Taxes are nuanced and complex, but you don’t need to be a certified expert to call yourself tax savvy. With the right knowledge and strategies, you can transform this annual obligation into an opportunity for financial growth.
What does it mean to be tax savvy?
Despite misconceptions, being tax savvy doesn’t mean dodging taxes. It’s about understanding the tax system, knowing how it impacts your financial situation, and using it to your advantage. The ultimate goal of being tax savvy is to legally and strategically lower the taxes you pay so you can boost your financial growth.
Maximizing your pre-tax contributions
Pre-tax contributions are a portion of your income you invest before tax has been applied to the amount. You’ll have to pay taxes on those dollars eventually, but these contributions can lower your taxable income and, consequently, your tax bill. That also means more money going straight to your savings or investments.
Retirement plans: Employer-sponsored 401(k)s allow employees to contribute a portion of their pre-tax wages. These contributions, combined with matching funds from the employer, can compound significantly over time. For anyone not participating in a company plan, traditional IRAs also allow pre-tax contributions.
Health plans: If made through payroll deductions, contributions to a health savings account (HSA) are pre-tax. HSA funds also get to grow tax-deferred (more on that below), and withdrawals are tax-free if you use the money for approved medical expenses.
Leveraging tax-deferred and tax-free options
What about all the earnings that your contributions accumulate? With tax-deferred strategies, you can postpone paying any interest, dividends, or capital gains until you make withdrawals — a powerful tool for anyone expecting to be in a lower tax bracket in retirement.
Tax-advantaged accounts: 401(k)s and traditional IRAs are tax-deferred, which means 100% of your investment will compound over time. Roth IRAs offer the added advantage of tax-free withdrawals (the difference being they’re funded with after-tax dollars, so you won’t get an immediate tax break).
529 college savings plans: 529 accounts are specifically designed to help cover education expenses. While you’ll typically contribute after-tax funds, your money grows tax-deferred. These funds can then be withdrawn tax-free if you use the money for qualified expenses.
Deferred annuities: With annuities, an insurance company provides a regular stream of income in exchange for a one-time or recurring investment. You generally contribute pre-tax dollars, the funds grow tax-deferred, and eventual distributions are taxed like ordinary income.
Avoiding unexpected taxes
Individuals holding investments in taxable accounts, such as brokerage accounts, often get caught off guard by taxable distributions. For example, mutual funds must distribute capital gains to shareholders, even if you haven’t sold shares. Whether you take the distribution as cash or plan to reinvest it, you’ll have to pay capital gains taxes. Stay vigilant about the nature of your investments and understand their tax implications.
Best practices to follow
Being tax savvy involves more than understanding tax-saving vehicles; it’s also about adopting sound strategies for managing your tax plan.
Start Early: You shouldn’t wait until April to start thinking about your taxes. While you won’t face penalties as long as you file on time, year-round planning gives you time to leverage any strategies for minimizing your tax bill and maximizing your growth opportunities.
Diversify & Allocate Strategically: Varying your accounts gives you more flexibility when managing your tax liability. For example, investments that generate significant income are generally held in a tax-advantaged account where earnings won’t trigger a taxable event. Conversely, placing your tax-efficient investments in a taxable account ensures you’re not wasting their built-in tax benefits.
Document Everything: Submitting erroneous credits or deductions can lead to a 20% penalty. Detailed and organized record keeping can help prevent errors from happening in the first place and, in the case of an audit, make it easier to prove you correctly took deductions.
Regularly Reassess: Market conditions, life situations, and tax laws change. Your tax strategies should evolve, too. Periodically review and adapt your tax strategy to better position yourself for financial growth.
Want to know more about which tax-savvy strategies are best for you? Our tax professionals are here to put you on the right path. Contact us today to start creating a financial plan that maximizes your financial growth and tax-saving potential.
