Tuesday, April 26, 2016

You may be doing your taxes all wrong


After having just filed your 2015 return and possibly being shocked at how much you owed, you may be ready for some tax planning to reduce the pain from now on. While “tax planning” is a frequently used term, it’s not necessarily well-understood. Here’s the scoop:
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!
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 to you under our beloved Internal Revenue Code.
While the federal income tax rules are now more complicated than ever, the benefits of tax planning are arguably more valuable than ever.
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 your tax bills along the way.
Tax planning and financial planning are closely related
Financial planning is the art of implementing strategies that facilitate reaching your financial goals, be they short-term or long-term. Sounds pretty simple: However, if it actually was simple, there would be lots more rich folks out there (including yours truly).
Tax planning and financial planning are closely linked, because taxes are such a large expense item as you go through life. As your income goes up, 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 puzzle.
Horror stories when folks fail to make the connection
Over the years as a tax professional, I’ve 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: Joe is a 45-year-old unmarried professional. He considers himself to be financially astute. However, he is not very knowledgeable about taxes. One day, Joe meets Joan, and they quickly decide to get married. Caught up in the excitement of a whole new life, Joe impulsively sells his home right before the marriage. The property is in a good area and has appreciated by $500,000 since he bought it 15 years ago. Joe and Joan intend to move into Joan’s home, which is, frankly, a dump. But Joe is an ace DIY remodeler, and he plans to work his magic on Joan’s property. Ignoring taxes, this a good plan.
Result without tax planning: For federal income tax purposes, Joe has a whopping $250,000 taxable gain on the sale of his home: $500,000 profit minus the $250,000 federal home sale gain exclusion allowed to an unmarried seller.
Result with tax planning: If Joe had kept his home and lived there with his new bride for two years before selling, he could have taken advantage of the more generous $500,000 home sale gain exclusion allowed to married couples. That way, he could have permanently avoided $250,000 of taxable gain. If necessary, the couple could have sold Joan’s home instead of Joe’s. Since her place is a dump, she could have sheltered any taxable gain with her separate $250,000 gain exclusion. Alternatively, the couple could keep Joan’s property and work on remodeling it while still living in Joe’s highly appreciated home for the requisite two years.
Moral of the story: By selling his home too soon without considering the tax-smart alternative, Joe cost himself $62,500 in taxes: completely avoidable $250,000 gain taxed at an assumed combined federal and state rate of 25%. In a higher tax bracket, the damage would be even worse. The whopping tax bill on the home sale is a permanent difference, not just a timing difference. The bill could have been zero. The point: You cannot ignore taxes when contemplating major transactions. If you do, bad things can happen, even with seemingly intelligent moves.
The last word
There are many other ways to commit expensive tax blunders. Examples include selling appreciated securities too soon when hanging on for just a little longer would have resulted in low-taxed long-term capital gain instead of high-taxed short-term gain, taking retirement account withdrawals before age 59½ and getting hit with the 10% early-withdrawal penalty tax, and 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 the rest of this year unfolds, some of my future columns will focus on tax-planning strategies that many folks can benefit from. Hopefully, we can together do a better job of keeping your tax bill on the right side of reasonable from now on.