Written by: Brian Martin, Wealth Manager
Being “tax efficient” looks a little different for everyone. That said, there are always methods to ensure that you save on your taxes and get the most out of available deductions. In essence, being tax efficient simply means that you are aware of tax laws and know how to use them to your advantage. This involves accounting for potential tax savings in the current tax year as well as executing strategies to save on taxes in future tax years.
Tax efficiency is a product of many factors that may be available to you in managing your finances. One factor that is typically available to everyone is understanding how to manage taxes within your cash flow. Cash flow measurements offer the best indicator of your current and future tax efficiency ratio. By evaluating how much money you have coming in and going out, you can uncover where tax savings opportunities may exist in your overall financial plan. This is especially useful if you have a set income each month. You can measure that against your expenses, assuming the maximum taxation on that income. Then, see how much money you have left over. This difference between your fully taxable income and your monthly expenses will highlight your tax savings opportunities.
Once you know your maximum tax liability, you can work to reduce it — thereby increasing your available funds and maximizing your tax efficiency. One easy way to do this is to contribute to a retirement plan, such as a 401k. These contributions will reduce your taxable income, which in turn will create a tax savings. If there is not a material difference between your taxable income and monthly expenses, you may need to make sacrifices or lifestyle changes over both the short and long term in order to build tax savings strategies into your cash flow. For example, cutting expenses may allow you to save more into a retirement plan, thereby reducing taxes. In any case, assessing your cash flow is the first and most important step when measuring your tax efficiency.
When looking for tax deductions, your total gross income is the key determinant. The higher your income, the more beneficial tax deduction strategies can be to you. Itemizing deductions can certainly help in many cases, but the standard deduction is still the best solution for the vast majority of people who want to lower their tax burden or increase their tax refund.
If you have children or other dependents, there are plenty of tax deductions and credits available when filing your taxes. For example, if you pay for childcare or dependent care while you are working, those costs can be tax deductible. Similarly, if you contribute to a 529 account, some states allow for a state income tax deduction — though there is no Federal income tax deduction.
You should always keep diligent paperwork concerning high medical costs as well. These costs can often be offset with tax deductions. However, this does not apply to all medical or healthcare costs you incur throughout the tax year. These expenses usually have to be in excess of 7.5% of your Adjusted Gross Income (AGI) to qualify for deductions.
It is also important to note that tax planning is closely tied to investment strategies. It is important to understand that the burden of paying taxes when you sell investments can be reduced by holding those investments for longer than one year, assuming these are held in a taxable account. If your employer does not offer a 401k plan, you can open a Traditional IRA to get additional tax benefits in the current tax year. Alternatively, if you want to maximize your future tax efficiency, you should consider a Roth 401k or Roth IRA. Contributions in a Roth account do not offer current year tax deductions, but that money grows tax free and can be distributed tax free in future years. It all depends on whether you are seeking to reduce your tax obligation now or later. Self employed individuals and small business owners have additional tax savings opportunities available as well in the form of different retirement plans available and business expense write offs.
Some other tax efficient investments include stocks or stock mutual funds that pay qualified dividends. Qualified dividends are typically taxed at lower rates compared to interest income. If you have a lump sum of after-tax money and want to invest it in a tax efficient way, an annuity may make sense for you because it allows for tax deferred growth of your investment. Municipal bonds and municipal bond funds also allow you to invest for tax free interest income.
In addition to helping you devise comprehensive financial plans, Merit can offer a cash flow analysis to help you measure and understand your overall tax obligations. This will then help you understand the best opportunities to reduce or save on taxes. A lot of the answers to your most important tax efficiency questions can be found by simply analyzing your cash flow.
Merit can also help you explore Roth conversion strategies to save on future taxes or gifting strategies to reduce assets from an estate. In terms of investing, Merit can do a short and long-term capital gains analysis in effort to harvest gains and losses for tax purposes. Different distribution strategies during retirement can greatly affect your tax efficiency as well. For example, how and when do you take money out of your retirement accounts in order to maximize tax efficiency? With the help of a Merit Financial Advisor, you can answer these kinds of questions and optimize your tax efficiency now and in the future.
To learn even more about tax efficiency and finding the best tax deductions, be sure to contact Merit Financial Advisors today!
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Please discuss your specific situation with the appropriate professional.