Tuesday, July 1, 2014

Why tax planning is so important / Do what you want, but do it in a tax-smart way

Bill Bischoff for MarketWatch.com writes:  While the term “tax planning” is frequently used, it is not necessarily well understood. Here’s what you need to know. 

What tax planning really means
Tax planning is the art of arranging your affairs in ways that postpone or avoid taxes. By employing effective tax planning strategies, you can have more money to save and invest or more money to spend. Or both. Your choice. 

Put another way, tax planning means deferring and flat out avoiding taxes by taking advantage of beneficial tax-law provisions, increasing and accelerating tax deductions and tax credits, and generally making maximum use of all applicable breaks available under our beloved Internal Revenue Code. 

While the federal income tax rules are now more complicated than ever, the benefits of good tax planning are arguably more valuable than ever before. 

Of course, you should not change your financial behavior solely to avoid taxes. Truly effective tax planning strategies are those that permit you to do what you want while reducing tax bills along the way. 

How are tax planning and financial planning connected?
Financial planning is the art of implementing strategies that help you reach your financial goals, be they short-term or long-term. That sounds pretty simple. However, if the actual execution was simple, there would be a lot more rich folks. 

Tax planning and financial planning are closely linked, because taxes are such a large expense item as you go through life. If you become really successful, taxes will probably be your single biggest expense over the long haul. So planning to reduce taxes is a critically important piece of the overall financial planning process. 

Horror stories when folks fail to make the connection
Over the years as a tax pro, I have been amazed at how many people fail to get the message about tax planning until they commit a grievous blunder that costs them a bundle in otherwise avoidable taxes. Then they finally get it. The trick is to make sure you don’t have to learn this lesson the hard way. To illustrate the point, consider the following example. 

Example: Josephine is a 45-year-old unmarried professional person. She considers herself to be financially astute. However, she is not well-versed on taxes. One day, Josephine meets Joe, and they quickly decide to get married. Caught up in the excitement of a whole new life, Josephine impulsively sells her home shortly before the marriage. The property is in a great area and has appreciated by $500,000 since she bought it 15 years ago. She intends to move into Joe’s home, which is a dump, but Josephine is a proven genius at remodeling, and she plans to work her usual magic on Joe’s property. 

Result without tax planning: For federal income tax purposes, Josephine has a whopping $250,000 gain on the sale of her home ($500,000 profit minus the $250,000 home sale gain exclusion allowed to unmarried sellers). 

Result with tax planning: If Josephine had instead kept her home and lived there with Joe for two years before selling, she could have taken advantage of the larger $500,000 home sale gain exclusion available to married joint-filers and thereby permanently avoided $250,000 of taxable gain. If necessary, Joe’s home could have been sold instead of Josephine’s. Alternatively, Joe’s property could have been retained, and the couple could have worked on remodeling it while still living in Josephine’s home for the requisite two years. 

Moral of the story? By selling her home without considering the tax-smart alternative, Josephine cost herself $62,500 in taxes (completely avoidable $250,000 gain taxed at an assumed combined federal and state rate of 25%). This is a permanent difference, not just a timing difference. The point is, you cannot ignore taxes. If you do, bad things can happen, even with a seemingly intelligent transaction. 

The last word
There are many other ways to commit expensive tax blunders. Like selling appreciated securities too soon when hanging on for just a little longer would have resulted in lower-taxed long-term capital gains instead of higher-taxed short-term gains; taking retirement account withdrawals before age 59½ and getting hit with the 10% premature withdrawal penalty tax; or failing to arrange for payments to an ex-spouse to qualify as deductible alimony; the list goes on and on. 

The cure is to plan transactions with taxes in mind and avoid making impulsive moves. Seeking professional tax advice before pulling the trigger on significant transactions is usually money well spent. As we get closer to the end of the year, some of my columns will focus on tax planning strategies that many folks can benefit from. Please stay tuned. Visit MarketWatch.com by clicking here.

1 comment:

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