Should you only watch your rearview mirror when you drive your car? Of course not, but looking backwards is how many people handle their income taxes. Looking forward with a comprehensive financial plan, however, allows you to be proactive, and that can put you in a better position to reduce taxes for years to come. The benefits of wise tax planning compounded over your lifetime can have a significant impact on your wealth and financial security.
Tax preparation
How did tax season go for you this year? Did you have all your forms and documents? File on time? Take all your deductions and credits to reduce what you owe? All of that is important to do every year. However, you still may be missing out on significant savings, even if you use a professional tax preparer when it’s time to file.
That’s because with tax preparation, you are largely trying to make the most of what already happened last year. By the time January-April tax season arrives, there are limits to what else you can do to save money. For additional tax savings in the future, you need to look ahead and take action in the current year.
Tax planning
If tax preparation is like looking in the rearview mirror, then tax planning is more like looking forward through your windshield. And just as you adjust your driving in anticipation of what lies ahead, tax planning helps you optimize your tax situation years before it’s time for annual filing. The purpose of tax planning is to think proactively and take advantage of the structure of the tax code so you can move toward your long-term financial goals more efficiently.
Some income tax-planning tactics include itemizing deductions, grouping expenses and charitable contributions, harvesting investment losses to offset gains, or increasing retirement plan contributions to defer income. And where investments are located, how accounts are titled, and how beneficiaries are designated all have impacts on taxes related to estate planning.
But how do you know if you are using those tactics correctly? For example, extra retirement plan contributions may reduce your taxes today, but would you still do it if other options put you in an even better tax situation later?
It starts with a plan
Tax planning is most powerful when used in a coordinated strategy instead of just applying individual tactics. The process begins by defining your long-term goals and your time horizon, and that allows you to create a framework for decision making. This framework provides the structure for how and why decisions are made now and in the future.
Your financial plan can then help provide clarity on a number of common tax questions. For example, how can you best manage your tax bracket to reduce what you owe each year? When and how should you sell a business or real estate? How much should you save in 529 plans for college? When should you consider a non-deductible IRA strategy? What about Roth IRA conversions? What's the most tax efficient way to invest for the future and then take your money out of your accounts later? And how does that affect retirement, the cost of health insurance, and when to take Social Security?
Team effort
Effective tax planning can require a high level of knowledge and expertise, especially in complex situations, and coordinating the work of various professionals can yield the best results.
The process starts with you and your goals, not your taxes. But when we develop your financial plan, we also consider ways you can reach your goals more efficiently. We can coordinate that work with the other professionals in your life, such as your accountant, to incorporate their recommendations and complement any tax planning they may be doing for you already.
Key takeaways
Tax preparation is like looking in the rearview mirror as you try to make the most of what happened in the past year. To save more on taxes, also focus on the road ahead and consider a proactive approach that can pay off for years to come. A comprehensive financial plan is important because it provides a framework for decision making. And when effective tax planning requires a team of professionals, your plan helps everyone to coordinate solutions with your best interests in mind.
Tim Drake helps individuals and families build and align their finances for living a fulfilled life. Working with integrity and mutual respect, his comprehensive process includes investments, debt and cash flow management, insurance, and tax, retirement, and estate strategies. He is a Senior Financial Advisor at Pegasus Financial Planning and Pegasus Management Services, a fiduciary, fee-based Registered Investment Advisor (RIA).