Planning For Lifetime Tax Minimization Has Benefits

Jalene Hahn |

There are many aspects to financial planning. Every individual has different goals and objectives. One universal goal is to “pay as little tax as possible under the law.” The key phrase is “as possible under the law.” A recent webinar I attended described the tax return due in April as a scorecard for how well you’ve managed your taxes. Year-round tax planning can proactively tilt that April scorecard in your favor.

Tax planning starts with a review of past tax returns with an eye toward looking for missed opportunities. During the fourth quarter of the year, make sure you are taking advantage of all the opportunities available. In addition to annual tax planning, one concept to consider is looking at lifetime tax implications and trying to achieve lifetime tax smoothing. The goal shifts from the lowest current taxes to the lowest lifetime tax bill.

Achieving lifetime tax smoothing is compounded by the constant changing of the tax code. There are some tax fundamentals everyone should understand. Basics are income and deductions. Theoretically, the more income you have, the more you should pay in taxes. The reality is that different kinds of income are taxed at different rates. “Ordinary” income is currently taxed at a lower rate than capital gains. Capital gains (or losses) are triggered on the sale or disposition of assets. Deductions and credits are used to offset income or reward certain economic behaviors.

The term “tax bracket” or “marginal tax rate” refers to the highest tax bracket your last dollar of taxable income falls into. The more important measure is your “effective tax rate.” Your effective tax rate is the average rate of tax you pay on all income. It is always lower than your marginal tax rate. You may be in a 22% tax bracket, meaning you will pay 22% in taxes on the next $1 of income. However, there are quirks in the tax code, sometimes referred to as “tax humps” or “tax torpedoes” that can escalate your marginal tax rate beyond the standard tax brackets. Adding income can trigger part of your Social Security Income to become taxable. This stops when 85% of your Social Security Income is included in your taxable income.

The other complication with the tax code is that some provisions are temporary and scheduled to expire. These are often included in legislation to mitigate the revenue cost associated with the legislation. These provisions somehow have a way of becoming permanent. One recent example is making a qualified charitable deduction, or QCD, from a retirement account. This provision was introduced in 2006 with a Dec. 31, 2007, expiration. It was extended several times before becoming “permanent” in 2015. However, remember the tax code is permanent “until Congress changes its mind.”

So how can you engage in long-term tax planning with all these moving targets? It’s not easy. A good example is deciding to contribute to a ROTH or regular IRA. Early in your career, your income is generally lower than it will be later in your career. Lifetime benefits of tax-free growth will generally outweigh the
benefits of a current tax deduction. Do you have access to a deferred compensation plan or health savings account? Would it be better to sell stocks this year or next?

As with most aspects of financial planning, there is no one-size-fits-all. Any tax planning is better than none. Ideally, you can find a professional who can facilitate shifting from a one- or two-year tax time horizon to looking at tax minimization over a lifetime. Also remember that some things that make mathematical sense just go against our instincts.

Ben Franklin said, “But in this world, nothing is certain except death and taxes.” Just because death and taxes are certain doesn’t mean we don’t want to live longer and pay lower taxes.