Benefits of Tax Planning
For years it was assumed that tax planning was reserved for the wealthy, but with the changes and complexity of tax laws, that's no longer true. With today's different tax and savings strategies, even middle-income earners can reap the benefits of tax planning.
Basic tax planning starts with your AGI or Adjusted Gross Income.
This is your total income after any adjustments have been applied. Reducing your AGI is a primary goal of many tax planners in order to lower the taxes due in a given calendar year.
One way to lower your AGI is to use tax-deductible tools such as an HSA or FSA:
- HSAs (Health Savings Accounts) are tax-deductible, but can only be used if someone is in a High Deductible Health Plan (HDHP). The funds go in pre-tax, grow tax-deferred, and come out tax-free if used for qualified medical expenses. This is a great way to save for future medical costs. You do incur a penalty if funds are withdrawn for non-medical expenses prior to age 65, but after 65, non-medical withdrawals are simply taxed at ordinary interest rates. HSAs are NOT a use-it-or-lose-it benefit; rather, the balance can carry forward throughout your lifetime.
- FSAs (Flex Spending Accounts) - the most common types of FSAs are a Healthcare FSA and a Dependent Care FSA. Like an HSA, the funds go in pre-tax and come out tax-free for their intended purpose. However, unlike an HSA, unused funds at the end of the year are forfeited instead of carried forward. You must provide receipts for the healthcare or childcare expenses in order to be reimbursed by the FSA. So while it is still a valuable tool and can lead to significant tax savings, you want to make sure that you only contribute the amount that you estimate you will spend (on healthcare or childcare) for the year so as to avoid forfeiting any at the end.
One of the easiest way to lower one's AGI is to contribute money to a 401(k) or other retirement plan on a pre-tax basis. 401(k)s or other employer plans (such as a 403(b) or a Simple IRA) are paycheck-deducted and can help automate your savings. Depending on someone's income and situation, they may also be eligible for a pre-tax IRA, which is deducted at tax time. (By the way, 401(k), IRA, and other retirement plan contribution limits increase over time with inflation, and those over 50 can contribute an additional "catch-up" contribution as well. If you're already maxing out, make sure you make any necessary adjustments as those limits change.)
Analyze Pre-tax versus Roth
However, one important aspect of tax planning is to not only lower this year's tax bill, but to look to the future to try to minimize taxes over one's lifetime. While pre-tax savings can lower this year's tax bill, they will still be taxable at some point in the future (both the principal saved, and any growth). For individuals in their highest-earning years, who will likely be in a lower tax bracket in retirement, it may make sense to defer as much as possible - especially because in Illinois, pre-tax savings avoid the Illinois Income Tax rate of 4.95% altogether (Illinois does not tax IRAs upon withdrawal).
For individuals who are in lower tax brackets today and/or are far from retirement, it may make more sense to add Roth 401k or Roth IRA savings. Unlike pre-tax savings, Roth savings are NOT tax-deductible today and do not reduce your current tax bill. The benefit is that Roth dollars then grow tax-deferred, and can be withdrawn tax-free in retirement, (if owner is over 59 1/2 and have had the Roth savings for 5 years or more). This means that all the growth over time occurs tax-free for qualified withdrawals. This also make sense for individuals who feel that tax rates will increase in the future (through Congressional action) or want to give themselves more flexibility to control their income taxes in retirement. Therefore, a tax planning conversation should focus not just on minimizing taxes today, but throughout someone's lifetime.
Other tax planning tools
For individuals on the other side of retirement, who maybe have pre-tax funds and are now faced with taxes on withdrawals (perhaps forced withdrawals such as Required Minimum Distributions), tax and distribution planning may be able to help. Sometimes, careful Roth Conversions early in retirement can be beneficial in the long run. Additionally, for those charitably inclined and over age 70.5, donating IRA assets directly through a QCD strategy can lower their AGI. You can read more about Qualified Charitable Distributions here.
Aside from lowering your AGI, another area that tax planning traditionally focused on was increasing itemized deductions. However, following the Tax Cuts and Jobs Act of 2018, deductions for state and local taxes paid have been capped at $10,000 while the standard deduction was doubled. That makes it much less likely for itemized deductions to exceed the standard deduction.
One strategy that can help those who are charitably inclined may be to use a Donor Advised Fund (DAF). This allows someone to give more in a single year and recognize a large itemized deduction (either by donating cash or an appreciated asset, such as a stock), then distribute it to the charities of their choice over the following years. You can read more about Donor Advised Funds here: Can a Donor-Advised Fund Supercharge your Giving?
Finally, tax planning should plan not only for today's income taxes, but for any taxes that you and your beneficiaries may pay. This may include discussions about appreciated assets (that may be subject to capital gains taxes) as well as how to best leave assets to your heirs. For instance, a pre-tax IRA is taxable to the beneficiaries whereas a Roth IRA is not, which may impact decisions about which type of account to save into, withdraw from, or whether to convert.
As you can see, there are many strategies that someone might use to lower their taxes either today, or in the future. With all the changes over time, you may want to contact a finance or tax expert to help guide you through the maze, as well as get you on track for potential tax savings.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.