Money Matters: It’s not what you earn, it’s what you keep
Over the last several years, the subtle changes to the tax code has made tax planning more important to help you keep more of what you earn. Yesterday’s practice of simply dropping your documentation off to your CPA to complete your taxes is not sufficient. Technically speaking, this is historical reporting, not planning. Planning actively looks forward. Do you fall into the reporting “trap?”
To adequately plan, there are a couple of key concepts one needs to realize as they will most likely affect you for the rest of your life. First and foremost, taxes pay for the interest on the national debt, which is currently $17.9 trillion and estimated to be $21.897 trillion by the end of 2015.[i] [ii] The money necessary to pay the interest on this debt will be collected from corporations and fundamentally from individuals. This is not likely to go away anytime soon. Income and capital gains tax rates are at historically low rates. Therefore, planning how your income will be subject to various taxes becomes essential in the future.
Income is a very broad collective term. It includes wages, business income, interest, dividends, capital gains, retirement plan distributions and so forth. Not all “income” is taxed the same, but is taxed at various rates and can be confusing. For example, in a given year your family earns $160,000 in wages, you have $30,000 in interest, dividends and capital gains from your stock portfolio and sell your house for a profit of $100,000. All of these separate events trigger various taxes, such as the new Net Investment Income Tax – a 3.8% surtax and subsequent higher tax on income above a certain threshold.
One common technique to lowering your taxes is to reduce your taxable income by saving into a qualified retirement plan e.g. a 401(k) plan, especially early in life. This can be a great method of saving because of the inherent discipline created with by monthly paycheck savings. These accounts are deferred from taxation. However, the magic word is “deferred.” You will have to “pay the piper” starting at age 70 ½ for the rest of your life on mandatory withdrawals. Add those withdrawals to our previous example, and our expanded view of income subject to taxes gets larger very quickly! This may result in income that shouldn’t trigger a surtax, but causes other income to be subject to it.
This gives unique planning opportunities to those that work with knowledgeable people and understand techniques to help manage taxes in the future through a structured approach. At a minimum one should understand:
· How the Net Investment Tax will impact future events.
· Yes there is a cost to Medicare, its not free and your income determines how much you pay!
· Roth conversions of IRAs may work towards saving you in taxes later in life.*
· Re-characterizations of Roth IRAs, may allow you to get money back.
· How being considered divorced in the eyes of the IRS can impact your taxes.
· How scholarships may be tax-free and the implications for you and your kids.
· You may have capital gains on bond sales in 2014!
· How to structure losses to reduce capital gains in the future.
Far to often, people think of tax time beginning in February and ending on April 15th. I hope you see that these are just the reporting timeframes and that taxation is a continuous process that needs to be managed as a necessary facet of your life. If some of the concepts are foreign to you, I urge you to seek professional help with your taxes and planning with the mindset of, “a dollar saved, is a dollar earned.” Look forward through the front windshield versus the rear-view mirror.
Peter Hartwick is a Personal Wealth Manager at Personal Wealth Group Inc., 7007 College Blvd., Overland Park. He is also a member of the Financial Planning Association of Greater Kansas City.
This story was originally published December 11, 2014 at 11:59 AM with the headline "Money Matters: It’s not what you earn, it’s what you keep."