Taxes are a topic that bring out passionate responses from all sorts of people. Although they directly fund government-provided resources, including education, infrastructure, and security, the general consensus is that nobody likes to pay taxes.
The key is being tax smart…or tax efficient. A smart financial plan put together by knowledgeable professionals can help people figure out how to be as tax efficient as possible. That is, helping them understand the best time to pay taxes and to minimize liability.
At Pinnacle Financial Advisors, our strategy for maximizing tax efficiency is rooted in figuring out how best to allocate clients’ assets into three specific buckets – tax now, tax later, and tax never – while ensuring they have enough flexibility to address both short- and long-term financial opportunities and burdens that may arise.
What do we mean by tax now, tax later, and tax never?
Typically, the most liquid assets in a portfolio, tax now assets usually consist of vehicles such as checking and savings accounts, certificates of deposit (CDs), mutual funds, stocks, bonds, and treasuries that are taxed annually. While assets can be quickly and easily transferred into useable cash, their flexibility means that they may be taxed at a higher rate. How? Well, consider that the more you earn and the more you invest in resources such as savings accounts, mutual funds, and stocks, the higher the tax bracket you will fall into. Also, by incurring income tax annually, individuals may miss out on the compounded rate of return that they could have earned. The key is to distribute wealth into tax-deferred vehicles that can be drawn when income isn’t as high, resulting in a lower taxable rate on withdrawals.
Comprised of IRAs, 401(k)s, pension plans, variable and fixed annuities, and savings bonds, most tax later assets are invested pre-tax, with taxes paid upon funds being withdrawn. While growing your assets in tax later vehicles can reap significant interest earnings, the challenge is that people must wait until they’re 59½ years old to access them. These funds are not locked in and can be withdrawn whenever the need arises, but there is a 10-percent tax penalty, plus regular income tax due for withdrawing funds before age 59½. The good news is that money can be gradually and coordinately withdrawn, thereby keeping an individual’s tax bracket lower than it otherwise would have been. You can think of it as paying tax on the harvest, but not on the seed.
It’s hard to believe, but there is such a thing! These vehicles include Roth IRAs, muni bonds, whole life insurance cash value, and variable universal life insurance cash value, and provide potentially tax-free income. What do we mean? Well, take a Roth IRA – the maximum investment has a yearly cap, and taxes will already have been paid on the contributions in the year in which they are made. Over time, the dollars will grow tax-free and can be withdrawn without tax. The catch? You typically have to wait until age 59½ to withdraw funds. You can think of it as paying tax on the seed but not on the harvest.
No one bucket is the be-all, end-all in financial planning and wealth management. In fact, since there’s a lot of life to live between tax now and 59½ years of age, diversification is a must. After 59½ diversification remains important, to provide sufficient liquidity and to preserve wealth. At the end of the day, a good financial plan – one that takes the long view into perspective, focusing on saving, managing, anticipating, and maximizing opportunities laid out by tax laws – is vital in ensuring long-term success and financial independence.