They say timing is everything, and that’s certainly true when it comes to your tax strategies. As tempting as it may be to want to save a buck today, the most effective tax strategies don’t just focus on how to minimize this year’s tax liability.
Smart tax strategies take into consideration what your tax bill is going to look like 3, 5, 10, and even 30 years down the road. In short, having a proactive, long-term approach to your tax planning will typically net you the greatest results over the course of your lifetime.
So, before you send off your tax forms to your CPA, stop and ask yourself if you’re taking these critical steps to building the right long-term tax strategy for you and your loved ones.
Avoid Costly “Quick Fix” Tax Strategies
Here’s a good example of how short-term tax strategies might seem like a good idea at the time but can cost you later. Imagine you get this year’s tax return and, like most people, you’re looking to save as much as you can this year. You think to yourself: I’ll move some money into a traditional IRA by April 15th and take the tax deduction on those contributions. Perfect…right?
Not so fast. Depending on your circumstances, the money saved on taxes this year through an IRA contribution is likely not worth the tax burden you’ll have to pay on the account distributions later when you’re in retirement and on a more limited income. A long-term tax strategy disciplines you to avoid quick fixes that will cost you in the long run.
Map Out Your Future Tax Brackets
Since the tax bracket you’re in determines the blended tax rate that you pay, effective tax planning strategies also try to forecast which tax brackets you will be in and when. Obviously it’s not a perfect science: tax laws change frequently, and your circumstances could unexpectedly change, too. But educated tax bracket planning is still better than no tax bracket planning at all.
For example, let’s say you’re at a professional peak in your career, but you know you want to be semi-retired in the next 10 years. You’re likely in a higher tax bracket today than you will be 10 years from now. In that case, it makes sense to try and defer as much tax payment as possible now, since you’re paying a higher tax rate now.
Or let’s say you’re retired and have been living off the money in your bank account for the last 6 years, which means your taxable income is almost nothing. That’s put you in a very low tax bracket. But you’re also quickly approaching the age for required minimum distributions from your IRA and Social Security—which are expected to bump you right back into a higher tax bracket. A good tax strategy will reposition your assets while you’re in the lower bracket to help you save more on taxes once those distributions kick in and you’re paying a higher rate on everything.
Take Advantage of HSAs, 529s, and Roth IRAs
Long-term tax strategies are also smart about how you use three tax-advantaged savings vehicles:
- Health savings accounts (HSAs) which, if you have a high-deductible insurance plan, allows you to set aside pre-tax money for qualified medical expenses.
- 529 plans, which are state-sponsored plans that allow you to set aside after-tax money for college and other qualified education expenses. Many states offer a deduction for annual contributions.
- Roth IRAs, which allows you to save after-tax dollars for your retirement and pay no taxes or penalties on qualified withdrawals
The key to all three of these vehicles is that your contributions and earnings grow tax-free. So, the longer and more you save within them, the better.
Let’s consider how you might use an HSA differently if you’re thinking long-term about your tax strategy. Imagine you’re a relatively healthy 45-year-old who is used to spending your HSA dollars whenever medical expenses pop up. But with a long-term tax strategy, you shift gears: you start paying for your medical expenses out of your cash flow instead, allowing your HSA dollars to sit untouched, generating tax-free earnings for you. As you get older and your health needs grow more complex (and expensive!), you’ll now have a much greater pool of money saved up to cover your growing medical costs.
Reassess Your Tax Strategies Ahead of Major Life Milestones
Since the best tax strategies are built around a long-term view of your life, it’s no surprise that your tactics should change as you hit major life milestones, such as starting a family, sending the kids off to college, and retirement. Naturally the best course of action is to meet with a financial planner annually to reassess your tax strategies. But, at the very minimum, here are just a few of them times when you’ll want to proactively reassess your tax planning:
Buying a Home
If you’re buying your first home, that’s usually when you can start itemizing your deductions. Why? Because your mortgage interest is deductible and usually significant enough to push you past the standardized deduction threshold. (For many taxpayers, their largest deduction is their mortgage interest!) There are plenty of other tax benefits to home ownership and real estate investment as well. For example, if you’re a first-time home buyer, you may be able to withdraw money from your IRA penalty free to assist with your down payment.
Marriage/Divorce
Just because you’re married doesn’t mean to have to file taxes jointly. Certain circumstances, such as health-related expenses and student loan debt, may make filing separately the smarter move. Just as importantly, if you were filing jointly but are now going through a divorce or were recently widowed, how will your new status as a single filer impact your tax bracket and your tax bill? The tax brackets are different for single filers, with higher rates starting at lower income levels.
Getting Into Investing
If you’re at a stage in life where you’re serious about investing, it’s important to understand the differences in taxation between short-term capital gains and long-term capital gains. Often times, investors make trades in the name of portfolio optimization without realizing a simple fact: short-term losses are taxed at a higher rate than long-term ones. Before you jump into the trading fray, talk to your financial advisor about the right tax strategies for your portfolio.
Starting a Business
If you’re an entrepreneur, there are countless factors that can impact your tax strategy. Should you file as an S Corp, a C Corp, an LLC—or something else? Are your start-up costs deductible and should they be amortized over a period of years? Which employee retirement plan should you choose in order to lower your own taxes and provide the greatest benefit to your staff? Check out our guide to financial planning for business owners to learn more or be sure to schedule a time to talk to us for additional guidance.
Selling a Business or Property
Just like starting a business, selling a business or real estate property requires its own tax strategy. For starters, how should you structure the sale? Do you want the buyer to pay you one lump sum so that all the taxable income hits your books at once, or do you want to break up the sale into installments that you recognize over a period of years? You also need to consider what you’re losing on the tax level by selling the business. For example, any deductions you’ve historically claimed for making employer contributions into your staff 401k? You won’t be able to count on those now that you’re moving on.
Planning Your Estate
Unfortunately, very few people understand the tax implications of their estate plans and, as a result, unintentionally burden their loved ones after they’re gone. Take, for example, a tax-deferred asset, such as your IRA. When you pass, the IRS doesn’t just forgive the tax bill on it. Instead, your family becomes liable for it. Every asset—from your real estate investments to your life insurance policy—should be evaluated as part of your estate plan’s tax strategy.
Even something as seemingly small as how you title your assets can impact how much goes to the IRS versus how much goes to your intended beneficiaries after you pass. Let’s say you start an investment account in your name with $100,000 and when you pass it’s worth $300,000. The IRS will grant your spouse/beneficiary a “step-up in basis” provision that honors the investment as a $300,000 starting value—meaning they don’t have to pay the capital gains tax on the $200,000 the account earned before you passed. However, if you had opened that investment account as a joint account, your spouse/beneficiary would only be granted the step-up in basis on your half of the account—and would be stuck paying the capital gains tax on his/her half.
Start by Finding a Trusted Advisor
The best advice for building a smart long-term tax strategy? Find a financial advisor who excels at tax planning. This is not the same as having a good CPA. It’s your CPA’s job to understand all the latest tax laws and help you manage your taxes to them each year. A financial advisor’s job, on the other hand, is to understand your complete financial picture and build a long-term tax strategy that protects you over the course of your lifetime.
At Advent Partners, our Certified Financial Planners don’t just give you smarter long-term tax strategies. As part of our Out-of-Office Advocacy approach, we work directly with your CPA—as well as your estate lawyer, insurance agent, and other professional service advisors—to make sure your entire team is working off the same financial playbook for you.
Schedule a time to talk to us now and learn how we can help you strategically reduce taxes, solidify your financial peace of mind, and ultimately use your financial gifts to lift up what really matters: the people and causes closest to your heart.
