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The Role of Taxes in a Financial Planning Strategy

September 30, 2014

Taxes are a major expense item and need to be managed separately and carefully.

At a minimum, you should be aware of your tax situation with projections prepared regularly and big picture explanations of what is taxed, how, why, when and potential strategies that could reduce them.

Many people become overly consumed with saving taxes and miss the point that their goal should be to become wealthier, with saving taxes being one tool.  For example, I could wipe out all of a business client’s taxes if they pay me a fee equal to their profits.  As ridiculous as this sound’s, many people do similarly dumb things.  Here are some strategies to consider:

  • I talk to clients that have large gains in a stock they recently purchased but want to hold off selling until it qualifies for long term capital gains.  My advice is that once they no longer think the stock would keep appreciating, or are doubtful it would remain at the present level they should consider selling it and taking their profit, albeit that they will pay tax at higher rates. I’ve seen this holding/lower tax attitude erode large gains into eventual losses.
  • Many people believe that taking large mortgages is a great strategy to save taxes because the interest is tax deductible. They will save taxes that way, but will be poorer in the long run since they will be paying more interest than they need to. Even if they are in a combined federal and state 40% tax bracket, 60% of the interest paid is still their money!
  • Another bad “strategy” is when you have funds in a tax-deferred account such as an IRA and also in your own name and you allocated your investments so stocks are in the IRA and tax free bonds are in your own name.  The bond interest will not be taxed. However, by reversing this strategy and buying the stocks in your own name and investing in higher yielding corporate bonds in the IRA you will pay more current tax but in the long run be wealthier since the stocks and dividends will be eventually taxed at favorable rates, while the bond interest will accumulate at a tax deferred basis.
  • Contributing to employer sponsored 401(k) or 403(b) plans or if self-employed, then one of the many qualified retirement plans available for those businesses, is a way to get current tax deductions, accumulate investments on a tax deferred basis and build wealth for your future financial security.  Also, many employers contribute some matching funds to their employees’ 401(k) accounts increasing the benefits of these accounts.
  • Another issue to consider is whether to convert an IRA to a Roth IRA.  The amounts converted will be taxed now, but once the funds are in the Roth IRA, the principal and income will never again be subject to taxes.  This can also be very beneficial if done in a year your income is unusually low.
  • You should consider employer sponsored cafeteria salary reduction plans allowing you to pay medical costs that otherwise would not be deductible with a portion of your pretax salary.

Contributing to a charity can be easier (and better) tax-wise if appreciated long-term held securities were donated rather than cash.  You would get a full charity tax deduction for the current value of the securities and would not be subject to capital gains taxes on the appreciation. Tax savings are important, but they are only one piece of the strategy in a much bigger picture of becoming wealthier.  Consider all the issues and the big picture before acting.

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