Taking the Mystery Out of Taxes

Here are five principles to share with all of your clients so they can start planning now for the number that really counts.

By Steven Jarvis

Editor’s Note: Steven Jarvis will host “The 2023 Next Level Tax Planning Summit” for advisors on Sept. 27-29 in Las Vegas (virtual option also available).

Taxes can feel like a mystery. Everyone knows they have to pay taxes each year, but beyond that the process can feel like an inexplicable black box of complexity, anxiety and pain. With the tax code being some 80,000+ pages long, it can be daunting to even dip a toe in the water of tax understanding. The good news for financial advisors (and their clients) is that even understanding some basic principles can make a huge difference over the lifetime of someone’s wealth.

Great tax planning is often the result of small, consistent actions over time. Which means that it can make a significant impact over time to start small, and then build. With that in mind, here are five principles that every taxpayer should know, that most likely no one has ever explained to them:

Getting a refund does not mean you are winning.

For too many taxpayers, taxes are a once-a-year consideration. As a result, most taxpayers are intimately familiar with what happened at tax filing time: “Did I get a refund or make a payment.”

While it can be exciting to get a refund and it hurts to owe the IRS, this is the wrong number to focus on.

Imagine going to the grocery store and having your total bill come to $287. If you hand the cashier $1,000, you would never brag to your friends about the $713 refund they gave you back. The $713 refund tells you nothing about whether you got a good deal on what you actually received for the $287 you spent. The same thing applies for taxes.

We all intuitively know that when it comes to the grocery store, but for some reason too few people apply this same logic to their tax return. Getting a refund or making a payment is only an indication of how well you anticipated how much you would owe for the year. It tells us nothing about whether there is an opportunity to pay less through proactive tax planning. The more important number to know and focus on is line 24 of IRS Form 1040; this is the amount of a taxpayer’s hard-earned money that the IRS kept for the year: their total tax. That is the number we want to bring down over time through proactive tax planning.

Your tax rate changes.

The U.S. has a progressive tax system, meaning the amount of income tax you pay is partially dependent on the amount of income that you earn in a given year. That part most people know. What they miss is what that implies for tax planning: Some years will be lower than others, creating an opportunity to strategically recognize income in relatively low tax years and defer income in relatively high tax years. This is the reason there is a potential difference in outcome when you recommend Roth vs. pre-tax retirement plan contributions. Advisors frequently make recommendations on contribution types, but often neglect to help their clients understand the “why.”

Every plan, including tax plans, are out of date the minute they are thought up. No one knows what the future will bring. Taking the time to build a taxpayer’s foundation around tax concepts like this will help improve the outcome as plans have to be adjusted over time. Instead of going back to the drawing board every time something changes, advisors who have spent time on tax education can tie their recommendations back to the same core principles.

Understand how your next $1,000 of income is taxed.

This is more commonly discussed as understanding a taxpayer’s “marginal tax rate,” but people don’t think in terms of percentages. To build on the second point and really help a client understand whether it’s going to be in a low-tax vs high-tax year, an advisor should be able to articulate “how the next $1,000 of income is taxed.” Putting this in terms of dollars instead of percentages will make the concept more relatable and better set expectations for what will happen in a given year.

In the simplest terms, this will mean multiplying $1,000 by the tax bracket the taxpayer expects to be in. In the 22% bracket, rather than saying, “You have a 22% marginal tax rate,” (which is about as effective as saying “marshmallow, marshmallow, marshmallow’”), say, “For every additional $1,000 you earn, the IRS is going to expect you to pay $220.”

Unfortunately, taxes are rarely as simple as we’d like them to be. Depending on the taxpayer’s income level, how much they pay on the next $1,000 of income could also be impacted by tax-credit phaseouts, shadow taxes like Medicare premiums and net investment income tax, and preferential income (like long-term capital gains) pushing the taxpayer into higher tax brackets. This approach is not meant to be all-encompassing but to provide a framework for questions to ask and potential complexities to be on the lookout for.

Tax rates are already set to go up.

Continuing to build on this theme of understanding relative tax rates and making decisions about the timing of income, it’s important to remember that we already know that tax rates are set to increase. The lower tax rates that were enacted with the Tax Cuts and Jobs Act in 2017 are set to expire after 2025 and tax rates will go up in 2026. That doesn’t mean that every taxpayer needs to run out and make drastic changes, but it’s important to know that tax rates going up in the future is not theory, it’s already set to happen.

Don’t spend money just to save on taxes.

The appeal of saving money in taxes can at times prompt people to irrational behavior. While there are no patriotic awards for overpaying the IRS, spending additional money you weren’t planning to just to get a tax benefit rarely puts a taxpayer ahead. The most common offenders are charitable giving, tax credits around solar panels and electric vehicles, and business expenses. These are all commonly touted online (especially on social media), but they only make sense if they relate to something that you were already planning to do.

Let’s take one of these a step further. Best case scenario, giving to charity could save a taxpayer in the highest federal tax bracket $370 for every $1,000 they give (this assumes they can itemize their deductions, only ~10% of taxpayers actually can). This means that you have to spend $1,000 to save $370, or in other words you have $630 less than you had before. If it’s an organization the taxpayer is passionate about and wants to support, that can be a great thing. If they are just trying to pay the IRS less in taxes, that is a very expensive way to go about it.

The same is true for business owners looking to lower their tax bill through “tax write-offs.” Yes, buying a new laptop could potentially be deductible for a business. But spending $2,000 on a laptop that you don’t need to save a fraction of that off your tax bill is a losing proposition. The approach should be to make great financial decisions that are in line with your goals and only then look for a tax-efficient way to execute those decisions.

Additional Reading: Inherited IRAs: Create a 10-Year Plan Today

To have an impact on taxes over time a taxpayer has to be aware of basic tax principles and regularly revisit their tax situation as it inevitably will change from year to year. There is no need to learn everything all at once, but the foundation is important so that building can continue year after year.

Steven Jarvis, CPA, MBA, is cofounder of Retirement Tax Services, which offers year-round tax services to financial advisors and their clients. Retirement Tax Services will host “The 2023 Next Level Tax Planning Summit” on Sept. 27-29 in Las Vegas (virtual option also available).

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