Smart Tax Planning Pays Off

If you're financially successful or expect to become so, taxes are or will become one of your biggest expenses — and most people want to minimize their tax obligations. Roughly two-thirds of Americans say they pay too much in federal income taxes, according to a poll from the University of Chicago Harris School of Public Policy and The Associated Press-NORC Center for Public Affairs Research earlier this year. About 69% feel the same about local property taxes, and 62% say the same about state sales tax. Less than 20% want to pay higher taxes for more government services.

Here's what you should know about federal tax planning for individuals and why it matters.

What is Tax Planning?

Tax planning is the art and science of arranging your financial affairs in ways that postpone or avoid taxes. By employing effective tax planning strategies, you can increase cash flow and have more money to spend, save, and invest.   

Specifically, tax planning means deferring and/or avoiding income taxes by making maximum use of legitimate tax breaks available under the tax code. This includes increasing and accelerating tax deductions and credits. The federal tax rules are more complicated than ever, making the benefits of proactive planning more valuable than ever. 

Important: Don't change your financial behavior solely to avoid taxes. Truly beneficial tax planning strategies permit you to do what you want while reducing tax bills.

Uncertainty about future tax laws adds to the challenges. Through 2025, the Tax Cuts and Jobs Act (TCJA) offers lower federal income tax rates for many individual taxpayers. Most TCJA provisions for individual taxpayers are scheduled to expire after 2025. It's currently unclear which provisions, if any, Congress will extend and which ones will be allowed to expire. It largely depends on the political landscape in Washington, D.C. Your tax advisor can help you stay atop the developments after the November elections.

How Does Tax Planning Relate to Financial Planning?

Financial planning is identifying and implementing strategies to reach your short- and long-term financial goals. However, executing your strategy isn't always simple. If it were, more people would be well off.      

Tax and financial planning are closely linked because taxes are a significant expense throughout your life. Therefore, tax reduction planning is critically important in the financial planning puzzle. Failing to understand this can lead to bad results. Unfortunately, some people don't learn this lesson until they commit expensive mistakes. Consider these two hypothetical examples.

Scenario 1: A Poorly Executed 401(k) Rollover

Louise (age 50) left her job to accept a better position at a different company. She had $400,000 in her 401(k) account with the old company. She decided to roll the 401(k) account balance into an IRA. She heard from a co-worker that this strategy would allow her to manage the money while preserving the tax deferral advantage.

However, she didn't consult her tax advisor before making the rollover. She arranged to make an electronic funds transfer of the 401(k) account balance into her personal brokerage firm account. Then, she planned to roll over the $400,000 into an IRA.

Unfortunately, Louise was unpleasantly surprised that only $320,000 was transferred into her personal account instead of the expected $400,000. That's because her former employer's plan automatically withheld $80,000 (20% of the account balance) for federal income tax. This is mandatory when the transfer goes into a personal account.

As a result, Louise won't be able to accomplish a $400,000 tax-free rollover unless she can come up with the "missing" $80,000 and deposit that amount — along with the $320,000 that was transferred into her personal account from the 401(k) account — into her rollover IRA within 60 days. What are Louise's options?

If she can't find an extra $80,000 to contribute to the IRA, she'll be taxed on that amount because it wasn't rolled over. Plus, she'll generally owe the federal 10% early withdrawal penalty tax on the $80,000 because she's under age 55. She may also owe state income tax. Here's a summary of the taxes Louise will owe on the $80,000 that isn't rolled over:

• $19,200 for federal income tax ($80,000 times 24%),
• $8,000 early-withdrawal penalty tax ($80,000 times 10%), and
• $5,600 state income tax ($80,000 times 7%).

Assuming a 24% federal income tax rate and a 7% state income tax rate, her total tax hit on the amount not rolled over will be $32,800. This permanent detriment could have been completely avoided with proper tax planning.

On the other hand, suppose Louise can raise the missing $80,000. Then, she can accomplish a tax-free rollover of $400,000 into her IRA. In this situation, she'll recover the $16,000 of federal income tax that was withheld ($80,000 times 20%) through reduced income tax withholding for the rest of the year and/or when she files her 2024 tax return. She'll also avoid the 10% federal penalty tax and the state income tax hit. But she could have easily accomplished all that perfectly legal tax avoidance up front with proper tax planning.   

How could proper tax planning have led to a better outcome for Louise? Instead of transferring the 401(k) account balance into her personal account, she could have arranged an electronic transfer directly to a rollover IRA. This is a so-called "direct trustee-to-trustee" transfer. Such transfers are exempt from the 20% federal income withholding rule. So, her rollover IRA would have received the full $400,000 upfront, and she could have successfully accomplished a tax-free rollover with no tax bill or hassle.

Scenario 2: The Lost Home Sale Exclusion

George (age 45) recently got married. Before the wedding, George sold his home, which had appreciated by $500,000 since he purchased it in 2004. The couple planned to move into the wife's home, a small fixer-upper that they planned to renovate. Unfortunately, the couple failed to discuss their plans with a tax advisor.

When you sell your principal residence, if you meet certain tests, you can exclude up to $250,000 of gain under one of the most valuable federal income tax breaks ($500,000 for married joint filers). As an unmarried taxpayer, George was able to exclude $250,000 of the gain from the sale of his home, resulting in a $250,000 taxable gain ($500,000 minus the $250,000 federal home sale gain exclusion). He owed 15% federal income tax on the gain, plus the 3.8% net investment income tax and state income tax.

How could proper tax planning have led to a better outcome? Instead of selling his home before the wedding, George could have held on to the property and lived in it with his new spouse for two years before selling. George could have taken advantage of the $500,000 home sale gain exclusion break available to a married couple by postponing the sale. That would have permanently avoided $250,000 of taxable gain and the resulting tax hit. If necessary, the couple could have sold the fixer-upper, which probably had a smaller gain that could have been sheltered with his spouse's $250,000 home sale gain exclusion.

Alternatively, if the couple could afford to hold on to both homes, they could keep the fixer-upper and remodel it while living in George's house for the requisite two years after the marriage. Then, they could sell George's home and claim the $500,000 home sale gain exclusion. Finally, they could occupy the newly renovated fixer-upper for two years, sell it, and shelter up to $500,000 of gain with the exclusion of a married couple.

A Valuable Exercise

Proactive tax planning is worth the effort — especially if you have a lot at stake and/or tax rates increase. While you might already understand the two tax issues in the above hypothetical scenarios, other situations can be more complicated. A lack of detailed knowledge of the tax code can lead to costly mistakes. Contact your tax advisor for the best tax planning results for your circumstances.

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