Every individual has had to deal with taxes upon joining the workforce. For some, they learn around the ripe age of 16. For others, their first taxable wages appear after graduating college. Regardless of when you’re first taxed, it’s something that will happen, likely, until the day you die. The frustrating aspects usually surround the annual changes and intricacies around the tax codes and laws. I recently had the pleasure of sitting with our financial planner, Nicole Baker. She is a licensed financial planner who frequently deals with varying tax efficiency strategies. We delved into how to manage taxes efficiently in an inflationary environment.
Q: Can you first explain what we mean by ‘tax efficiency’ and why it’s imperative in times of inflation?
A: Absolutely. Tax efficiency is a term we use to mean “not paying more taxes than you have to”! When we’re experiencing inflation, every dollar counts! So, if we’re paying more taxes than is necessary, we’ve got less to spend on other things like food and shelter!
Q: Considering recent inflationary trends, how does inflation impact tax efficiency in financial planning?
A: With the higher cost of goods (and living in general), the IRS also increases certain tax-related levels to keep up with inflation. 401(k)s/IRA maxes are increased. Social Security income cap is increased. Tax brackets are increased. HSA contribution maxes are increased. The standard deduction is increased. The gift exclusion is increased, or the most money you gift a person/trust/entity without paying taxes.
Q: What strategies can individuals employ to improve tax efficiency in their financial planning during high inflation?
A: Most folks are better off going with the standard deduction (versus itemizing). Because of that, taking advantage of pre-taxed benefits is a very efficient way to reduce your liability. Make sure you are “paying yourself first”. Are you putting money away for your future self? Doing this with pre-tax money saves you from paying taxes on that income and ensures you have something tucked away for the future. Remember, pay attention to the possibility of loss, though, as there is no guarantee in the market. If you’re contributing to a 529, check if your state provides credit on state income tax. Lastly, if you’ve done anything on a large scale that was “environmentally beneficial,” like buying an electric car or installing solar panels, check to see if there is a tax credit for that.
Q: How important is it to consider the impact of taxes on retirement savings, especially in an inflationary environment?
A: In financial planning, taxes are always something we need to be considering. For retirement specifically, we need to look at how much they can save on taxes by contributing to their retirement funds now (when funding the investments with pre-taxed money). We also need to consider what tax bracket they plan to be in when they retire and start pulling funds from their accounts that will be taxed as income. Roths are an excellent tool for retirement because you pay taxes now, and then in retirement, you get to enjoy the growth you’ve seen tax-free. It can also be passed to your beneficiaries without any tax burden added (whereas a 401k or other IRA will be taxed as income to those who inherit it).
Something we can’t really plan well is knowing what the tax brackets/tax code will be in the future because that’s constantly changing.
Q: What roles do tax-advantaged savings vehicles play in managing tax efficiency?
A: It reduces your liability and postpones it until you are (presumably) in a lower tax bracket. Traditional IRAs and 401(k)s are tax-deferred vehicles. By deferring taxes, one potentially pays less tax on these funds upon withdrawal in retirement, assuming a lower tax bracket post-retirement. Roth IRAs and Roth 401(k)s are tax-free vehicles. Despite paying taxes upfront, the account holder benefits from tax-free growth and withdrawals, which can be significant over a long period. Choosing the right mix of these vehicles based on individual financial goals and tax situations is crucial to an effective strategy.
Q: Finally, how often should individuals review and adjust their tax efficiency strategies?
A: Honestly, this is something that should be considered annually. Tax brackets and opportunities are changing all the time. It’s just one of those things that is best to stay on top of because if you’re paying more than you must, it’s better to know sooner rather than later!
Please note that Summit Financial Group of Indiana does not provide tax or legal advice. The information contained in this document is generic in nature and should not be construed as tax or legal advice. We always recommend that you consult with your legal and tax professionals regarding your specific situation. Securities offered through Regulus Financial Group, LLC. Member FINRA/SIPC. Investment advisory services offered through Regal Investment Advisors, LLC, an SEC Registered Investment Advisor. Registration with the SEC does not imply any level of skill or training. Regulus Financial Group, LLC and Regal Investment Advisors are affiliated entities. Summit Financial Group of Indiana is independent of Regulus Financial Group, LLC, and Regal Investment Advisors.
