Let’s face it, nearly every financial decision you make directly impacts how you will be taxed in the future. By taking a proactive approach, you can ensure that you’re making the best possible decision in the short and long term. Let’s walk through some key tax planning strategies that can help your financials today and in the future.

Anticipate the Future

Most accountants and tax professionals look at taxes retrospectively. But this reactive approach can lead to missteps, missed opportunities, and money that ends up going to the government rather than into your bank account. For example, many clients work hard to save money for retirement through traditional, pretax contributions to IRAs, 401ks, and more. This money is not taxed when it is added to these investment accounts, but rather when you withdraw it at the time of retirement. To top things off, that money is considered ordinary income, which can then bump you into a higher tax bracket. You might consider using more tax efficient savings strategies, like a Roth 401k or IRA. With proper tax planning, you can be strategic and allocate funds appropriately in order to avoid unexpected high taxes when it comes time for retirement.

Avoid Common Pitfalls

Without a proactive approach to tax planning, many people find themselves making mistakes that can hurt them financially — both in the short and long term. The most common pitfalls include overpaying taxes, getting a surprise tax bill, or paying too much in taxes during retirement. These are all things that can be avoided if you approach them with a strategic eye.

Overpaying your Taxes

It’s quite easy to overpay your taxes. The best solution is to pay close attention to your tax return. I, myself, nearly overpaid in taxes this year because I missed contributions to my health savings account (HSA). I made full contributions to my HSA, but the contributions were missed when we filed our taxes. Due to COVID, we received a late notice in the mail showing our full HSA contribution. When I went through to double-check my tax situation, I realized the error and spoke with my accountant, getting a much larger return than I would have otherwise. In the end, reviewing all of my tax documents really paid off. If there are mistakes on your tax return, they could come back to haunt you down the line.

Getting a Surprise Tax Bill

Surprises can be fun, but not when it comes to your tax bill. This is especially true for business owners, who, in my experience, run the biggest risk of owing the IRS at the end of the year. By tax planning, you can create a clear plan to turn that tax bill into a refund. A good starting place is to anticipate your projected income and expenses. By anticipating future needs you can create a plan to mitigate your tax situation.

You might consider reviewing your legal business structure, adding a company sponsored retirement plan, or implementing a healthcare plan, to name a few, to reduce your business tax burden. It’s also important to understand what you can write off, what is considered income, and when you need to pay. Once you understand where you are currently and where you will be in the future, tax season shouldn’t be able to sneak up on you.

Paying too Much Taxes During Retirement

The last pitfall to avoid is paying too much in taxes during retirement. I’ve met many retirees that saved diligently in their 401ks and IRAs over the years, enjoying the benefit of tax deferral along the way. However, Uncle Sam doesn’t forget about untaxed income, so once people reach retirement, often at the peak tax bracket in their life, they find their taxes to be their biggest expense to incur as they step into retirement.

One of the greatest tax gifts many people have access to is the Roth 401(k). Unlike the Roth IRA, the Roth 401(k) doesn’t have income restrictions on contributions. In fact, it was recently discovered that Peter Theil, the famous billionaire entrepreneur, has about $5 Billion in his Roth accounts. By understanding what your income streams will look like in retirement, you can manage your tax burden in a better way. This process can start as soon as you start saving for retirement, but it’s most valuable for those in their late 40s and 50s who are hitting their peak earning years and have the most opportunity to integrate long-term tax planning into their financial plan.

Understand Long and Short Term Strategies

When it comes to tax planning, it’s important to consider both short and long-term strategies since the two are very different. Most of the time, long-term tax planning deals with retirement and requires anticipating future needs. This demands a certain eye for detail as well as patience to reach the desired outcome.

One of the best things you can do is to consider the taxation of money coming out of accounts. For example, Traditional IRA and 401k contribution give you a tax break today, but at retirement, the distributions from those accounts are taxed at ordinary amounts. From a tax standpoint, this strategy is inefficient and ineffective. There’s almost always a smarter way to approach this.

You may want to consider the Roth 401k, which allows you to contribute up to $19,500 (in 2021) without income restrictions or phaseouts, with a catch-up contribution for people over 50 of an additional $6,500. This account also allows you to pay tax on the amount of money you start with and not what you grow it to be—essentially paying tax on the seed, not the crop.

When it comes to short-term tax planning, we switch gears from retirement to your yearly tax return. Many people can reduce their current tax bill by contributing to a traditional IRA or 401k, but that may not be the best long-term tax strategy. You may also want to consider making contributions to a Health Savings Account if you are eligible. If you are an investor, you could also focus strategies around capital gains tax that will help keep your ROIs in your own pocket. Consider tax efficiency of your investment strategy, as taking short-term capital gains can derail your financial gains.

In Conclusion

Tax laws are notoriously complex, but it’s important to take a look at them through a financial planning lens. When you take the time to understand what gets taxed when and anticipate your future needs, you can avoid making common mistakes like overpaying and surprise tax bills.

While there’s no exact income threshold you need to hit to start doing tax planning, you may want to consider talking to a financial planner once you get into the 24% tax bracket. If you feel like you pay too much in taxes or think you’re missing an opportunity to save on taxes, you should consider a full tax planning analysis at a wealth manager’s office. At Four Points, we use comprehensive tax planning software to help you see opportunities to manage your taxes more efficiently.

For help in understanding how you can be strategic about your taxes or would like a copy of our 2021 Tax Cheat Sheet to use as a quick reference guide while you do your taxes, please don’t hesitate to contact us. We’re always happy to help you in your pursuit of building a strong financial future.