There is a phrase we say a lot here at Plancorp: “We should run a tax projection.”
You might hear it when you ask if it makes sense to boost your charitable contributions this year, or when you call us with the good news that you’re getting a big bump in non-salary compensation. We also might reach out suggesting we run a new projection when there’s a change in tax laws.
The reason we recommend tax projections so often is that understanding the potential tax impact of different options can help you make better decisions. That’s not to say that taxes are the ultimate consideration—there might be very good reasons to accept a higher tax bill if the move provides other benefits. But by running those numbers, we can guide you toward a conclusion with a full understanding of the pros and cons of any financial move.
So what exactly is a tax projection, where do they fit in to the wealth management process? Here’s an overview of how we use them.
What Is A Tax Projection and How Do They Work?
A tax projection, like a financial plan, shows what the future might look like based on a set of assumptions. We start with the income and deduction information from your last tax return and adjust for anything we know about the current year—including changes in income, tax rates, potential deductions, and so on. Then, we calculate what your taxes would be based on those conditions.
The more we know about your current year’s finances, the more accurate the projection will be. That’s why we often wait until later in the year to run a projection. But for clients with more complex finances—such as business owners, executives with lots of non-salary compensation or someone retiring this year or next—we might run a few tax projections a year based on different scenarios. Basically, any time there’s a big change in your finances we can run a “what if?” analysis to see:
- The combined federal/state tax cost of every additional dollar of income you generate.
- The combined federal/state tax savings of every additional dollar of deductions you take.
The Benefits of Tax Projections
The output of a tax projection is more than just dollar figures, though—it’s critical information. We believe that tax projections add value in the planning process for three key reasons:
They eliminate surprises
We never want our clients to owe a big, unexpected tax bill—even if it’s for something positive like strong investment performance. Tax projections provide clarity about next year’s potential tax bill. These estimates are especially important in times when tax law is changing. The Tax Cuts and Jobs Act (2017), SECURE Act (2019) and CARES Act (2020) are all recent examples of legislation that changed the game for individuals.
They help you make strategic decisions
There are multiple ways to structure a financial plan or complete a financial transaction—each with its own pros and cons. When you analyze tax projection data, you can be more strategic about the option that’s best for you. For example, how to structure the sale of business, the most tax efficient way to deal with executive compensation, decide whether to do a Roth conversion, or optimize taxes in retirement. Ultimately, we would settle on the approach that provides the greatest benefit to you overall.
They help minimize taxes today—and in the future
We all have to pay our taxes, but we don’t want our clients paying more than they need to. We also don’t want to make a decision that reduces taxes today at the cost of a bigger tax bill in the future. Striking that balance is much harder without tax projections.
For example, maybe you give the same amount to charity every year. We could examine whether bunching several years’ worth of donations into one year using a Donor Advised Fund would actually save money over the long run. Alternatively, we might look ahead and realize that there’s a big potential tax bill on the horizon—say, when you have to start taking required minimum distributions. In that case, we could run a tax projection to decide if it’s better to hold off on bunching deductions for now, so we can use the technique later.
In each of these scenarios, what makes tax projections so effective is that we use them in the context of all the other information we have about you. As your advisors, we know the details of your financial plan. We understand your lifestyle today and your goals for the future. We can look ahead to future milestones and anticipate the parts of finances that will change in conjunction with them.
Tax projections fit in along with all this other information as we work with you toward your financial goals. By examining potential moves from multiple sides and considering as much data as possible, you can feel even better about the decisions you make. And we believe that’s a recipe for building wealth in the long term.
Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.