Tax Planning

“The two greatest obstacles to accumulating wealth are debt (spending more than you earn) and taxes. By reducing your tax obligations and staying out of debt, you will be able to accelerate your journey to financial security.”

Taxes represent a major reduction in your income, which means you will have less money available to save, invest, and pay off debt. The myriad of taxes imposed by federal, state and local governments stand as the greatest obstacles of accumulating personal wealth. As a result, understanding how taxes impact your ability to build wealth and implementing strategies through financial planning to minimize your tax burden are essential actions.

In fact, when every tax is tallied – federal, state and local income tax (corporate and individual); property tax; Social Security tax; sales tax; excise tax; and others – Americans spend at least 29.2 percent or often much more (over sixty percent in some municipal jurisdictions) of their annual income in taxes and fees each year.

There are many different kinds of taxes, most of which fall into a few basic categories: taxes on income, taxes on property, and taxes on goods and services. There are strategies that can help you reduce the amount you pay each year, depending on your particular financial situation.

Taxes are one of life’s certainties. Tax planning and strategies are a few of the top ways retirees can boost their cash flow and portfolio returns in retirement.

Income from salary is subject to significant federal and state income taxes, thus, as your income increases, income taxes become greater as well. The United States federal government levies tax on its citizens and residents on their worldwide income. Non-resident aliens are taxed on their US-source income and income effectively connected with a US trade or business (with certain exceptions). For individuals, the top income tax rate for 2021 is 37%, except for long-term capital gains and qualified dividends (discussed below).

Surprisingly, U.S. taxpayers enjoy relatively low tax rates compared to other Developed Countries. It might seem like the U.S. Treasury takes a large chunk of your gross income every time you file a tax return, but the U.S. is actually on the lower end of the scale compared to other developed countries.

According to a 2020 analysis from the Organisation for Economic Co-operation and Development (OECD), U.S. tax revenues are 24.5% of its gross domestic product (GDP). That’s well below the average of 33.8% for the other 35 OECD-member countries.

Most states, and a number of municipal authorities, impose income taxes on individuals working or residing within their jurisdictions. Most of the 50 states impose some personal income tax, with the exception of seven: Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming, which have no state income tax. New Hampshire and Tennessee (until 1 January 2021) tax only dividend and interest income. Several states impose an income tax at rates that exceed 10%.

Tax obligations are a big consideration in many financial decisions, including retirement accounts, tax-advantaged investments like municipal bonds, and renting versus buying a house. These financial decisions are so important that knowing basic tax information is critical.

Income tax system

As with any progressive income tax system, U.S. taxpayers with higher incomes pay higher income tax rates. The result: half of U.S. taxpayers pay 97 percent of all income taxes.

The top 1 percent of earners alone pay over one-third of Federal income taxes.

Income taxes are only part of the story. Payroll taxes, sales taxes, and excise taxes are all regressive, meaning lower-income individuals contribute a greater share of their total income towards these taxes than do higher-income individuals. Yet, it turns out the U.S. federal tax system remains very progressive. Meaning, Americans with the highest incomes pay the largest share of all federal taxes.

Your long-term investing strategy could be impacted in a big way by taxes, so you may want to figure out the best strategies for investing to help maximize your gain and minimize your tax burden.

Smart tax investing

Making smart tax decisions can have a big impact on the amount of money you can have and spend in retirement.

Investing and withdrawing retirement funds in a tax-efficient way is among the top ways retirees can boost their returns and cash flow in retirement, according to an analysis published by researchers at Morningstar.

The best kind of long-range financial planning , which includes tax avoidance strategies, can help you today, according to Fideltiy Investments, possibly helps you out much more in the future, and leaves you in a better position than if you hadn’t planned at all.

Taxes are something every American pays, pays and pays at some point in their lives – they’re inevitable. Taxes represent and significant levy on your ability to accumulate wealth and take advantage of the miracle of compound interest.

Total effective tax rate

The working and middle class pay a higher tax rates than the richest people in America. For the working classes in America, tax rates increased steadily over the last several decades, according to Emmanuel Saez and Gabriel Zucman, economists at the University of California, Berkeley. The working and middle classes — the 50 to 90 percent of Americans with the lowest incomes — pay higher tax rates than billionaires.

When one considers all the taxes that Americans pay, such as state and local taxes, which account for a third of all taxes paid by Americans and are in general highly regressive, the total effective tax rate, which is the total amount of taxes paid as a percentage of income, the working and middle class pay an high percentage of their earned income in taxes than the wealthy.

While tax rates for 99% of taxpayers are progressive, the tax rates for increased levels of income in the top 1% actually decline, according to figures compiled from IRS.
The effective rate for the top 1% is 22.83%, while the rates for the top 0.1%, 0.01%, and 0.001% fall to 21.67%, 19.53%, and 17.60%, respectively. In other words, a household earning $250,000 (the 1% threshold) pays a higher rate than a household earning more than $30 million per year (0.01% threshold).

The Regressive American Tax System

How combined federal, state and local taxes fall on American adults, by income percentile. Three regressive taxes, consumption, payroll and residential property, account for most of the burden on the working and middle classes :

Source: NYT

When all taxes paid to the federal, state and local governments: the federal income tax, of course, but also state income taxes, myriad sales and excise taxes, the corporate income tax, business and residential property taxes and payroll taxes. In the end, all taxes are paid by people. The corporate tax, for example, is paid by shareholders, because it reduces the amount of profit they can receive in dividends or reinvest in their companies.

Here is a non-complete list of the different taxes and fees levied by federal, state, and local governments that Americans pay.

Income Taxes (federal, state and local – An income tax is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. tax system is known as a “progressive” system because it uses marginal tax rates instead of a single tax rate. The more you earn, the more of a percentage you’ll pay on your top dollars. Individual income taxes are the largest source of tax revenue in the U.S. You do not want to make financial moves just because you think a tax change is coming, but instead you should do so because it helps you toward your overall goals. Before making a decision, always consult with a tax advisor.
Capital Gain Taxes – In the United States, a tax is levied on all income generated from a taxpayer’s capital gains, which are profits from the sale of an asset that was purchased at a lower price. The most common capital gains are created from the sale of stocks, bonds, and property. You may be tempted to realize long term gains on highly appreciated stock you want to hold for the long term, and then buy it back later at a higher cost basis. Don’t let the tax tail wag the investment dog,” says David Peterson. “You should be buying and selling based on your view of the long-term value of the assets, not based on the tax consequences.”
Social Security – All taxes levied by the government to plan for a taxpayer’s retirement could be considered retirement taxes. In the United States, we pay into a social security system that provides income to retired workers from the general fund. Our tax is regressive as we all pay the same rate up to a specific cap. Then all income above the cap is not taxed.
Sales Taxes – Consumption taxes, also known as sales taxes, are levied at the point of purchase for specific goods and services. It is usually a percentage determined by the levels of government charging the tax. Due to individual state and local taxes, the exact rate you pay will vary widely by location.
Real Estate / Property Taxes – Property taxes are imposed on property by reason of its ownership. They are usually paid on real estate, but can also be paid on personal property, such as boats, automobiles, recreational vehicles, and other business inventories. It is based upon a jurisdiction’s assessment of the worth of a property based on its condition, location and market value, and/or changes to the amounts apportioned to various recipients of the tax.
Estate Taxes – The inheritance tax, also known the “death tax”, is a tax that arises from the death of a taxpayer and is imposed on the transfer of property upon the death of the owner. It was created to prevent the perpetuation of tax-free wealth within the country’s most affluent families. Once you give money away or fund an irrevocable trust, you can’t control it, so be sure that it’s what you desire. You want to stress test your plan to make sure you have the assets and income you need for your own retirement. With all financial planning, it’s important to make sure to think and plan for the long term. It can help to consult with a financial planner and a tax professional for support in assessing your own future needs and setting the right course, even if taxes do rise.
Business Taxes – Also known as corporate taxes, business taxes are direct taxes levied on the profits of businesses. However, expenses that are deemed necessary to the business can often be deducted to lower the amount of profits subject to tax, some business opt for the eis scheme option that helps them raise capital in a faster way.
Payroll Taxes – The U.S. government mandates that employers subtract payroll taxes from their workers’ paychecks each pay period, and then match the sums deducted. These payments are called FICA taxes because they are authorized by the Federal Insurance Contribution Act. Total FICA taxes on individual workers are 7.65 percent of income; 6.2 percent goes to fund the nation’s Social Security system, while 1.45 percent goes to Medicare. Self-employed individuals are liable for the entire 15.3 percent, although one half of that amount can be taken as an above-the-line business deduction on a person’s income tax return.
Excise Taxes – Any tax that is based on the value of the product being taxed is considered an excise tax. They are based on the quantity of the product. Common examples include those levied on alcohol, gasoline, and cigarettes.
Gift Taxes – A gift tax is a one that is levied on the transfer of a property by one taxpayer to another while receiving either nothing or something with a less than equal value in return. Selling something at less than its full value, or making an interest-free or reduced interest loan, may qualify as giving a gift.
Tariffs – An import or export tariff is paid when someone moves any good through a political border. Typically, it is used to “encourage” local businesses and “discourage” the purchase of foreign goods, as it increases the price for the foreign goods.
Highway and Bridge Tolls – Tolls are charged to drivers who cross through designated bridges, tunnels, and even some roads. They’re usually always paid in fixed amounts each time you drive pass through the restricted area. Tolls are frequently used to fund state projects, but can also be used for privately funded projects.
User Fees – They are taxes that are assessed by federal, state, and local governments on a wide variety of services, including airline tickets, rental cars, utilities, hotel rooms, licenses, financial transactions, business licenses, building permits and many others. Depending upon where someone lives, a cellphone, for example, may have as many as six separate user taxes, running up the monthly bill by as much as 20 percent.
Community Development District – Self-imposed assessments and fees by developers for the financing and management of new residential communities.

Tax avoidance strategies

Investors can maximize their tax savings by holding certain investments and funds in the appropriate type of account. This is called “asset location,” which boosts an investor’s after-tax rate of return.

For example, investors should generally consider holding stocks and stock funds in taxable accounts. These investments are more “tax-efficient” — meaning most of their return is from capital gains taxed at a rate that’s less than ordinary income.

Investors should generally hold dividend stocks, bonds and bond funds in retirement accounts. These investments are less tax-efficient, since most of their returns are dividends taxed as ordinary income.

Sequencing withdrawals

Sequencing withdrawals efficiently from different piles of savings can lead to a lower tax bill in the long run.

The prevailing wisdom is to pull money from taxable accounts first. Then, retirees can draw down tax-deferred 401(k) accounts and IRAs. Roth accounts should generally be tapped last.

“That’s a pretty good rule for the vast majority of people out there,” Blanchett said.

Taxes are secondary consideration to net return

Taxes are an important component of many decisions, but don’t let it get in the way of focusing on the take home return. It is financially better to get a 10% return and pay 20% in taxes for a net 8% return than to simply get a 7% tax-free return.

However, there are instances in which investors (and their advisors) can be more strategic. It requires paying attention to the marginal income tax rates.

At some point, you’ll have to pay taxes on gains you earn in the stock market. If you plan to sell anything that year and realize gains, a bad market day can provide a nice opportunity to reduce your tax bill. If you have investments you plan to shed anyway, sell them on down days to realize the loss. Then at tax time, those losses can be used to balance out your investment gains and lower the bill you’ll have to pay to Uncle Sam.

In investing, where you put your investments—meaning the type of account you choose—can make a major difference in how much you can earn, after tax, over time. That’s because different investments are subject to different tax rules, and different types of accounts have different tax treatment. Sorting your investments into different accounts—a strategy often called active asset location—has the potential to help lower your overall tax bill.

3 main types of investing accounts

Many investors have several different types of accounts that can be aligned with specific investing goals. Some are subject to taxes every year, while others have tax advantages. Here are the 3 main investment account categories:

Taxable accounts such as traditional brokerage accounts hold securities (stocks, bonds, mutual funds, ETFs) that are taxed when you earn dividends or interest, or you realize capital gains by selling investments that went up in value.
Tax-deferred accounts like traditional 401(k)s, 403(b)s and IRAs allow payment of taxes to be delayed until money is withdrawn, when it is taxed as ordinary income.
Tax-exempt accounts like Roth IRAs, Roth 401(k)s, and Roth 403(b)s require income taxes to be paid on all contributions up front, but then allow the investor to avoid further taxation (as long as the rules are followed). Fully tax-exempt accounts such as health savings accounts (HSAs), allow you to make pretax or deductible contributions, earnings, or withdrawals, if used for qualified health expenses.

Ideally you will first maximize your tax-deferred options such as your 401k and IRA first, since these investments can grow tax free from capital gains and dividends. Once you maximize these, continue investing in your brokerage account or real estate. Simply put, there is no tax on wealth. The more you invest, the more you will reduce your tax bill to your net worth.

While many things can drain your net worth, the most insidious are debt and taxes. By reducing both, you will be able to achieve financial freedom far faster.

By using strategies that reduce income taxes, you’ll be able to keep more of your income, rather than turning it over to the tax authorities. One method is to invest as much of your cash as possible which minimizes your taxes to your net worth.

The easiest and best way to shield your income from taxes is retirement plans. Instead of surrendering, tax advisors recommend implementing proven tax strategies to reduce the burden. Maximize your after tax deductions such as your 401k and IRA, and then invest the rest in stocks, ETFs, and real estate.

References:

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