential capital gains rates, while interest income will be taxed at ordinary income rates.
In contrast, Individual Retirement Accounts, SEP IRAs, and 401(k) or 403(b) employer-sponsored retirement plans are tax-deferred accounts. Your contributions to these accounts are made with dollars that haven’t been taxed (i.e. they’re “pre-tax” contributions), and the earnings generated in the accounts aren’t taxed when they’re received. However, when you begin taking distributions, each dollar withdrawn will be taxed at ordinary income rates.
Finally, there are also Roth retirement accounts – IRAs, 401(k)s and 403(b)s. Roth accounts don’t provide you with a tax break when you contribute to them – your contributions are made with “after-tax” dollars. Your earnings generated in the account aren’t taxed when they’re received. And when you begin taking distributions, your withdrawals are totally tax-free.
Ideally, you’ll accumulate savings in all three of these buckets. That way, when you retire and need income from your portfolio, smart tax planning will allow you to pay the least amount of total tax. For example, in years when your income is low, you can take distributions from your IRA, and pay the required income tax at a lower rate. And in years when your income is high, you can take tax-free distributions from your Roth account.
Tax Planning and Charitable Giving
The Tax Cuts and Jobs Act of 2017 made several significant changes to the tax code. These changes include a nearly doubled standard deduction, limitations on itemized deductions, reduced income tax rates, and reforms to several other provisions. For example, taxpayers are now limited to deducting a total of $10,000 among state and local property, sales, and income taxes paid (known collectively as “SALT”).
While these changes simplified the tax code for individuals by eliminating the need for millions of households to itemize their deductions, they also impacted charitable giving. This is because by making the standard deduction larger, the value of itemized deductions was lessened. It’s now more advantageous for many taxpayers to take the increased standard deduction than to itemize their deductions.
However, with some astute tax planning, you can still receive a tax benefit for your charitable giving, even if you typically would take the standard deduction rather than itemize. The strategy is to combine, or “bunch”, several years’ worth of giving into a single tax year.
How does it work?
First, review your planned giving for this year and the next few years. The goal is to exceed the standard deduction for this year with the combined amount. Then, “bunch” all of the giving together and do it this year. You’ll itemize your deductions for this tax year to reduce your taxable income. For next year, though, and perhaps for a couple of years after that, you won’t make charitable donations, and you’ll just claim the standard deduction when filing your taxes.
And if you’re really interested in super-charging your charitable giving through bunching your giving, a donor advised fund may make sense.