"We should run a tax projection." You’ll hear that a lot around Plancorp Wealth Management.
Why? To help you make the most informed decisions.
Are you considering some charitable contributions this year? Did you just get an increase in salary or big bonus? Are the tax laws changing? Understanding how those life events or opportunities will impact your tax bill are all great reasons to run a tax projection.
By projecting out the tax impact, we can make a more informed decision. Surprisingly, lowering your tax obligation for the next year may not always be the ultimate consideration - we may find valid reasons to accept a higher tax bill if it brings other benefits or sets you up for a lower tax burden of your lifetime.
So, What Exactly Is A Tax Projection, And How Does It Fit Into Your Wealth Management Process?
A tax projection, much like a financial plan, provides a glimpse of what the future might look like based on a set of assumptions. We start with the income and deduction information from your previous tax return. We then adjust for any known facts in the current year, such as changes in income, tax rates, potential deductions, and even financial changes you may want to make or life changes like starting a family. Once everything is reviewed, we calculate the potential tax liability based on the entire scenario for future years.
The Proof is In The Pudding:
The more we know about your current year's finances, the more accurate the baseline for the projection will be. We may wait until later in the year to run a tax projection, however, for clients with complex finances (such as business owners, executives with substantial non-salary compensation, or those retiring soon) we may run several tax projections a year based on different scenarios. We want to dial in your best scenario!
Any time there's a significant change in your finances, we'll want to run a "what if?" analysis to assess two global questions:
- What will be the combined federal and state tax cost of every additional dollar of income you generate?
- What will the combined federal and state tax savings of every additional dollar of deductions you take?
The output of a tax projection is more than just dollar figures; it's critical data. Tax projections add value to the financial planning process for three key reasons:
Tax Projections Eliminate Surprises. Let's save the surprises for your birthday. When it comes to paying taxes, we never want our clients to owe a large, unexpected tax bill, even if it's due to positive events like strong investment performance. Tax projections provide clarity about next year's potential tax bill, especially during times of changing tax laws.
And it’s not just your portfolio or life changes that can create those surprises. Legislation over the past several years such as the Tax Cuts and Jobs Act (2017), SECURE Act (2019), and the CARES Act (2020) have all had a dramatic impact on everyone, thus creating a need to navigate correctly with a tax projection. If your current advisor didn’t offer to run a projection as those tax laws changed, it might be a sign you’ve outgrown their advice.
Tax Projections Help You Make Strategic Decisions. There are multiple ways to structure a financial plan or complete a financial transaction - each with its own list of pros and cons. Analyzing tax projection data allows you to be more strategic about choosing the best option for you.
Being proactive and taking a strategic approach can help determine the most tax-efficient way to structure the sale of a business, handle equity compensation, decide whether to do a Roth conversion, or optimize taxes in retirement. Ultimately, the goal is to settle on the approach that provides the greatest overall benefit.
Tax Projections Help Minimize Taxes - Today and in the Future. Benjamin Franklin said it best, "Nothing is certain except death and taxes". I bet Ben would have appreciated using a tax projection back then! Everyone must pay their tax obligation, however we don't want you to pay more than necessary.
Here’s what most people get tripped up by: trying to reduce taxes today at the expense of a larger tax bill in the future. Tax projections help to create a healthy balance to identify a tax-efficient path to the financial future you want.
Sometimes a tax projection is used to identify a short-term issue like identifying an amount for a Roth conversion or calculating a quarterly tax payment. But other times they can be used to extend 2+ years in the future to help inform longer-term planning.
Here's A Great Example
Let's say you donate the same amount to charity every year. With the increased personal exemption amount under the Tax Cuts and Jobs Act, you actually may not be receiving a tax benefit from those charitable gifts.
Or maybe you’re getting close to retirement when your ordinary income, and marginal tax rate, will be decreasing in the future. With the help of a tax projection, we could examine whether grouping several years' worth of donations into one year using a Donor Advised Fund would save you money in the long run.
Alternatively, we might anticipate a significant future tax bill, such as when you start taking RMD's (Required Minimum Distributions,) and your marginal income tax rate increases. By using a tax projection, we can identify potential planning opportunities, such as converting a portion of your pre-tax retirement account to a Roth, thereby subjecting that income to a lower rate while locking in tax-free future growth. Thus, helping to decide if it's better to hold off on grouping deductions now or using that strategy later.
Does Your Advisor Offer Tax Projections with Your Financial Planning?
Tax projections are effective because we use them in parallel with the information we already have. A good Wealth Manager should already understand the details of your financial plan, your current lifestyle, and your future goals.
A good Wealth Manager not only offers tax projections, but more importantly has a deep level of understanding of them and can offer a high-level of tax advice.For your long-term planning, your Wealth Manager needs to have the ability to run increasingly informed projections – something you can’t just get anywhere.
Looking ahead to future milestones and anticipating how different aspects of your finances will change in conjunction with them is an ideal way to help grow and protect your assets.
Offering tax projections brings power to the decision-making process and should absolutely be a staple service from your Advisor. By examining potential moves from multiple angles and considering as much data as possible, you can be confident about the decisions you make.
What’s My Next Step?
Are you using tax projections to benefit your long-term wealth planning? If not, you’re missing out on an essential piece of your financial planning pie! Your best first step towards aligning your financial future is with a comprehensive analysis. We can let you know if you are on track to achieve your goals as well as point out what you might be missing.
