Tax Prep vs Tax Planning – is the goal of minimizing lifetime taxes
Marcus Schafer (00:06)
This is episode 19 of Greenstream where logic meets life and investing. This is Marcus Schafer co-hosted with Pat Collins. We’re both at Greenspring Advisors. Today, we have a super interesting conversation for Pat, who comes from the CPAs and is the enrolled agent. What is the difference between tax prep and tax planning? So Pat, maybe I’ll kick it over to you to get us started.
Pat Collins (00:29)
As you said, this is one of my favorite topics. I’m looking forward to getting into it. We’re filming this ⁓ in mid-October. This is the time to start thinking about tax planning. Tax preparation tends to happen after the end of the year. in short, tax planning is really the work of trying to minimize your taxes over a given year or a multiple set of years. So all the strategies and different types of projections that go into that.
preparation, sometimes people call it tax compliance, is really making sure that you do all you fill out all the forms correctly, you follow the laws that you file your taxes on time. This is what I think a lot of people think of when they’re thinking about taxes and doing taxes is getting all of their documents, gathering them all up and handing them over to their accountant to prepare their taxes. But there’s more that goes into it. We think there’s a lot more that goes into it. So.
In the podcast today, we’re going to talk a lot about the strategies that we employ or things that we look at to try to minimize tax over a single year, but it could most likely be over multiple years. So I’m excited about it. think it’s a topic that goes kind of under the radar sometimes. A lot of times people compartmentalize their finances. say they have, my investments are with my financial advisor and my taxes are with my accountant.
And there’s a lot of kind of overlap with that. So we’re gonna talk about that. The last thing I would just say before we get into it is that I think it’s important to think about is this being done for you? And for most clients they say, yeah, my accountant tells me or my tax preparer tells me, hey, you should think about doing this next year or something like that.
The Challenge of Tax Planning – comes down to timing and uncertainty
But what we found is that for many clients, the real details of looking at strategies, implementing them, trying to figure out how much tax that’s going to save, that’s typically not being done. The business, just maybe this is a little bit inside baseball into the finance world and financial advisors is business of doing individual tax preparation, tax compliance. That one thing that you talked about in the beginning, it’s really
a volume type of base business. If tax preparers are doing sometimes hundreds or thousands of tax returns, it’s very difficult to go backwards in time and say, I’m going to reach out to these people at the end of the year and do tax planning. It does happen from time to time, but what we found with many of our clients is that they’re not getting that type of advice.
So it doesn’t mean that it can’t be done, but we just think it’s an important time. This time of year is a really important time to start thinking about taxes, because if you wait until January or February when all your forms start coming in, your 1099s, your W-2s, all that kind of stuff, it’s too late. There’s really almost nothing you can do at that point. So hopefully this is going to be timely for our listeners.
Marcus Schafer (03:31)
Yeah, I think it really builds off of the financial plan, right? Which is strategy. A lot of people will come in, do a one-time financial plan. We’re happy to help people do that. But one of the challenges, what it tells you is, here’s what I think my tax rates are going to be over time. And what you learn is if you can plan that out, then you can start to think about different strategies. But then life gets in the way. And so some strategies you actually end up implementing, other strategies you don’t.
And then there’s things that you didn’t foresee that pop up that you want to take advantage of. And just to kind of build some structure to it, kind of what you essentially have to do is you have to estimate how much income you’re going to have for the year before the year is finalized, which is in itself pretty challenging to do. So you have to think about, what are my wages? What are my potential bonuses for my employers?
What about distributions from my investments? What have I done so far? And that in itself is a lot of work and you have to do it towards the end of the year, which creates another time crunch and you have to leave certain amounts of cushion, right? Hey, I don’t know exactly what my bonus is. I think it’s going to be about this. know, bonuses oftentimes paid December 15th, that type of thing. So you only kind of know, Hey, I think December one.
I know my bonus and now I have 30 days to implement some of these strategies. So it’s just about trying to think what’s my tax rate going to be this year and the difference between my marginal tax rate, my effective tax rate. And then what can I do to take advantage of that based upon what I think tax rates are going to be in the future.
Pat Collins (05:24)
Yes, there’s a number of challenges with it. And, you know, I come from ⁓ my father was a CPA, did tax returns, and then he was an accountant. What I found is that oftentimes accountants, what they’re really good at is the compliance part of it. They are very good at making the numbers all match up. There’s a little bit of art to what we’re doing here because you have to do projections into the future, whether it.
It could be a very short future. could be, I’m doing a projection. I need to figure out, estimate what my income is going to be between all my investments and my earned income and my business income and my real estate income. May not have all that information in the calendar year that I’m trying to make a projection. But as we’ll talk about, sometimes you’re doing multi-year projections to try to figure out how am going to minimize my tax over the next 10 years? And so that gets really tricky.
We have no, you know, there’s no certainty around that because you don’t know what our income is going to be five or 10 years from now, much less we don’t know what tax rates are going to be five or 10 years from now. So there is kind of a little bit of an art to it. You have to make assumptions. It’s kind of like a financial plan where you are making assumptions into the future. So I think there’s, we’ll talk about that as far as how we navigate that, but I do want to make sure and stress that there’s no certainty with this. Like there is when you are doing a tax return.
which is I know exactly what the income is, because I have a form, it tells me what it is, I put it on the return and it tells me how much I get in a refund or what I’m gonna owe. This is a little bit different, we’re trying to make estimates there. And if you do it well, it can be really, really valuable. The one thing, this last thing I’ll say before we get into kind of some of the strategy side of it is my experience has been tax planning.
is not in most cases is not about hitting like the home run where all of a sudden someone has $100,000 tax liability and we take it to zero because of these magical strategies that we put in place. It’s kind of tax planning effectively is making these small adjustments that will give you hit the singles basically. And hopefully you can save a few thousand dollars a year.
And you do that over time, it can be really impactful to your overall after-tax wealth. But oftentimes, again, we’ll talk about the strategies. These are not things that all of a sudden you realize, oh my gosh, I can just avoid all these income taxes. Most of the time it’s around when you pay your tax, not necessarily if you’ll pay tax, basically.
Projecting Future Tax Rates – the One Big Beautiful Bill Act provides more certainty for future tax rates
Marcus Schafer (07:58)
It would you do this anyways? And then the question is, well, when is the best time to do that? And how can you maximize it given you would have done it already as opposed to some secret sauce that, you know, the switch you always see on online, the rich are using this tactic to avoid paying taxes. That’s not really what it is for most people.
You mentioned uncertainty about future tax rates. Tax rates change over time, which is why there’s uncertainty. The most recent tax bill that was passed, perhaps it gives us a little more near-term certainty than maybe over the past five years. We did a webinar on that. ⁓ It’s on our YouTube. We’ll kind of link it as well. So if anybody’s super interested, dive back into what’s happening there. But it kind of
wrote some of this stuff into law, which takes an act of Congress to overturn some of it. But then there’s also different phase out. So there is just tons of different complexity. And maybe if you’re ready for it, maybe we’ll just start jumping into some of this stuff right now,
Pat Collins (09:13)
Before we jump into it, I guess this one comment, because you brought it up and I think it’s an important one, thinking because we probably won’t go back to this a whole lot, is the history of tax rates in the US and what that looks like. And so there’s really two different rates that we always look at. There’s the marginal rate and the effective rate. So US system, like most, is a progressive tax system, meaning the first amount of income is taxed at 10 percent and then 15 and then so forth, 22, 24.
So you have this progressive tax. When you think about a marginal tax rate, which is really important in the planning process, that’s like the last dollar that you’ve earned. What is that being taxed at? So if I’m, when people say, I’m in the 24 % bracket, that means the last dollar that they were taxed at was taxed at 24%. The effective rate, or sometimes people call it the average rate, would be if I just took my overall tax that I’m paying and divide it by my income.
it’s going to be lower than your marginal rate because it’s a progressive system because my first amount of tax that was paid or my first amount of income was at a much lower rate and it’s to keep stepping up. So why is that important? Well, when you’re thinking about strategies of deductions or bringing income in, the marginal rate is really important because that’s telling you what the benefit is of maybe a deduction or what the tax is going to be if I pull income into a year. So that’s really important.
If you look over time, the marginal rate in the U.S. has been all over the board. It has been as high as over 90 percent for the top marginal bracket. Right now, it’s at 37 percent, but it really moves around. We’re definitely on the lower end of where we have been in history. Interestingly, if you look at historical average rates, meaning kind of the rate that you would pay on average of your income that goes to tax at different levels.
That’s pretty steady. example, the average effective rate, I kind of did some, some numbers here for the middle quartile in the federal side has been about 13%. That’s currently what it is today, but it hasn’t changed a whole lot. It’s gone down a little bit. The highest rate, the top 1 % right now in the, in the U S are paying about 30 % effective rates. The lowest quartile is essentially paying zero. They’re not paying any federal taxes really.
So again, the average rate and the effective rate are important when we’re thinking about this and we’ll probably talk about them. So going into kind of more of the strategies now of what you should be looking at to do tax planning. probably one of the most important questions we ask our clients and try to figure out is what do think your income is going to be this year versus next year versus the following year and so forth, kind of trying to project that out.
Strategies for Low Income Years – pull taxes forward by converting assets to Roth accounts and delaying deductions
High income typically means that, for example, if I’m in a high income tax year and I think next year I’m going to be in a lower income tax year, that creates opportunities for me to try to pull deductions in to this year because I’m in a higher marginal rate. Therefore, my deductions are more valuable. They’re getting maybe 37 % on every dollar is getting returned to me for a deduction. If next year I’m in the 24 % bracket marginally, then
I only get 24 cents back on the dollar when I get a deduction. So those types of things are really important when you’re thinking about where to kind of pull in income or when to pull in deductions. Deductions could be things like charitable contributions and things like that.
Marcus Schafer (12:45)
Yeah, so you’re looking at your marginal tax rate and this is on income you earn from a job, not capital gains. And we’ll kind of talk about the difference here in a little bit. And you’re just saying, here’s my tax rate today. What do I think it’s going to be in the future? And then hopefully you have guidance from somebody to say, okay, well, if it’s lower today than the future, we actually, weird, we want to pay more taxes today.
And there’s a benefit to that. Or if our tax rate is higher today, then it’s going to be in the future. There’s a benefit to paying taxes in the future. So we’re going to do strategies to shift our income into the future when we can recognize and pay. Hopefully the lower tax rate. And then to your point, rates are changing over time. So you probably still want to employ diversification in the sense of you’re not a
saying all my taxes I’m going to pay in the future as much as possible. You want to have different types of accounts. Okay. So, so let’s say Pat, you are in a lower income tax bracket this year than you think in the, future. This kind of comes into a few different scenarios when you’re younger and you’re kind of climbing the career ladder. That’s, that’s one also right before you retire, kind of leading up to retiring.
you kind of think about some of this stuff too, right? You’re going to say, hey, I’m in a higher tax bracket and I’m going to drop once I retire. So what are some strategies people should be thinking about?
Pat Collins (14:28)
Let’s start with the idea that we’re in a low bracket and we think we’re going to go into a higher bracket in the future. So this is ⁓ an ideal one maybe to stop and talk about what I think most of our listeners probably have access to, which is some sort of retirement plan or retirement vehicle. You oftentimes have a choice and that choice is you make pre-tax IRA contributions or 401k contributions, or do you make post-tax or Roth tax-free contributions?
And so the benefit obviously is if I’m making pre-tax contributions in a 401k or an IRA is that I get a deduction today. I get to deduct income. So this would be most advantageous when I’m in a high bracket today and I think I’m going to go lower. In the example we want to of touch on is I’m in a low bracket. I want to go higher. The focus should then be on Roth contributions and or we’ll talk about Roth conversions.
is another opportunity to do that, basically have the same outcome. But the idea is that I’m going to recognize that income today. I’m going to put that into a Roth IRA. And then in the future, when I take it out, it’s going to be tax free. Now, this one’s kind of tough for people because it is, especially if you’re young. We’re not talking about what would be my tax rate next year, the year after if I’m making a Roth contribution to my 401k, because
I’m not taking it out next year. If I’m 40 years old, I might have 30 years before I start taking this money out. So it’s really, what’s my tax rate going to be in retirement when I’m pulling this money out? That’s tough. We’re talking about 30 years from now. It’s almost, if you look at tax rates, there’s no guarantees, but tax rates change and tax rates will most likely change over the next 30 years. We don’t know where tax rates are gonna be.
That is a tougher one to do to think through. To your point, one of the ways we counsel a lot of clients, if you don’t know, maybe the best strategy is to diversify. Kind of like we don’t know which stock is going to be the best stock next year. So we diversify our assets so we don’t take this massive amount of risk. And it’s the same way with taxes. If I put all of my money in pre-tax 401k contributions and that grows, I’m creating this tax liability in the future that it’s kind of unknown. I don’t know what tax rates are going to be.
So if I have some diversification, could say, well, I don’t know where I’m going to be. I’m going to go 50 50. I’m going to take half my contributions to my 401k. I’m going to put it in a pre-tax. The other half, I’m going to put it into a Roth gives us some tax diversification for the future. way I like to think about it is what’s the probability of this is hard. Obviously there’s a little bit of an art to this, but what’s the probability I’m going to be in a higher bracket when I retire than when I where I’m at today. And if I think
You know, it’s unlikely because I’m not going to be earning income anymore. I know maybe tax rates could go up, but I’m not a hundred percent sure that’s going to happen. So maybe I’ll put that at 25%, 25 % chance that I’ll be in a higher bracket in retirement than today. Well, then that’s maybe a decent place to start when you’re thinking about your contributions is take 25 % of your contributions and put it into Roth because that kind of protects against that. And then 75 % put it into pre-tax. So again, not
perfect science to that, but it’s hard to do that because we don’t know what the future is going to bring.
Marcus Schafer (17:58)
Yeah, I have probably a more simplistic thought process where for a lot of people, you get the company match. That’s going to be pre-tax. So that already is kind of helping shape your tax diversification a little bit as well, because if you contribute with Roth, then you got that bucket, but then your match is the other bucket. And then there’s also just behaviorally, like don’t
Don’t forget that your paycheck will be lower because you’re paying taxes on the Roth stuff. A lot of times people just anchor to the percentage, hey, contribute 10 % of your income. So that might be a way just to gain thinking about how do I juice my contributions for the future if that’s what you want to do is kind of behaviorally, there’s a little bit of mental, mental accounting happening there.
Maximizing The Retirement Income Valley – leveraging temporarily low tax rates between retirement and the combination of social security and required minimum distributions
Pat Collins (18:54)
I think the other side of it that I would touch on if you’re going to be a lower bracket in the future, maybe this other scenario that many of our listeners might be approaching at least is what some people have called the retirement income valley, which is basically I retire, let’s say at 65 and I have five years till I’m required to start taking social security. Then I have a few more years till I need to take money out of my IRAs and generate income from that.
So I have this period for five years where I may have almost no income or maybe it’s just dividends and interest from a portfolio. And so it’s an interesting time because unlike the 40 year old who has 30 years before they need to take their money out, the retiree who’s 65, we have a little bit more visibility into what their income and tax rates might look like five years from now than today.
And so this creates this opportunity where most of our clients, they’re in higher tax brackets in their seventies than they are in their sixties after they’ve retired because of this, you know, these, these income sources that start kicking in. So it does create an opportunity Roth conversions at that point, maybe you’re retired. So you don’t have a 401k you’re contributed to anymore, but you have this IRA that you’ve built up over time and it’s got pre-tax money. You’re going to have to eventually start paying tax on that.
So that’s really another scenario where you would look to say, does it make sense for me to convert some of this IRA to a Roth IRA, pay tax now at a very low rate to avoid tax in the future at a higher rate? And so that’s a strategy to consider as well. It’s probably a good time to talk about just actually what’s going on in a tax projection.
I found these to be extremely important because there are things happening that sometimes you don’t foresee. what we’re talking about can seem very logical, but it’s too simplistic. for a given example, I might look and say, okay, I’m 66 years old. I don’t have any other income coming in or maybe I have some income coming in from my portfolio, dividends, interest.
but I’m gonna be in a much higher bracket in a few years. Absolutely, let’s do Roth conversions. And I start to do some Roth conversions. What I don’t even realize is that one, I start getting phased out of maybe deductions or things that I can take advantage of. Not great, that all the kind of effectively creates more tax that I thought I would be paying. There’s even things like Medicare has a surcharge on the premiums you pay.
The Complexity of Tax Projections – deduction phaseouts, Medicare surcharges, and other features of the tax code create complexity
based on how much income yet you have. So you have to consider that. So I’ve found that you have to do a projection in say, it’s very difficult to do it in like a spreadsheet. You actually have to kind of almost do your tax return at that point at the end of the year at a time like this to try to figure out what really is the impact of doing conversion and how we do that is you would do scenario one, which is base case. I don’t do anything before the end of the year.
And then you look at what would a conversion of say, a hundred thousand dollars of my IRA to a Roth IRA be. And I look to see how much extra tax am I going to pay on that and what that’s basically kind of the number I want to focus on. So we’ll probably talk about some stories, but there are many times where it seems logical to do something until you put it into a projection and you realize it’s impacting some other area of your taxes. You didn’t even realize.
Marcus Schafer (22:33)
Yeah. And some things like the medical surcharge, that’s just really tough to visualize where, oh, there’s this other bucket. you know, could be when you’re jumping brackets, could be a hundred or $200 per individual. So if you’re thinking a couple, it could be $2,500 a year in additional taxes. You didn’t think that you were paying because you’re looking at marginal tax brackets. You forgot that they’re slightly.
five marginal brackets you have to keep your eye on all at the same time. You have your income, your ordinary, then you have your capital gains, and then you have these medical surcharge brackets.
Pat Collins (23:12)
It’s a great point in that your increase in income tax from doing a conversion could impact your capital gains, could impact your IRMA. And so there’s all these different, it’s, the government and the IRS have not made this simple. Probably great for people like us that keeps us employed, but there is a lot of complexity to it when you start getting into it. So I would just say that’s certainly something that you should, if you want to do tax planning.
The best thing to do is to have some sort of system to be able to put in two different scenarios. Could be just a tax prep software. You could actually, you know, maybe try to use TurboTax or something like that and do it twice. But you have to go through that exercise because it’s very, very difficult to model out this kind of thing on a spreadsheet because there’s so many different moving parts. I’ll use one other quick example we just found with a client. We had a client with very, very high income.
and they were going to be retiring in a couple of years. So it was clear that what we thought was now’s the time to do a lot of charitable contributions. Because again, high marginal bracket, you’re going to be in this high marginal bracket for only a year or two. And then you’re to go to a much lower marginal bracket. Let’s get deductions in now. And when we ran the projection, we looked at it and said, this can’t be right, is it? ⁓ We’re not
you know, it’s actually more valuable to wait to take the deductions to after they retire. And what we found was with the new bill is that there was phase outs happening that were not giving them credit for these deductions. should have made it was better for them to hold up their cash or save their cash and do their charitable after they retire. So these are things where it doesn’t seem intuitive, but unless you have software to kind of really review it or you have some sort of tax prep type of software like a TurboTax, it’s hard to find.
Figure that out.
Marcus Schafer (25:09)
It gets to this point you raised earlier about this is hitting singles and doubles and it’s not hitting home runs. And some of the things maybe in a second, we’ll just list out a bunch of different tactics you could use in these different scenarios. But we had somebody that was asking us, Hey, have you thought about doing where you contribute to a IRA and then you convert it to a Roth? We could talk maybe about the rules. And the response was like,
Well, I can only do like $8,000 a year. So I haven’t, it just wasn’t like as important relative to my account size. We hear that a lot and that’s kind of one of the benefits of, you know, yeah, it’s only $8,000 a year, but if you did it five years in a row, then it’s starting to, starting to be meaningful. And this is the type of thing that is just so, there is just so much to keep, keep track of. Let’s just name.
some different strategies you could do, right? So we have, that’s a Roth conversion. What else do you have, Pat?
Pat Collins (26:18)
If we’re talking about low income and expect to be in a higher income, two strategies that you would be thinking about in broad sense would be, I want to pull income into this year. That’s what a Roth conversion does. You’re taking it, you know, instead of taking your income later, you’re taking it now. And I want to push deductions out into future years. Basically, I don’t get if I’m in a low income bracket, because, you know, in most cases, I’m going to get more back from my buck when I’m in a higher income tax bracket. So.
That would mean maybe delaying charitable contributions to the following year could potentially be a strategy that you would look to do. Again, like I said, it could mean changing the mix of your 401k contributions to ⁓ overweight Roth versus pre-tax. The other part would be, can you pull income, other types of income into this year? Sometimes strategies could be maybe I’m planning on selling a stock at some point in the next few years.
Maybe I sell it this year, realize the gains because I’m in a lower bracket this year for capital gains than I would be when I would plan to sell it. So that’s another strategy that we tend to see. And then finally, this is maybe where, you know, if you own a business or a consulting company or something like that, you know, you’re in a much lower bracket. You could ask maybe somebody to prepay your fee and maybe you give them even a little bit of a discount and you say, hey, if you pay me all upfront now, I’ll give you a 10 % off.
And if you’re a cash basis taxpayer, that would be an option to pull income into this year versus maybe having it next year when you’re going be in a higher bracket.
Strategies for High Income Years – using pre-tax accounts to push income into the future, while bringing deductions into the present through a bunching strategy
Marcus Schafer (27:57)
Yeah. All right. What about the opposite perspective? Let’s jump over there. So you’re in a high bracket now expect to be in lower brackets. Now, what are these types of deductions you might be taking now as opposed to taking in the future?
Pat Collins (28:17)
basically
just flipped. you have basically if I’m in a high bracket, I want to pull deductions in, I want to push income out. ⁓ pulling deductions in would be things like charitable contributions. It could be, you know, I want to overweight 401k pre-tax contributions versus Roth. Obviously, I avoid doing things like conversions in those types of years. And then maybe even a little bit more granular again, kind of going back to the business.
Yeah, if I have, it’s this year, if it’s, you know, I’m supposed to get paid from a contractor in December, I might just ask them, just, just pay me in, you pay me in January, basically, and I’ll, I’ll cash check then. So if you have any control over timing, if you’re, if you have an employer that, ⁓ you know, has some flexibility with you, you might say, just pay me my bonus in January versus my December 31st paycheck. Most of times that’s not going to happen most because employers.
get a deduction when they pay your bonus. So they want to make sure they get the deduction in the current year. But those are types of things that you want to consider when you’re thinking about tax planning at the end of the year.
Marcus Schafer (29:25)
It does vary for people. And I think there’s kind of like two of these tax brackets where if you’re kind of right on the edge of it, they seem to matter a lot. And that’s the difference between 24 % tax bracket and the 32 % tax bracket is one of those. And if you’re kind of floating right around that line, sometimes you’re jumping in, you’re alternating years to get, you know, if you still want to contribute to charity.
You’re kind of doing bunching strategies where you’re saying, hey, this year I’m going to bunch more deductions and then next year I’m not going to do those deductions.
Pat Collins (30:05)
Yeah, there’s maybe two things I want to touch on that are more, you know, it kind of goes along with this. I call it rate arbitrage. When you’re thinking about tax rates, how do you kind of arbitrage that? So you get the best overall lowest tax over time. One is this concept of bunching. And so I think it’s important when I say, well, if you’re in a high bracket, just pull deductions into this year. That makes sense. But you also have to understand the tax code. We have
We calculate our gross income, how much total income to have, and then we get deductions off of that. And the way the IRS works on the federal side is that we either do one of two things. We either add up all of our deductions, and these are things like mortgage interests, state income taxes, charitable contributions. We add them up. Those are called itemized deductions. Or the government says, you don’t have to do any of that stuff if you don’t want. We’ll just give you a standard deduction. And in most cases, you take the greater of the two.
So for example, if you’re over 65, I think the standard deduction is around $34,000 right now. So if I am giving to charity, let’s say I’ve got my mortgage paid off and I have $5,000 of state income taxes that I paid. When I look and say, should I make a charitable contribution this year? Maybe I’m in a kind of higher bracket and I realize, okay, if I make a $10,000 charitable contribution,
My itemized deductions is gonna be my state income taxes I paid, $5,000, and then another 10,000 of charitable. That’s $15,000. My standard deduction is 34. I’m gonna take the standard. So I got no value in making a charitable contribution. I think a lot of people have not fully grasped that. There is almost no value unless you are exceeding the standard deduction. And even if I did make a charitable contribution, let’s say, I’d say to myself,
I really want to get some benefit out of this charitable contribution. So let’s make sure I get over the standard. Okay, I make a $30,000 charitable contribution. Now my total itemized are $35,000. I was at 34 before I only got $1,000 of that charity of that 30 that I actually got benefit for. So I think it’s something really to keep in mind is what the standard versus itemized are.
And if you are going to do itemized deductions, that’s, is where this bunching strategy could come into play, where you say, instead of making charitable contributions every year, I’m going to do five years of charitable all at once. And then I will then wait for five more years and do it again. So all of sudden now I have a much greater amount that could go over the itemized deduction. So that’s the first kind of thing to think about is bunching these things. The other one would be.
when you’re thinking about, let’s say a Roth contribution or a Roth conversion, you’re gonna pull income into this year. It’s really important when you do the projections to figure out how much room, like one of the questions we have, how much do I do? How much Roth conversion do I do? Well, to your point, there’s different rates where you move into higher rates. So you wanna be mindful of that and say, if I’m in the 22%, let’s say the 24 % bracket, and I have…
$60,000 of additional income I could take before I go into the next highest bracket. That would be a scenario where I would say, okay, well, let’s try to fill that bracket up with $60,000 and not go into this next bracket because then I’m getting an extra 8 % or so of tax on every dollar above that 60 that I put in. So these are some of the types of things when you’re thinking about these kind of, am I a high bracket? Am I a low bracket? When should I take deductions?
There’s also these kind of underlying strategy of understanding where you are within your rates. And then if you’re going to do deductions, potentially looking at how much is itemized versus standard and bunching things, if that makes sense.
Business Owner Tax Strategies – utilizing cash balance and pension plans
Marcus Schafer (34:03)
Yeah, that’s excellent. then what about, so this is kind of like all of these are mostly available to W2 employees. But if you’re a business owner, and depending on the size of the business, there might be some additional tools that you should, you could be thinking about. So as a business owner, what are some of those additional levers that they might be able to pull?
Pat Collins (34:27)
it obviously comes down to deductibility of expenses a lot of times. I don’t want to get too much into that because it kind of there’s some gray areas as far as what you can deduct what you can’t. But I would say the big ones, depending on the size of your business, how many employees you have on the retirement plan side, there certainly are different options that you could consider. And this is where you want to bring in an expert to understand what’s the benefit or the value of these.
But the IRS, you know, most people are just used to 401k’s to save for retirement. There are other types of plans that are out there. They tend to look like the old pension plans basically. But if you have a very small company, maybe, you know, the best scenarios tend to be, or the best kind of profiles tend to be high income earners with not many employees. So, you know, think about like consultants that maybe are independent contractors, could be professional services firms.
that have maybe a number of high paying professionals with a lower paying staff. But you can do things called like cash balance or pension plans. And we’ve seen scenarios where clients were able to save, know, inside of a 401k, maybe between their employer match and what they put in, maybe they’re putting in 40 or $50,000 at the very top end.
and these might allow for 150 to $200,000. So if you’re very high income and you’re making, let’s say seven figures and you’re solidly into that 37 % bracket, and we’re here in Maryland where we have a very high state rate as well. could be approaching 10 % ish based on all the different rates that you pay or taxes that you pay. So when you look at that and say nearly 50 % of your last hour of income is being paid and is being paid in tax. Finding ways to defer.
can be really beneficial. So if you tell somebody or show somebody that they could defer, let’s say $200,000, and that is at least for the time being, deferring, you know, maybe something like $100,000 of taxes, it can be very beneficial. So if you fit that profile of kind of owning your business, typically where it gets to be harder is if you have 200 employees, it gets to be very difficult because there’s some rules around being equitable.
with these retirement plan contributions. And you can’t just say, I’m to give it all to myself and none of my employees. So once it starts, it starts to get very expensive to have to do this for lots of employees.
Incorporating Expected State Taxes – can change the math if you plan on moving to a state with very different taxes
Marcus Schafer (36:59)
One other thing you mentioned that I don’t think we at least highlighted, but the importance of state tax in this decision, how that also affects whether or not you want to be doing some of these mechanisms. you know, if we’re thinking about the difference between the 24 % tax bracket, 32%, that’s 8%, the difference between a Maryland state tax and a no income state tax.
is pretty significant as well. So you also want to be thinking about, hey, what are the chances I move to a different state when I’m actually taking this? And that’s not to say that that should be your reason. We have a bunch of clients that move and it turns out markets are pretty efficient and the cost of other goods goes up.
But it is to say that.
Maybe if you know you’re going to be moving to Florida in two years, it probably doesn’t make sense to pay the Maryland tax converting that to a Roth just to take it out in two years in Florida.
Pat Collins (38:06)
It’s a great point. Obviously we have clients that come to us that want to understand the difference of domicile where they’re living. Obviously, Florida is a popular one, like you said, and that’s probably maybe even a totally different podcast of thinking about cost of living in retirement. But like you said, there’s tax and then what we found sometimes, and this is just something for people to think about if this is a, you know, obviously a podcast on taxes.
But a lot of times I’ll hear clients say, when I retire, I’m moving to Florida because I’m getting out of this high tax state. What they don’t realize when you do the math is all of sudden you have no income anymore or very, you your income goes down significantly. The time to have moved would have been when you were in your highest tax years, your highest earning years. So you get a minor benefit by moving in retirement, but then that’s oftentimes offset with things like property insurance, for example.
all of sudden you now have a $20,000 property bill, your Maryland tax would have been $18,000 and you realize, it’s basically a wash. So, you know, want to think through that before you make the move. One of the other things that I think tends to be a topic that people want to understand is this time of year, if we’re doing tax projections is, well, am I going to get a refund? Am I going to owe money? How much? How do I make sure I’m withholding the right amounts?
How To Avoid Penalties – understanding safe harbor rules, how to withhold taxes with the least amount of effort, and maximize interest until you pay
So I thought maybe just for a minute, we could talk about just making sure you avoid penalties, making sure you’re setting up your kind of withholding strategy correctly. So there’s basically a rule with the IRS and with most states, which is called the safe harbor rule, which basically says, if you meet the safe harbor, you don’t have any penalties when it comes to filing taxes, which is great. So there’s two ways you can meet the safe harbor. One is you have to withhold at least 90%.
of your current year tax. So if I know this year I’m going to owe $100,000 in taxes, I need to make sure I’ve withheld or paid an estimated taxes $90,000. If I’ve paid 80, I’m going to have a penalty because basically what the IRS does not want is for me to not pay any taxes, get to keep all that money all year and then just pay it at the very end. So there’s a penalty, there’s interest that’s due on that. The other way to meet the safe harbor is I pay
depending on your income, but let’s say I’m a reasonably high income, it’s 110 % of my prior year tax. So if my prior year tax was $100,000, as long as I pay in 110,000, I’m fine. I don’t have to pay any penalties. So how do you plan around this? This is another interesting planning topic to think about. So if I’m gonna go, let’s just say last year, use that example, I’ve paid $100,000 in taxes.
Let’s say this year I’m going to owe $500,000 in taxes. Maybe I’m selling a real estate property. I have something big happening. I get this huge bonus, whatever that may be. I want to make sure I use the safe harbor from the prior year because I don’t want to pay my, you know, pay the government any sooner than I have to. That tends to be our strategy. Even if you say, I don’t like surprise, I don’t want to have to pay anything. That’s fine. Just set up an account, earn your interest for a year and then pay it to them. Know that you have that money set aside.
But in this example, I have to say that I don’t have to pay $110,000 to avoid penalties. I know I’m going to have in that example, a $390,000 tax bill come next April, but I can keep that money sitting in an account and I can pay it next April and I can earn interest throughout the way. So that would be the strategy. If you’re going to be in a much higher bracket, use the prior year safe harbor. The other way would be what if I’m going into a super low bracket? Let’s just say.
You know, last year I made, you know, I paid $100,000 in taxes this year because maybe I’m retired. I’m only going to pay $20,000 in taxes. Well, I don’t want to have to, I don’t want to withhold 110 % of my prior year tax because I don’t, I’m going to owe that. I’m going to get this gigantic refund. I’m giving the government money earlier than I actually have to. So in that case, I have to, I should be doing 90 % of my current year tax. I should look at that and say, let’s be, let’s estimate it.
And that’s, need to just make sure I put in at least $18,000 to meet my, my, my tax, safe Harbor. So the last thing I would say on that is accountants pretty much always I’ve seen tend to err towards just pay the safe Harbor based on prior year tax because it’s a known quantity. I know when I do my taxes, I know exactly what 110 % of the next year taxes paying 90 % of the current year tax is kind of risky because.
I don’t know what the tax is gonna be throughout the year. I don’t know exactly how much income I’m gonna earn. So it takes more work, it takes being more proactive, but I would just say it’s something to think about when you’re trying to avoid penalties is thinking about which safe harbor method do I wanna take.
Marcus Schafer (43:08)
Yes. Yeah. And then, ⁓ you know, just thinking about which method you want to take, how do you pay those estimated taxes? Right. So you could do the four quarterly payments. There’s a website and a system set up to do that. You could withhold somebody like us could help you do the withholdings from accounts, especially if you’re a retiree and you’re drawing on Social Security. There’s an avenue to do that. We could help with the
the RMDs and withholding from there. So it’s not too onerous. I think there’s some ways about that. But again, I think this is great example of singles and doubles. It’s, hey, do want somebody else to hold on to your money for a little bit? Or do you want to have control over it? A big ⁓ principle we have in investments is there’s value in optionality.
I have the money that gives me flexibility if I need to use it or I need to leverage it. And I value that flexibility as opposed to giving it to the government, getting a refund. ⁓
Pat Collins (44:12)
Yeah, I just had a client. ⁓ We’ve had several of these this year across the firm that have sold businesses and had really, really large sale prices and capital gains. And, you know, we’ve calculated the tax and obviously we could pay, you know, their safe harbor through 90 % of their current year tax. But if they’re going to owe $5 million in taxes and we do the math and say, wow, we could put that in a T bill for a year before you owe it.
and that might earn close to 4%. And all of a sudden, that’s $200,000 of interest that you could earn on that money that you’re going to owe in tax. That seems even like more than a single a lot of times. That could be a double one type of thing. yes, sometimes it’s nice to just pay the tax and be done with it. Our feeling is take as much advantage as you can for as long as you can with money that you have to pay taxes on.
The Importance of Asset Location – selecting tax-efficient investments for taxable accounts, tax-inefficient investments for tax-deferred accounts, while factoring in expected growth
Marcus Schafer (45:04)
Exactly. And you kind of bring us into this interplay between the investments and the taxes. Investments are going to kick off two different types of income, right? You have ordinary income that they kick off, and then you have capital gains. And I think that those two points, this white tax location, asset location is so important, right? Putting investment types that kick off income type taxes.
And to tax deferred accounts is super helpful because, you know, think about different, if you had $5 million in cash, you’re going to have to pay income tax rates on the interest that’s earned from that. So you just have to think a lot about that. And index funds have been amazing, but they kind of hide some of these different less efficient investments like REITs. They kind of hide them within something that you think is more efficient. And that’s just…
Probably basis points of added expense ratio would be one way to think about it, but it could really hurt if your account’s big enough and you’re right at the cusp of some of these marginal tax brackets and the ability to not do certain tactics.
Pat Collins (46:18)
We talked about this at a very early episode about the value of an advisor and different firms have tried to kind of quantify this idea of asset location, kind of what you’re talking about of trying to put investments that are inefficient, I would call it from a tax perspective, in side of accounts that are tax deferred or tax free. And this is this one where I would call it a single. These are singles that you can take and it won’t be a home run.
but you can have small amounts of value by thinking about what type of account this is, what types of assets should I own in it, what should I avoid in it. And then there’s other accounts like we talked about Roths here for a while. These are accounts that are tax free. We want to get the most growth as possible out of those accounts. We don’t want to have those sitting in cash. We don’t want to have those sitting in bonds. We want to get long-term returns out of our Roths typically. So
Forced Capital Gain Distributions – how to spot likely distributions and maximize the expected distribution through giving to charity or tax loss harvesting of other investments
I think these are all like little singles that you can take that will add up over time. There’s kind of a thing that I’ve been seeing in the industry really over the last two or three years. It’s kind of this combination of a few things happening in the investment industry. So one is there’s this massive shift towards passive investing and ETFs. So people are saying,
I want to move more to low cost funds, which is great. We’ve been preaching this forever for 21 years now. And so it’s nice to see the industry starting to move there. The other thing is that the U S markets have been doing extremely well as far as returns in the U S stock market. So there is a local mutual fund that I will remain unnamed, but, ⁓ you know, company that has lots and lots of funds that are U S based.
that are actively trading and investors just preferences. People are taking money out of those accounts and moving them towards lower costs, ETFs, passive investments. Vanguard is just kind of seems to be gobbling every dollar up that’s coming into the industry right now. And so what does that mean for taxes? If you were in a mutual fund, even if you don’t sell it,
if there is capital gains inside of your mutual fund. And that’s kind of this phenomenon that’s happening is you have people selling, moving to passive, the fund has to sell, it’s creating capital gains because it has everything’s up in their funds. It then has to pass through a capital gain to you, even if you don’t sell the fund. So this happens typically in December of most years for funds. This is a really important thing to understand if you are an investor.
is am I in a fund that could be passing through capital gains to me and how am I dealing with that? So in some cases, the answer is I’m gonna just pay the tax. The other answer is maybe I sell the fund and pay the capital gain on my position just right now because I wanna get out of this like everybody else isn’t going to pass it. There’s other options that we would say, which is maybe.
you use that position to fund a charitable contribution. And you can do that different ways and give it directly to charity. can put it into something called a donor advised fund, but that way you get a deduction potentially, and you’re able to avoid that’s capital gain distribution as long as you make that contribution into the donor advised fund or to the charity prior to the distribution being paid out. So just something to keep in mind when you look at your portfolio is if you have a lot of mutual funds that are actively traded,
Every year I would be looking at your 1099 from, you know, a Fidelity or Schwab or wherever you hold your assets. Look at your 1099 at the end of the year. Did that company pay out capital gains? You may be paying more taxes than you even realize because of your investments.
Marcus Schafer (50:07)
Yeah. And what’s really, really challenging about that too is you mentioned the US market broadly is up. Well, those companies are even paying out capital gain distributions in a given year when the markets are down, which is especially painful, right? 2022, there were still some big capital gain distributions. And you mentioned one way to solve for it, sell. Another way, give to charity.
A third way is you could try to use the rest of your portfolio to think about doing what’s called tax loss harvesting to generate losses that can then offset those gains. that’s, if you bought something more recently, say last year, that active fund kicked off a capital gain distribution. You did something, you bought some investments and those happen to be down. You could sell those, recognize the tax benefit and then buy something else. You got to be
careful about not buying the exact same thing or something too close to it to preserve the spirit of the rule. But there’s a lot of tactics and this is probably a separate episode is really thinking about what’s the evolution of the tax focused investment sphere. But it’s really evolved and there’s a lot more tools and strategies to start harvesting those losses to offset potential
larger capital gains elsewhere in a portfolio.
Pat Collins (51:36)
One of the things that we tend to do here kind of behind the scenes is we’re measuring the tax drag on our clients’ portfolios. And that tax drag, the way I kind of define that is what percentage of my return is lost to taxes. And it’s unique for every client because every client’s in a different rate, tax rates and whatnot. They have different types of accounts. If you have all of your assets in an IRA, you don’t have any tax drag because you’re not paying a tax on that until you withdraw the money.
But it’s an interesting exercise if you own all of your money in a taxable account, for example. If I earned 8%, how much did I lose? All you see on your statement typically is 8%. When I figure out how much tax was associated with that 8%, is it 7.6 % or is it 5 %? A lot of it depends on the strategies you’ve employed on how tax efficient you are. Morningstar did a study and they estimated somewhere around 2%.
of returns are lost to taxes. So it’s not insignificant. It’s definitely a number that you want to keep in mind when you’re thinking about how to manage a portfolio.
Marcus Schafer (52:45)
It’s something you want to keep in mind, but also you have to be careful. We’ll talk about this in later episodes, but you don’t want to push things too far given your scenario, right? So you don’t need to be more overly aggressive trying to harvest losses. Like a good baseline test is, would I invest in this thing? Would I do this strategy if it wasn’t for the tax benefit or is it a pure tax play? And we’re also thinking about that at the back of our head.
a lot of times saying, hey, there might be a little tax benefit, but given how uncertain investments are, like, I’m not sure, I’m not confident enough that that benefit’s gonna outweigh this potential cost. So there’s reasons to not do it. And I just think finding that line is super, super important.
Pat Collins (53:34)
We always say, never want to let the tax kind of tail wag the dog of your investments. So if you’re making decisions solely on taxes, that’s a mistake typically. You want to make sure, I use the example, if I got into this industry during the tech boom and I had clients that had made lots and lots of money on technology stocks that ultimately went bankrupt and most of them did not want to sell.
because they didn’t want to pay the tax. I don’t want to pay capital gains taxes on this. Well, one year later, surprise, you don’t have to pay any taxes because you have no more gains anymore because the stock went to zero. that’s making a decision based on tax is never a good thing, solely on tax.
The Importance of Proactive Tax Planning – there is value in sorting through the complexity
Marcus Schafer (54:22)
Yes, yeah. And the summary to bring it all back around, it is super, super helpful to not, obviously, tax prep, tax compliance, you have to get it done and you have to get it right. It is very helpful before the end of the year to think about what you expect to happen when you do that tax prep, that tax compliance, and start to implement strategies.
are going to expire at end of the year, some kind of continue until you do your taxes. But think about doing some sort of tax planning in advance so you could start implementing what has to happen. And so that you can actually make some of these tactical things that will, if you’re doing them, you expect them to add value over time. That’s a big part of what we think a good financial advisor should be doing is coordinating with the CPA.
to make sure that, hey, again, if you’re gonna do this regardless of tax benefit, if we could get a higher benefit, then let’s try to maximize any decision you’re making.
Pat Collins (55:31)
Yeah, just, the last thing I’ll add and just kind of reiterate something we said early on would be, I agree 100 % with everything you said there. If you’re going to do some tax planning though, make sure you have some tool to be able to do it with. Don’t just do it on the back of an envelope. It can damage you if you don’t understand all the different implications of making changes to bringing income in, pushing it out, things like that.
Marcus Schafer (55:55)
Yes. Well said, Pat. Thanks.
Pat Collins (55:57)
Thank you.