Planning Reflection | February 17, 2023
A common theme this time of year is figuring out how to be smart about taxes. Often, “being smart” either implicitly or explicitly means paying as little tax as possible this year. Extending this perspective further, it means paying as little as possible every year. Ironically, taking this narrow view could end up increasing your tax bill over your lifetime.
Consider planning a long road trip. If you want to get to your destination as quickly as possible, focusing solely on the distance traveled could lead you through an area with bad traffic later in the trip, adding to your overall time. Even if you typically want to reduce driving time, you may still decide to take a detour to enjoy a scenic overlook or a famous restaurant. If you only focus on minimizing mileage or time, you can inadvertently extend the journey or miss opportunities.
Applying this perspective to tax planning allows you to broaden your view to include future tax years as well as non-tax considerations. This can lead to paying more tax than you “have to” in one year to avoid paying at a higher rate just a few years later, or to accomplish some other goal. Good tax planning does not simply mean minimizing your tax bill every year.
Taking the Long View
Much of our tax landscape is set in stone each year. For example, salaried employees typically have very little control over how much of their work income is taxable. Your salary is your salary, and that’s what is reported on your W-2 at tax time. Despite this, there are a variety of decisions that do have a tax element to them. The basic question for any tax-oriented decision is whether the resulting tax bill will be higher now or in the future.
Paying taxes now can have its advantages. If you are at the beginning of your career and expect your income will rise significantly over time, you may want to consider Roth IRA or Roth 401k contributions. Roth contributions are not deductible (you have to pay tax on those dollars now), but they lead to tax-free retirement distributions in the future. Similarly, if you are retired and not yet claiming Social Security benefits, you may have an opportunity to do a Roth conversion of pre-tax IRA money to a Roth IRA while your income is low. Paying some tax now can result in meaningfully lower taxes later on those same dollars.
Conversely, sometimes it’s advantageous to pay taxes later. If you are at the peak of your career and expect your income will be lower in retirement, traditional 401k contributions often make more sense than Roth. You get a tax deduction now while you’re in a higher tax bracket, and you’ll pay tax on later distributions at a lower rate. Alternatively, if you have an unusually high income year – maybe you sold a business or a property – you might make a large charitable contribution to a donor-advised fund (DAF) that amounts to multiple years’ worth of regular giving. The charitable deduction is more valuable this year because your income is so high, and it’s OK to forego that deduction in future years while you make grants from the DAF.
Taking the Wide View
Reducing taxes is not the only consideration in most financial decisions. Other factors are often more important, and taking a wider view allows you to reach a more satisfying outcome even if the tax bill is higher.
Paying taxes can be an additional cost of pursuing something you want to do. You might choose to sell a highly appreciated investment to pay for a long-desired kitchen remodel. This likely creates additional tax due to capital gains, but the daily joy and satisfaction you’ll get out of the renewed space can be well worth the tax cost. Another example is that you might sell your long-time Bay Area house to move closer to your grandkids in another state. Again, there may be a large tax bill as a result of selling the house, but it’s difficult to put a price on living near your loved ones.
Paying taxes can also be a cost of something you need to do. If you’re experiencing a cash flow crunch while your child is in college, you might temporarily choose to save less in your 401k. Deferring less income means higher taxes, but the extra cash flow may ease your stress when it’s time to pay tuition. Alternatively, if aging in place becomes untenable in your current home, you might need to sell your house and move elsewhere. The tax implications of the sale are important to understand, but prioritizing safety and proper care is more important.
A Balanced Perspective
There is an adage that you should “not let the tax tail wag the dog.” In practice, this means that deciding between Roth and traditional 401k contributions is only relevant if you have money to set aside for retirement. Similarly, the charitable deduction is only worth pursuing if you’re charitably inclined. To put this another way: being tax-conscious with your decisions is good planning, but typically you should not take action exclusively for tax reasons.
Taxes are complicated. Lengthening your view on taxes will help you pay less over time. Widening your view can give you permission to make decisions that may not be “tax smart” but that add value to your life. Taken together, a broader view allows you to better balance tax considerations with other priorities.
About Sam Wood-Bednarz, CFP®Sam Wood-Bednarz is a Partner, Senior Advisor, and Director of Advisory Services. He provides clients with a sense of confidence and security in their financial lives. |
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