What is tax planning?
I recently came across a CPA that made a post on LinkedIn that said, “tax planning is not about eliminating taxes. I’d rather have someone pay tax than buy an asset they don’t need.”
I was confused too.
Because nothing could be further from the truth. The core of tax planning is to legally eliminate your tax liability as much as possible. A more formal definition of tax planning is “The analysis of a financial situation or plan to ensure that all elements work together to allow you to pay the lowest taxes possible.” Put simply, it is making sure your investments, retirement income strategies and withdrawals, business operations and estate planning all work together to make sure that you pay less in taxes and keep more of your income and assets for yourself, your family and loved ones. We all know that we must pay taxes, but one should always be trying to reduce the amount of taxes paid now and in the future.
Filing your taxes and having a CPA or EA prepare your tax return is not tax planning. That is tax preparation. You need to do your tax planning for a given tax year before you file your taxes. For example, you need to do you tax planning for the 2023 tax year during 2023 or earlier, not in spring 2024 when you are preparing to file your 2023 taxes. Once you are filing your taxes, it is too late for most tax planning strategies.
What are some basic examples of tax planning strategies? Let’s look at those below.
Tax Loss Harvesting
This strategy is one of the most common tax planning strategies. Tax loss harvesting is simply selling an asset that you own at a loss on purpose so you can use that loss to offset a gain from another asset that you sold. For example, let’s say you sold 100 shares of ABC stock for a realized gain of $1,000. You likely will have to pay tax on that $1,000…unless you can offset that $1,000 gain with a $1,000 loss. So you and your financial advisor look through your portfolio and notice that if you sold 100 shares of DEF stock that you would realize a loss of $1,000 on that transaction. So you discuss it and go ahead and sell the 100 shares of DEF stock at a $1,000 loss to offset the $1,000 gain from ABC stock. Now you have no taxable gain for tax purposes.
Roth Conversions
This is another tax planning strategy, but it may take years to implement correctly. However, it can be worth it in the long run.
A Roth conversion is when you convert pre-tax retirement funds, such as traditional IRA or 401k funds, into after-tax Roth money. Whatever you convert in a given tax year is taxable as ordinary income to you in that tax year, but once the funds are in your Roth IRA and you meet certain requirements when you pull the funds out in retirement the withdrawals are tax-free.
Since whatever you convert is taxable as income to you it is important to analyze from a tax perspective how much you should convert each year to avoid potentially bumping you into a higher tax bracket or negatively impacting other deductions and credits. You can do partial conversions too; you do not need to convert your whole pre-tax account to a Roth account all at once. That is why this strategy may take years to successfully implement.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
Retirement Income Strategies
This is an on-going tax planning strategy. In retirement, especially in the early years of retirement before you reach full retirement age, it is important to manage what your income is so you don’t negatively impact your social security benefits or other pension benefits. Likewise, you don’t want to unintentionally increase your income to a level that will negatively impact tax deductions, credits or Medicare benefits.
You need to analyze from a tax perspective which accounts you withdrawal money from. You likely have a taxable account, pre-tax account and maybe a Roth account. You also may still have self-employment income or rental real estate income as well. All of these sources of income need to be monitored and analyzed on an ongoing basis to reduce potential tax liability as much as possible. For example, you may inadvertently subject yourself to the additional Medicare tax of net investment income tax by not paying attention to where you are making withdrawals from and taking income from and accidentally increasing your income to a level that subjects you to these additional taxes. This is also true of selling assets in retirement. Don’t just sell assets willy nilly without thinking about the tax implications.
The bottom line is that tax planning is about reducing your overall tax liability now and in the future. Period. If you are working with a CPA that says otherwise, it may be time to look for a new CPA. As you navigate your retirement and retirement plan, be careful not to neglect tax planning as part of that. As always, work with your financial planner and tax preparation professional to make decisions that are specific to your situation so you can make the best financial decisions possible.
Didion Wealth Management and LPL Financial do not provide tax advice or services. Please consult your tax advisor regarding your specific situation.