Did you get a surprise when you filed your taxes this year? It’s common for taxpayers to be caught off guard – either owing more than anticipated or receiving an unexpected refund. Though most taxpayers are relieved once taxes are filed, many have little understanding about how to manage their tax situation to enhance their savings and investment strategies.
Many find the process of managing taxes too daunting and simply react to taxes resulting from savings and investment decisions, rather than implementing strategies to minimize their taxes beforehand.
In 2020, many investors overreacted during the pandemic and, fearing market volatility would erase investment gains, sold appreciated investments, subjecting them to increased taxes. Others sold assets in 2021 and incurred taxes because they suspected a proposed tax increase would push capital gains rates from 20% into tax rates of 37% or more, though ultimately there wasn’t political support to pass such tax increases.
To avoid these types of reactive, knee-jerk approaches to decisions, you need a comprehensive tax strategy in place. Once equipped with appropriate strategies – such as those outlined below – taxpayers can adapt their savings and investment decisions and consider taxes as part of the equation.
Savings and Income Tax Advantages
Planning for taxes is meaningful because they influence other overarching financial decisions, including what we purchase, where we live and work, and when and where we can retire comfortably. Managing taxes effectively requires looking at short-and long-term factors, primarily around savings and spending, investments and legacy planning. Often taxes can be lowered depending how much is saved and what savings vehicles are used. Current income tax rates affect our ability or willingness to save – especially in light of incentives offered by qualified retirement plans. For instance, investing in a 401(k) or an IRA can reduce current taxes and provide tax-deferred investment growth until assets are distributed. Alternatively, a Roth IRA or a Roth 401(k), may result in greater current tax payments but permit tax-free growth and tax-free distributions when funded with after-tax dollars.
Choosing between those alternatives requires looking at the overall situation. An investor in the 24% income tax bracket, for example, who contributes $10,000 to a pre-tax 401(k) plan can save $2,400 in federal taxes, lowering the net overall investment “cost.” A designated Roth 401(k) or Roth IRA, assuming savings at the same $10,000 level, would not provide any current income tax break, but would allow the account owner to later take withdrawals tax-free, provided other parameters are met (e.g., five-year account period and/or meeting other restrictions).
Individuals should compare taxes saved through savings deferral at their current tax rate with those rates likely to apply once tax-deferred assets are to be withdrawn. For example, a married couple or individual with …….