If you don't have a tax plan we'd guess you're leaving money on the table. A tax plan that is coordinated with your financial planner, attorney, and tax professional could potentially reduce your taxes and save you money.
Most of us take full advantage of the tax deductions we know about. The problem lies in the gaps between our tax, financial, and legal work. Without a coordinated team of advisors, you could unknowingly make financial or legal decisions that generate a tax increase.
An effective tax plan will bridge your investments, income, business structures, retirement plan, charitable giving, and estate plan to ensure you're running a tax-efficient ship. Your tax plan will spur you to ask such questions as, "Will the investment my financial advisor is suggesting lower my taxes or raise them?" and "Is the S-Corp my attorney is suggesting more tax-efficient than the alternatives?"
In this two-part series, we'll cover three tax-saving ideas: tax-efficient investments, business structures, and timely tax planning.
Investments: Three Keys to Make Yours Tax-Efficient
Your investment income is the most heavily taxed part of your financial plan, and is an area grossly overlooked by most investors. Added atop your earned income, investment income increases your taxable base and is billed at your highest tax bracket. How do you make your investments tax efficient?
Key 1: Put Your Investments in the Correct Tax-Structured Account
When we're talking tax efficiency, there are three main types of investment accounts. By utilizing all three types, you'll have a variety of investment-income sources with varying tax implications.
Accounts such as CDs or interest-bearing bonds. You'll pay ordinary income tax on these investments.
Accounts such as IRAs, 401ks, and 403bs. Put money into these accounts before paying taxes, and pay ordinary income taxes on your qualified withdrawals later. The principal grows tax deferred.
Accounts such as Roth IRAs and Roth 401ks. You'll fund these accounts with income you've already paid taxes on now, so you won't pay Federal income taxes on qualified withdrawals later.
For example: Sally had two investment accounts with a bank, which was treating her accounts as trusts. Due to the regulations and detailed accounting trusts require, Sally was paying $12,000 per year in taxes on these investments.
After asking a few questions, Sally's advisor discovered these accounts were not really trusts at all. To her surprise, simply changing the account types cut her tax bill in half. Sally saved over $6,000 per year just by putting her money in the right type of account.
Key 2: Match Your Investments to Your Overall Financial Plan
Which investment structures should you use? That varies per person and is where your financial plan comes in. You have to identify what you want your money to do for you long term and what sort of risk you're comfortable with. These basic components of a financial plan will help you determine the returns you're looking for and when you'll need access to your money.
Key 3: Review Your Investments for Tax Efficiency Annually and When Major Life Changes Occur
We often see new clients who have been holding an investment fund for years. They haven't looked at it or made any changes, many times in decades. Because of tax law or income changes, they may be paying too much in taxes on their investment income.
An example might be the investment account of a widow, set up by her husband 20 years prior. After the husband passes away, the widow might not touch the account for years. We see this often. Though the fund can be performing the same as any average investment, there can be quite a bit of buying and selling going on within it. The active trading generates income—and a hefty annual tax bill. By simply reallocating the investments to tax-efficient accounts, the widow could potentially reduce her tax bill while maintaining a similar return on her investments. while maintaining a similar return on her investments.
This is a hypothetical situation based on real life examples. Names and circumstances have been changed. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.