Almost everyone in the United States is responsible for paying income taxes on their taxable income. Yet, the last thing anyone wants to do is worry about filing their tax return. For a lot of taxpayers, tax season can cause a lot of undue stress.
Although taxes can be a stressful topic, it’s a good idea to have a way to incorporate a good tax plan into your financial planning. Here are 7 reasons why tax planning is important.
Reason #1: Reducing stress at tax time
During tax season, people are usually stressed out because:
- They’re trying to get all the important tax documents for filing their tax return
- They’re not sure whether they’ll receive a huge tax bill when they file their tax return
- They don’t know whether the Internal Revenue Service is going to penalize them for a mistake they might have made.
Proper tax planning can help eliminate all of these worries. A good tax plan will help people:
- Recognize the tax documents they should be looking out
- Ensure their tax liabilities are paid throughout the year
- Have peace of mind that their tax return accurately reflects their tax situation
Additionally, proper tax planning ensures that the proper decision is made when it needs to be made.
Reason #2: No missed deadlines
We’re not just talking about the tax return filing deadline here. A lot of tax strategies depend on the timing of particular transactions.
For small business owners, the end of the calendar year might be a significant factor in certain business decisions, like:
- The timing of purchases, especially large purchases of inventory
- Capital expenditure decisions, like when to buy equipment
- Timing of income for tax purposes
For real estate investors, this might involve when to buy or sell certain properties. Even individual taxpayers might be faced with the decision on whether to:
- Harvest long-term capital gains at the end of the tax year or push them into the coming year or future years
- When to max out their workplace retirement plan
- When to contribute to their IRAs
Proper tax planning allows you to know when decisions need to be made, so you don’t have to worry about missed opportunities. And that ultimately will help lower your tax burden.
Reason #3: Minimize tax liability
Strategic tax planning leads to maximum tax efficiency by helping taxpayers reduce the amount of taxes they owe in two ways.
Avoid making tax-inefficient decisions
Sometimes, taxpayers make financial decisions that are tax-inefficient because they don’t know any better.
For example, many people don’t know whether they should take the standard deduction or itemize their deductions on Schedule A of their tax return. And because itemized deductions change all the time, they don’t bother to keep up with the latest tax law changes.
So a taxpayer may inadvertently take the standard deduction automatically, even in a year that they:
- Had significant medical expenses
- Made huge charitable contributions
- Paid a considerable amount in state and local taxes
But usually, people make tax-inefficient decisions because they’re trying to reach some sort of financial objective, like generating a certain amount of cash. This is also another way having effective tax strategies can help.
Find more tax-efficient ways to achieve the same objective
Let’s imagine that you need to come up with $50,000. And you’re going to get that money by selling some stocks from your investment portfolio, so you talk with your financial advisor.
Some financial advisors might simply give an investment sales recommendation based upon the current holdings in your account, without considering the amount of taxes involved. Tax-focused financial professionals will always look at the tax implications of the sales so they can maximize the tax-efficiency of the recommendation.
This might include things like:
- Waiting to sell a specific holding until it qualifies for long-term capital gains tax treatment
- Selling the highest basis stocks or mutual funds in a holding to reduce the amount of taxes
- Capital loss and capital gains harvesting to keep your investment portfolio properly balanced
When you minimize the amount of taxes you owe, you have more discretionary income you have to put towards your savings goals.
Reason #4: Support savings goals
One of most effective ways to support your long-term financial goals is to maximize retirement contributions. The best time to start is in your early years of working, so you can take advantage of the magic of compounding interest.
When you pay less in taxes and increase your cash flow, you’re able to contribute more to your retirement plans. Or if you’ve already maxed out your 401k contributions, you can contribute to a traditional IRA.
But maximizing the amount of money you can set aside isn’t the only benefit of tax planning. Tax planning can actually help you with retirement planning itself.
Reason #5: Helps with retirement planning
Once you’re able to contribute more to your retirement plans, another aspect of advanced tax planning starts. That aspect has to do with minimizing the overall tax bill for your eventual withdrawals from those retirement plans.
How retirement plans work
There are two types of retirement plans and IRAs: traditional or Roth. The difference between those two has to do with when you are taxed.
Traditional retirement plans and traditional IRAs give an up-front tax break. In other words, 401k plan contributions and deductible IRA contributions don’t count as taxable income in the current tax year. The investments you make within those plans grow on a tax-deferred basis.
However, when you start to withdraw money, you’ll pay taxes on the money in the tax year that it’s withdrawn.
Conversely, Roth retirement plan contributions and Roth IRA contributions do not offer a tax break up front. However, earnings grow on a tax-deferred basis, and qualified withdrawals are made completely tax free.
So that begs the question: when is it better for me to contribute to a traditional retirement account vs. a Roth account?
When to shift from traditional to Roth
Generally speaking, lower income earners are better off making Roth contributions, and paying a lower tax rate on the money that can grow tax-free. Conversely, higher income earners are better off taking the up front deduction, with the expectation that they can withdraw at lower tax rates in retirement.
In today’s tax rate environment, a generally accepted inflection point is between the 22% and 24% tax brackets. Below the 22% bracket, Roth contributions are advised, and above 24%, traditional contributions are advised. At the 22% & 24% brackets, one could support contributing to either type of account, depending on their financial situation.
Sometimes, people have the opportunity to do Roth conversions at a lower tax bracket. This allows them to select the timing of income during lower taxable income years, and minimize the tax impact of required minimum distributions (RMDs) people face in their retirement years.
An advanced tax planning strategy is to develop a Roth conversion plan. This allows people to have greater control of when money exits their traditional IRA, and allows for the tax-free growth benefits in a Roth IRA.
We’ve written extensively about Roth conversions, and you can find specific articles of interest in our Roth IRA section.
Reason #6: Optimize the impact of your financial decisions
Not only does an effective tax strategy help with retirement planning, but you start looking at ALL financial decisions through the prism of tax efficiency. You don’t need to make every decision based solely upon the tax benefits, but many small businesses are much more successful because they incorporate such planning into their operations.
But it’s not just businesses that benefit. When you start thinking about achieving your financial objectives in the most tax-efficient manner, you start finding opportunities, like tax credits and tax deductions, where you didn’t find them before.
Ultimately, that helps your family members because you’ll have more to pass on when you die.
Reason #7: Maximize how much you pass on to your heirs
Who do you love more, your family or the federal government? While that seems to be an obvious answer, most people don’t recognize that even an extra dollar that goes to the government is a dollar they can’t pass on to their loved ones.
And most likely, that dollar would have grown, over time, to many times more. So, if one of your long-term financial goals is to have something left over for your loved ones, then tax planning becomes that much more important.
The most important thing to do before tax season arrives
Have a tax planning meeting with your tax professional, or financial advisor.
That’s it. Even if you don’t know ANYTHING about your tax situation, you should be able to set up a meeting to go over your taxes. And here’s what you should expect:
Have a tax projection done.
Your accountant or a tax-focused financial advisor should be able to run a tax projection for you. Most offices do this between June and September of the current tax year. That gives clients enough time to make estimated payments, change withholdings, or make any other adjustments before the end of the year.
You should also get a list of things that need to be done, either by yourself or your tax professional.
Get a checklist of to-do items from your tax professional.
Having a checklist makes things a lot easier to accomplish. Certainly, the checklist makes tax preparation much easier. And your tax professional should be able to do this for you.
If you can’t get these two things from your tax professional or financial advisor, then shop around. There are plenty of tax-focused offices that routinely do this for their clients.