The single greatest expenditure that most individuals face is taxes. Google “tax freedom day” and you’ll find the number of days you work during the year just to pay taxes. In 2017 that day was April 23; or 114 days (about 1/3 of the year) before you begin to keep what you earn. The Tax Foundation estimated that you work January to pay off federal taxes. In February, you pay Social Security, Medicare, other payroll taxes, and state income tax. In March, you pay state and local sales taxes, property taxes, and excise taxes. The first 23 days in April paid corporate income taxes (through higher prices on goods/services), motor vehicle taxes, and severance and estate taxes.
Given the impact of taxes on an individual’s financial well- being, tax discussions warrant a discussion in financial planning. Conventional wisdom on taxes is:
- If legally possible, avoid taxes.
- If avoidance is not possible, defer the tax to sometime in the future.
- If deferral is not possible, pay the tax at the least tax rate possible.
The income tax and investing consequences above can best be exemplified by contributions to a 401(k) defined contribution plan. Such contributions fulfill the planning priorities because:
- Contributions into a 401(k) plan are not counted as taxable income in the year earned. Those contributions are excluded from taxable gross income for the year (avoid taxes).
- Contributions grow tax deferred in the 401(k); no income taxes are paid until money is withdrawn from the plan (tax deferral).
- Retirement plan distributions are generally mandated by age 70 ½ (well past the normal retirement age for most individuals). Assuming the individual is retired, income should be lower than in working years, and, income tax rates should be less (pay at the least tax rate).
Taxes and Investing
Tax circumstances should be considered in the financial planning process in the context of investing. Why? Different investments are more suitable in specific investment accounts than others. There are two main types of investment accounts: 1) taxable (where taxes are due depending on actions in the current tax year), and 2) tax deferred accounts (IRAs, 401(k)s, etc.) where taxes are payable at some time in the future.
There are specific taxes consequences associated with these two types of accounts that can potentially impact investments in each.
- Tax deferred accounts—While taxes on the growth of investments in these accounts are not due until money is withdrawn from the account:
- When money is withdrawn from the account, the money (tax deferred contributions plus all earnings on those contributions) is taxed at ordinary income rates.
- Losses on investments in the account are not deductible against ordinary income or other investment gains.
- Taxable investment accounts—Current taxes are due depending on activities in the account during the year.
- Investments in the account which are sold within one year at a profit are taxable as ordinary income.
- Investments in the account which are sold after one year at a profit are taxable at a lower, long-term capital gains tax rate.
- Investments sold during the year at a loss can use that loss to offset gains on investment sales or to offset other income (currently limited to $3000 per year).
- Some dividends and interest are deemed “qualified” and are taxable at lower tax rates.
The characteristics above can provide some general guidelines for investments in specific types of accounts. Those investments less subject to loss of principle and more stable income (bonds) would be more suitable in tax deferred accounts. Investments subject to possible significant fluctuations in value (positive or negative) such as stock would be more appropriate in taxable accounts. Again these are general rules; specific circumstances may make deviations from the rule entirely appropriate.
Other Tax Consequences
Financial planning should also include possible tax consequences of estate transfer. While the Tax Cuts and Jobs Act of 2017 significantly increased the estate tax exemption amount to approximately $11 million per person, that increase may expire in 2027 or with other political changes.
We at Paragon Financial Advisors help our clients minimize the tax consequences on financial planning. Of course, we recommend that specific actions associated with particular client circumstances be discussed with the client’s tax professional. Paragon Financial Advisors is a fee only registered investment advisory company located in College Station, TX. We offer financial planning and investment management services to our clients.