Taxes are unavoidable but that doesn’t mean you have to pay more than you owe. What happens to your tax liability with proper financial planning? The simple answer is that it can allow you to minimize what you owe while preserving more of your income to fund your financial goals. Talking to a financial advisor is a good first step in creating a strategy for effectively managing tax liability.
Understanding Tax Liability
Tax liability refers to the money that an individual, business or organization owes to a federal, state or local tax authority. A simpler way to think of your tax liability is the difference between your taxable income and the tax deductions you’re able to claim.
As a general rule of thumb, earning a higher income can result in a higher tax liability. The U.S. uses a graduated tax system, which means that income and tax rates move together. As income increases, so does your tax rate.
The amount you pay in taxes is determined by your income, but capital gains can also affect your tax liability. That’s important to know if you’re focused on investing and building wealth, as higher net-worth individuals may face a steeper tax liability if they’re reaping capital gains from investments.
What Happens to Your Tax Liability With Proper Financial Planning?
Managing your tax liability is important as it can directly influence how much of your income or investment earnings you get to keep. The more income and assets you have to work with, the easier it becomes to build wealth.
Proper financial planning can help you implement strategies that are designed to minimize taxes while maximizing income and assets. Having a solid financial plan in place can generate significant tax savings year by year. You can then use those savings to generate additional income through investments, grow your retirement accounts and increase your net worth.
Does financial planning require you to work with a financial advisor? Not necessarily. You could always go it alone. But there are some distinct advantages to having a financial advisor help you formulate a plan for managing tax liability.
Financial advisors have extensive knowledge about how tax planning can affect your financial plan. A good advisor is also familiar with the tax code and the latest tax rules. Even if you think you have a relatively straightforward tax situation, a financial advisor may be able to pinpoint areas where you can improve tax efficiency that you might have missed.
Financial Planning Strategies for Minimizing Tax Liability
There are different ways to approach tax planning in order to reduce your tax bill, depending on the specifics of your situation. If you’re working with a financial advisor to create a tax plan, then it may include any or all of the following.
Retirement planning is a focal point of a solid financial plan, particularly with regard to taxes. Aside from ensuring that you have enough money to retire, it’s also important to consider how much of your savings you’ll be able to keep once you start making withdrawals.
In terms of how you plan for retirement, your financial advisor may suggest any of the following:
- Maxing out annual contributions to a traditional 401(k) or to a Roth 401(k) if you have that option.
- Contributing money to a traditional or Roth IRA each year.
- Funding a Health Savings Account (HSA) if you have that option with a high deductible health plan.
If you’re self-employed or own a business, you might open a solo 401(k), SEP IRA or SIMPLE IRA to save for retirement instead. It’s important to understand the tax treatment of different retirement savings options.
For example, traditional 401(k) plans and traditional IRAs allow for tax-deductible contributions. Qualified distributions are taxed as ordinary income in retirement. Roth accounts don’t offer a tax deduction, but you can make withdrawals tax-free when you retire.
A Health Savings Account is not a retirement account, per se. It’s meant to be used to save money for medical expenses, but it can double as a source of retirement income since you can withdraw funds for any purpose after age 65 without a tax penalty. You’ll just owe regular income tax on withdrawals.
Investment planning is related to retirement planning, but it can include different aspects of managing tax liability. For instance, say that you’re investing through a taxable brokerage account, which is subject to capital gains tax. Your financial advisor can offer different strategies for managing tax liability, which may include:
- Holding investments longer than one year to take advantage of the more favorable long-term capital gains tax rate.
- Choosing tax-efficient investments, such as exchange-traded funds (ETFs), which can trigger fewer turnover events than traditional mutual funds.
- Harvesting tax losses to offset some or all of your capital gains for the year.
Your advisor may also be able to guide you on how to deduct expenses related to investment properties if you own one or more rental homes. They could also help with executing a 1031 exchange if you’re interested in swapping out one property for another to minimize capital gains tax.
Tax Deductions and Credits
Tax deductions reduce your taxable income, which can help to push you into a lower tax bracket for the year. There are numerous expenses you might be able to deduct, including:
- Mortgage interest
- State and local taxes
- Charitable donations
- Business expenses
- Self-employment expenses
- Medical expenses
- Student loan interest
Tax credits, meanwhile, reduce what you owe in taxes on a dollar-for-dollar basis. For instance, if you owe $1,000 in taxes and qualify for a $1,000 tax credit, the credit can wipe out what you owe. Some credits are refundable which can increase the size of your tax refund for the year. A financial advisor can walk you through the various deductions and credits you might be eligible to take in order to reduce your tax liability.
As you approach retirement, it’s important to consider how you’ll withdraw the money that you’ve saved. Your advisor can discuss different strategies for withdrawing money from a 401(k), IRA or taxable brokerage account so that you’re not overpaying taxes or draining your retirement reserves too quickly.
Your advisor may also discuss ways to tax-friendly ways to create supplemental income in retirement, such as purchasing an annuity or taking out a reverse mortgage. An advisor can also help you figure out when to take Social Security benefits to maximize your payment amount and how to coordinate those benefits with other sources of income in retirement.
The Bottom Line
Knowing what happens to your tax liability with proper financial planning is important for creating a long-term strategy for growing wealth. Handing over more money than you need to in taxes doesn’t offer any tangible benefit and it can be problematic if it leaves you with less money to save and invest. Having a trusted financial advisor to work with can ensure that you’re meeting your tax obligations without shortchanging your goals.
Financial Planning Tips
- Tax planning can seem complicated if you’re not well-versed in the Internal Revenue Code. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Robo advisors can offer a more affordable way to manage financial planning, as the fees may be lower than what traditional advisors charge. However, it’s important to know what you’re getting for the money. For example, some robo-advisors offer tax loss harvesting but not all of them do. Additionally, robo-advisors aren’t really equipped to offer one on one advice about tax planning or investing. Those are good reasons to consider working with a human advisor instead, even if it means paying a slightly higher fee.
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