Updated: Sep 14, 2019
Tax preparation is not the same tax planning. One concept that separates accumulators of wealth from non-accumulators is their willingness to spend when they are not legally required to. Tax preparation is required but tax planning is optional. Read why you should consider taking that option.
When I was in college, I majored in Accounting. It wasn't (and isn't) the sexiest major in business; especially in the mid-1990s. I watched as many of my attractive friends found their way to Marketing and the rest switched their major to Management Information Systems or "MIS" to take advantage of the dot-com era. Admittedly it was mostly my determination to learn something new that kept me in accounting. That and the opportunity to become a superhero. I couldn't wait to take one class in particular: Federal Taxation. To most, it was the most boring class in the curriculum but to me it was the only one that the public ever cared about. What's deductible? What isn't? Being an accounting major didn't increase my chances for dates - I told you all of the beautiful people switched majors to Marketing - but it did prepare me to answer questions about income taxes for everyone from my dad, to my dad's friends and even my co-workers (I worked while in college like many other George Mason University students).
Federal taxation was the only class that made me feel like a superhero and perhaps that's why I'm a financial planner today: to be a superhero in tax and the many other strategies of comprehensive financial planning.
To be fair I hesitated to write about this topic because for one, I'm no longer an accountant. The other reason is people never expect that there's anything "they can do" about their tax situation. At least the people who don't consider themselves wealthy don't think so. Obviously there are plenty of people we hear about who try to do whatever they can get away with! But regardless of your income or wealth level, there is usually something you can do to improve your cash flow. And that's all tax planning really is: identifying legal methods for managing your present and future tax liability. And managing your tax liability will give your more control of your cash flow. So below are more than a few ways to identify those opportunities.
Managing Your W-4 and W-2
Thanks to the Tax Cut and Jobs Act of 2017, most of us have a better idea of how important it is to manage our W-4 before we get your W-2. The W-4 is a withholding form that most people only think about when when they start a new job. You calculate - it used to be pretty easy but now it is a "calculation" - how many withholdings the IRS and your state should account for when your employers pay you. If the tax laws don't change and your life doesn't change, you can pretty much leave this the calculation of withholdings the same for as long as you are with your employer. But in 2017, after 30 years, the tax laws did change (significantly). Many people received a tax bill they weren't expecting because they failed to account for these changes in their tax planning. For most, the IRS was taking out slightly less money from their paychecks (for federal income taxes) which over the course of a year turned many expected tax refunds into tax liabilities. Paying a tax professional to "run the numbers" before the end of the year would have at least given those folks a "heads up" about what their tax bill could look like before it was due. Below are a few personal changes that should signal to you, it may be time to adjust your W-4:
You buy a houseYou get marriedYou get divorcedYou get a raise or your spouse gets a raiseYou have a kid (or at least are claiming a kid)You start a business
Any one of those life events will cause the income taxes your employer is withdrawing from your paycheck to be "off" from what the IRS estimates. This is of course why we do any tax preparation at the end of the year in the first place. The IRS claims what amounts to a standard deduction for your income level and number of dependents. But they can't know with the W-4 forms if you buy a house or get divorced (for example); so the tax preparation process "trues up" what you owe from what you paid. So if any of the above events have happened to you (or for you) this year, see a tax preparer, and pay their hourly planning rate to estimate how much your tax liability may have changed from last year.
There are many people who purposely under report on their W-4 to create a forced savings through over tax collection throughout the year. This gives them an expectation for a tax refund in April. Doing this does outsmart bad spending habits; but only for a while. What can happen is your brain will eventually adjust to this expectation of a refund and "allow" you to spend heavily, during the holidays for example, in anticipation of a refund. And once you get that refund (hopefully), you'll be using that "found money" to pay off debt rather than add to savings. And that's when you learn that it's impossible to outsmart yourself. An alternative is to do some "tax planning" and:
Divide your expected future refund by 24 or 26 (paychecks)Ask your employer to "direct deposit" that amount from your paycheck into a savings account ORCreate an automatic bank transfer from checking to savings for that amount on each of your paydays
Completing those steps will ensure the money at least lands in your savings account. After that, it's all you. If you feel comfortable dipping into savings for a purchase, then it must be important. Regardless, automating the savings this way will increase your cash flow and your savings without increasing your spending appetite. All thanks to tax planning.
Roth vs. Traditional 401(k)
A frequent tax question is whether it makes sense to utilize your employer's traditional 401(k) or ROTH 401(k) or both. The answer of course depends on your personal situation but I'll highlight a few facts that may help you make that decision. Most employers don't offer a ROTH 401(k) so for most of you, don't worry about it! No seriously, a ROTH 401(k) is an account that does not give you a tax deduction today for your retirement savings but still allows your money to grow without being taxed. On top of that (according to the laws today), a ROTH account will allow you to withdraw that money in the future without tax liability. This is in stark contrast to the traditional 401(k) that allows investors to trade a tax deduction today for a tax hit when they withdraw the money later for retirement. The 401(k) was fully implemented in the early 1980s; a time when our National Debt was at about $1 trillion. Now, the National Debt is $22 trillion-ish so it begs the question of whether our tax rates will likely be lower in the future. What I tell some of my clients is if they have a ROTH option and have saved for years in traditional 401(k), it may be time to start filling up the other retirement bucket. No one can predict the future tax rates 10, 20 or 30 years from now; but if you have both taxable and non-taxable savings in the future, you'll keep your (cash flow) options open.
Business & Home Ownership
There is a reason that some of the largest tax deductions available are in fact, available. This is because they are supported by some of the largest lobbying organizations in the country! The Center for Responsive Politics - operating as OpenSecrets.org - reported that in 2017, "business" spent over $450 million lobbying the federal government (including US House Representatives and Senators). The top three contributors were the the Business Roundtable ($27,380,000), the National Association of REALTORS® ($54,530,861), and the U.S. Chamber of Commerce ($82,260,000). This is all in one year. With lobbying comes benefits. Our country has long supported capitalism, and you can believe that the nearly $500 million per year of lobbying isn’t going to waste. Pro-business policies abound and the tax deductions that allow you to start, manage, and grow your business are some of the biggest. So if you've got an idea and the heart to see it through, start a business! Our country supports you!
The Peter G. Peterson Foundation pegged the deduction of home interest as the sixth largest deduction ($61 billion) for taxpayers overall in 2016. The National Association of REALTORS®, is a trade association that represents the interests of about 1.3 million REALTORS® and 75 million property owners, according to their website. On behalf of these real estate professionals, the association pays attention to the national flood insurance program, fair housing, and of course, any and all tax reform. They have a federal taxation committee specifically focused on tax reform to preserve the benefits of investing in real estate and buying homes in general. With that kind of attention, you and I will rarely have to worry about losing our mortgage interest deductions. But you should always check with your tax preparer before the end of the year just in case (tax planning).
There are many opportunities for tax planning to make a great impact on your cash flow -now and/or in the future. Get a handle on this part of your financial life and you will take one step closer to the kind of wealth that will make a difference in the life of your family and the wealth of your community.
My goal is to empower smart generous, ambitious thinkers like you with financial knowledge so you can use it to go save the world. I hope this helps.
Thank you in advance for your service.