Long-Term Impact of Taxes on Your Financial Planning

Most people consider investment returns as a deciding factor while picking out an investment. However, the returns are not entirely yours always. Depending on the type of investment you choose, you could end up paying a significant amount of taxes. This is why it is crucial to keep in mind the repercussions of taxes on your financial planning. This can entail picking out tax friendly savings options, understanding the difference between short term and long term capital gains taxes, planning your estate to reduce its taxability, and much more.

Tax planning and financial planning

In order to understand how taxes can affect you, understanding tax planning and how it differs from financial planning is vital. You plan your savings, investments, income, etc., under financial planning. This also includes your expenses and budgeting to lower your outflow of money.

Incorporating ways to reduce your tax liability refers to tax planning. Under tax planning, you invest and save from the point of view of tax, thereby ensuring that you maximize your returns by not losing out on taxes at the time of maturity or distributions.

Here are some long term impacts that taxes can have on your financial planning and how you can reduce or eliminate them:

1. Select the right retirement savings account

When it comes to retirement savings, you may already have an employer sponsored retirement account like the 401(k) account. You can also choose an Individual Retirement Account (IRA), a Roth IRA, a Roth 401(k), and others. However, the deciding factor here remains the taxability of these accounts. A traditional 401(k) or IRA is taxed as per your ordinary income. The contributions to a traditional retirement account are made by pretax dollars and the funds grow tax deferred. On the other hand, Roth accounts are funded by after tax dollars. Hence, your money grows tax free and your withdrawals are tax free, as long as the money is used for a qualified expense and you abide by all the rules and regulations of the Internal Revenue Services (IRS).

The long term impact of taxability on these accounts can determine your retirement income and alter the course of your financial planning to a great extent. If you withdraw funds from a traditional account in a year where your gross income is high, you can find yourself in a higher tax bracket and lose a large portion of your income to taxes. Therefore, in this scenario, a Roth retirement account may be a better option.

The right way to choose an account would be to consider your total retirement income. If you have other sources of retirement income, such as pension accounts, Social Security benefits, inheritance money, returns from investments, etc. and predict your total income in retirement to be more than it is in the present, a Roth account can lower your tax liability since the withdrawals are going to be tax free in retirement. So a higher income will not impact your taxes at all. However, if your current income is higher than you expect in retirement, a traditional retirement account may suit you more, since your withdrawals will be taxed while your money will grow tax deferred.

2. Understand that Social Security benefits are also taxed

It is a common misconception that Social Security benefits are not taxed. The truth is that if Social Security benefits are your only source of income in retirement then your total income for the year may be too low to be taxed. In such a case, it may be accurate to say that Social Security benefits are not taxed. However, if you have other income sources, then your Social Security benefits are likely to be taxed since your gross income for the year will increase. Taxes on Social Security benefits are calculated as per your combined income. This is the total of the following heads:

50% of Social Security benefits + Adjusted Gross Income (AGI) + Tax exempt interest income

AGI is your total income like salary, dividends, retirement account withdrawals, etc. for the year minus the tax deductions. Your Social Security benefits are taxed as per the following table:

3. Know the tax dues on your estate

Estate planning is not only about dividing your income and assets amongst your heirs but also about planning the division in a manner that does not result in high taxes for your inheritors. If you do not plan the tax liability on your estate in advance, your hard earned money may never reach your heirs as you intended. Instead, it may be wasted on paying inheritance and estate tax.

As of 2022, the threshold limit for federal estate taxes is $12.06 million. This has been increased from $11.7 million in 2021. For married couples, the limit is twice as much at $24.12 million. If the value of your estate is higher than this threshold, you will have to pay federal estate taxes on your assets like real estate, cash, retirement accounts, investments, etc. Here is a table of estate taxes in 2022:

Keep in mind that the tax is only charged on the amount that exceeds the threshold of $12.06 million for individuals and $24.12 million for married couples.

It is important to consider the impact that these taxes can have on your estate’s overall value. You can discuss this with a financial advisor and consider options like charity, giving gifts, etc. to reduce your taxes. You can also consider moving to a state with no inheritance tax. This may sound a bit extreme, but can be a viable option in the case of large estates.

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4. Calculate the difference between short term and long term capital gains taxes

The tax rates largely differ for short term and long term capital gains. This, in turn, can decide your net income from investments. In simple words, long term capital gains are returns earned on investments held for more than a year, whereas short term capital gains are returns earned from investments held for less than a year. When you earn a profit on an asset, it is considered to be your capital gain. Similarly, when you incur a loss on an asset, it is considered to be your capital loss.

If you sell your asset within a year, you will be subject to a short term capital gains tax on your earnings. In this case, the sale from the asset will be added to your ordinary income and you will pay income tax as per the tax slab you fall into.

For 2022, the short term income tax slabs in the U.S are as follows:

For 2022, the long term capital gains taxes will be charged as per the following:

It may be more tax efficient to hold your assets for at least a year or longer to minimize your outflow in taxes. This can boost your investment returns and contribute to better savings for the future.

To sum it up

The long term impact of taxes can control your returns by great margins. This is why it is important to factor it in while planning your finances. Simply looking at the returns can be misleading in the long run, because the final outcome will not match your expectations when you finally hold your money in your hands. Hence, tax planning and financial planning need to go hand in hand, so you are always in charge of your money.

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