Read Time: 7 minutes
Welcome to the 41st edition of the Tech Financial Planning (TFP) newsletter.
Tax planning sounds super scary and complicated.
But you can boil it down to one of three options: accelerate & minimize, defer, or avoid
In this newsletter we’ll break down each of the three options and some potential planning ideas for each.
TL;DR
Accelerate and minimize might mean more taxes this year, but less over the life of your wealth
Defer means kicking the tax can down the road, which can be super valuable if you are a high earner
Avoid is the gold standard - who doesn’t want to eliminate taxes?
Reminder - taxes aren’t the only thing we can focus on
The Basics of Tax Planning
“You have the right to pay no more than the correct amount of tax…Taxpayers have the right to pay only the amount of tax legally due,” IRS Taxpayer Bill of Rights #3.
Tax planning is how we ensure we pay the right amount of tax over our lifetime without leaving a tip.
At its simplest, tax planning is about either accelerating income (and minimizing future taxes) or deferring income.
If it’s a lower tax year, it might make sense to pay more taxes this year.
And If it’s a higher tax year, it probably make sense to defer as much as possible
The reason is because we aren’t always looking to pay the least amount of taxes this year.
We are looking to pay the lowest taxes over our lifetime (or if leaving a legacy is important, over the life of our life.
This means we need to have an idea of our personal tax rate today, what our tax rate could possibly be in the future, as well as the actual federal and state tax brackets now and in the future.
Now this is certainly challenging.
We don’t know where we will be in 30+ years, nor do we know where government tax rates will be.
But we can take reasonable guesses and actions.
At times we’ll get it wrong, but by taking proactive measures, we can be more strategic and probably save on taxes over the long term
Quick Note: in my intro I mentioned 3 options, but so far I’ve only mentioned two.
What’s the third?
The third is to avoid / eliminate taxes altogether.
Obviously, that’s the dream scenario, but also sometimes harder to pull off.
But we’ll talk about it too!
Tax Rates Will Change Over Your Life
I really like this illustration from Kitces.com to show how life events change our tax rates over time.
While this illustration shows contributing to Roth IRA vs Traditional IRA (or somewhere in the middle), it might be better to think about it as:
Blue: accelerate income
Green and yellow: defer income
White: a bit of both
And then avoid where you can.
Reasons to accelerate
Why would I want to pay more taxes this year?
You’re making less income this year than normal
Laid off
Went back to school
Sabbatical
Live in state with no income taxes, could be moving back to a state with income taxes
Confident taxes will go up
The goal isn’t just to pay more in taxes because you’re feeling particularly generous (you can always donate against the federal deficit).
The reason why we’d voluntarily pay more this year is because it should help us pay less in taxes over the long term.
Aka if we were to make the same move in 10 or 20 years, we might pay even more in tax than we would today.
Some ways to accelerate
Contributing to your Roth accounts
You aren’t getting the tax deduction today, but you are building up a nice bucket of money that you won’t owe taxes on in retirement.
Future you will probably like this.
Harvesting capital gains
This is voluntarily selling stock for a gain and triggering the tax consequences.
Roth conversions
This means moving money from pre tax to after tax (and paying the taxes on the conversion).
This increases your income & taxes in the year you do it, but done correctly, can lead to less taxes down the road.
Exercising stock options
Particularly NQSOs, but also can apply to ISOs if you trigger AMT.
If you are exercising stock options, there’s a good chance you are increasing your “income” in that tax year.
That will mean more taxes, but it might also lead to a lot of money!
Plus, if you are exercising strategically, you might be spreading out the taxes over a number of years rather than one big tax bomb.
Reasons to defer
A dollar today is worth more than a dollar 10 years now (hello time value of money).
This mean all things being equal, it’s better to kick the tax can down the road.
The more you can push your taxes out, the better (unless it makes sense to accelerate - see above).
Generally this makes sense if you’re either a) a high earner (or you’re in your prime earning years) or b) if you have a big taxable year.
By big taxable year, think IPO, exercising a lot of stock options, big bonuses / commissions or something along those lines.
When that’s the case, it probably makes sense to push off taxes.
The line of thinking is it probably doesn’t make sense to pay taxes at the highest possible rates if we could do it down the road at a (hopefully) lower rate.
Some ways to defer
Contribute to traditional 401k or IRA
This will help you lower the amount of money you will be taxed on this year.
Other tax deferred accounts
Think FSA, HSA, or 529 (depending on your state).
This will also help lower your taxes this year
If you’re a real estate investor
There’s a number of opportunities like 1031 exchanges, cost segregation studies, and bonus depreciation.
Reasons to avoid
Yeah, this is what everyone wants.
It’s usually the best possible outcome - you would have had to pay a tax, but because you took action or implemented a strategy, you don’t have to anymore.
While avoiding is the best case scenario, sometimes this can be the hardest
Some Ways To Avoid
QSBS
This one can be a game changer for early employees at startups that hit it big.
Done correctly, you can potentially exclude up to 100% of capital gains, saving thousands or possibly millions of dollars.
But there’s certain rules you have to follow - Carta has a great overview here
Home sale exclusion
If you sell your primary home (and follow all the rules) you can avoid capital gains tax on the first $250,000 (filing single) or $500,000 (married filing jointly).
Pretty sweet.
Donating appreciated stock (and other charitable giving strategies)
Let’s say you were an early employee at a tech company that blew up and IPOd.
You might have a lot of stock with very low cost basis and potentially very big capital gains.
If you donate that appreciated stock you a) won’t pay any tax on the gains and b) actually get to use the donation as a deduction.
Estate planning (ie step up in basis)
This is where we get into tax planning over the life of your wealth, not just your lifetime.
Things like step up in basis, different types of trusts, and more.
Which can help your wealth pass to your heirs (or organizations) and avoid taxes.
Selling assets at 0% capital gain bracket
In low income years, you can sell some of your assets for gains and still pay $0 in capital gains (up to the 15% bracket).
Putting it all together
One of our primary advantages when planning for taxes is that we can look out over long periods of time and take advantage of opportunities as they come up.
This requires being strategic and proactive.
If you wait until December 31st to make moves for this tax year, you’re going to be pretty limited.
But if we start thinking months and years ahead, there’s a lot more room and opportunity at our disposal.
It’s also important to remember that taxes aren’t the only thing.
If you want to pay $0 in taxes, you could just make no money.
No income means no taxes.
Obviously, that wouldn’t work out well in the long term, but you get my point.
Taxes are key, but there’s so much more we need to consider.
For example, we are working with several clients on unwinding big positions of their company stock.
As we sell stock over the next couple years, we will pay more in taxes than if we didn’t sell the stock.
But that’s ok!
Because 1) the taxes they will pay are much less than their stock dropping 50%+ (hello 2022) and 2) it’s helping them accomplish other goals
I’ll leave you with one last quote from Steven Jarvis.
“We want to pay every dollar we owe, but we don’t want to leave a tip…tip your server, not the IRS.”
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