It’s no secret that planning ahead is a good idea in the financial world. Faced with today’s chaotic economy, 71 percent of Americans said they were at least somewhat likely to set concrete financial goals for 2023. But this process can affect more than how you deal with day-to-day expenses. When you start taking financial planning seriously, what happens to your tax liability?
With proper financial planning, you can significantly cut down on how much you owe to the IRS each year. As a result, you’ll be able to keep more of your income and put those funds toward your long-term financial goals. Here, you’ll find our complete guide to the ways financial planning can affect your tax liability for the better.
Tax Liability: Know the Basics
Before you can truly understand what happens to your tax liability with proper financial planning, you’ll need to know what financial planning actually is. Effectively, your tax liability is the amount of money you owe to tax authorities on the federal, state, and local levels. To determine your tax liability, consider the difference between your total taxable income and any tax deductions you can legally claim.
Typically, people with higher incomes also have higher tax liabilities. That’s definitely the case in America, since the United States tax system is graduated—meaning that your income level determines your tax bracket.
Of course, your income isn’t the only factor that can affect your tax liability. Along with this, you’ll also want to consider the potential effects of capital gains, especially if your top financial priorities include wealth-building and investment. People with a high net worth that collect capital gains from their investments could deal with higher tax liabilities as a result.
Here’s What Happens to Your Tax Liability With Proper Financial Planning
The good news is that your tax liability isn’t entirely out of your control. By taking steps to manage your tax liability, you can influence how much of your investment earnings and taxable income stays with you.
No one should make decisions that could affect their tax liability without knowing what they’re doing—and that’s where developing a strategy can make a huge difference. Once it’s in place, a solid financial plan can reliably help you save on taxes from one year to the next. Furthermore, you can use the money they save to build your income with wise investments and put funds towards retirement.
Though you can technically build your own financial plan, it’s almost always better to develop your plan with assistance from a knowledgeable financial advisor in collaboration with your tax accountant. These professionals have a thorough understanding of how your tax-related decisions will affect your overall financial plan, and they’ll bring priceless knowledge about the tax code and tax regulations to the table. Plus, no matter how simple your taxes appear to be, a qualified financial advisor can help you find surprising new ways to save.
Keep Your Tax Liability Low With These Strategies
There’s no “right” way to save on taxes—instead, you’ll need to consider several actions that could help to lower your tax liability. Based on your unique situation, your financial plan could utilize any combination of these tax liability strategies:
Retirement Planning
No matter what goals you’re hoping to achieve with your financial plan, there’s a good chance that retirement planning will be part of these efforts. Some retirement-related tax strategies your financial advisor may encourage you to utilize include:
- Putting money into a Health Saving Account, assuming this option is available to you
- Making annual contributions to a traditional or Roth IRA
- Maxing out your yearly contributions to a standard or Roth 401(k), if possible
For small business owners or self-employed people, planning for retirement might involve little more than opening SIMPLE IRAs, SEP IRAs, or solo 401(k)s. But regardless of what retirement plan you opt for, you should understand how your plan is treated from a tax standpoint. Your financial advisor can help you learn more about this topic and find a retirement plan that suits your needs.
Withdrawal Planning
Next, you’ll need to think about how and when you’ll eventually withdraw funds from your retirement account. Retirement account withdrawals often come with tax implications, especially if you take money out before you reach retirement age.
As always, it’s best to talk to your financial advisor about withdrawing money from your 401(k) or IRA. They’ll be able to help you build a withdrawal strategy that won’t bleed your account dry early on or leave you stuck with a massive tax liability.
Investment Planning
While investment planning has some connections to retirement planning, it also covers other topics tied to tax liability management. To illustrate how investment planning can overlap with tax planning, imagine you’re making investments through an account subject to a capital gains tax. There are a few different investment-related tax liability strategies your advisor might recommend in this situation, such as:
- Partially or completely offsetting your annual capital gains by harvesting tax losses
- Picking exchange-traded funds and other tax-efficient investments
- Holding your investments for more than a year, making them eligible for the long-term capital gains tax rate
Tax Credits/Deductions
Tax credits and deductions are similar in some ways, but they aren’t synonymous. A tax credit can help you cut down on the actual dollar amount you owe in taxes. If you owe $1,500 in taxes and successfully apply for a $1,500 tax credit, for instance, you’ll eliminate your tax liability.
On the other hand, tax deductions can help lower your taxable income, potentially moving you into a lower tax bracket in the process. Some common examples of deductible expenses include:
- Student loan interest
- Costs related to business and self-employment
- Local and state taxes
- Interest on mortgages
- Donations to charity
- Medical expenses
Don’t Build Your Financial Future Alone
By now, you should have a better understanding of what happens to your tax liability with proper financial planning. A robust financial plan built with your needs in mind can significantly lower your tax liability, help you create a tax-friendly retirement plan, and provide many other benefits.
But understanding this is merely the first step of your journey toward reducing your tax liability. You’ll also need to ask yourself, “how can I create the most effective financial plan possible?”. If you’re currently grappling with this question, the experts at Janney can help you find the answer.
The financial advisors at the Laurel Highlands Wealth Advisory Group of Janney Montgomery Scott LLC understand small business owners’ needs, including how to build an effective tax strategy. If you’re ready to lower your tax liability, don’t try to go through this complicated process on your own. Instead, set up a time to talk with one of our financial advisors at the Laurel Highlands Wealth Advisory Group as soon as possible.
