How Wealth Advisors Can Help do Tax Planning for The Two Types of Taxpayers
Effective tax planning is an important component of building wealth and is generally split into two time periods: near-term (i.e. the current tax year) and longer-term (beyond the current year). Near-term tax planning is primarily focused on minimizing your current tax liability and avoiding surprises and penalties at the tax deadline. Longer-term tax planning is primarily focused on strategically minimizing your taxes over your lifetime, even if it results in paying more taxes in the current year.
Another aspect of near-term planning is managing your federal and state tax liabilities through your withholdings and/or estimate tax payments. How you actually pay them depends on how you feel about managing your obligations throughout the year and your comfort with surprises come tax time. In general, this tends to push taxpayers into one of the camps when it comes to paying taxes throughout the year.
Those with a preference to avoid negative surprises and penalties (most, but not all taxpayers)
Those whose preference is not giving the IRS an interest-free "loan" (and may not care too much that they may owe taxes and penalties at the deadline)
Most taxpayers don't like a "negative surprise" when they file their taxes, obviously. There are a lot of reasons why you may find yourself in this unpleasant situation. A common reason is that you may not be withholding enough taxes from your paycheck. This issue is particularly acute with equity compensation such as Restricted Stock Units (or RSU's) since the federal statutory withholding rate is a flat 22%, which could be much lower than your marginal tax rate of 32% or 37%. Another reason is not withholding taxes for portfolio income (dividends, capital gains, etc.).
Often an unexpected tax liability will also include a penalty for not meeting the required quarterly tax payments. Just because you're withholding taxes regularly doesn't mean you're withholding enough to avoid penalties (you can read more about estimated tax payments here).
Penalties accrue based on required quarterly payments, and while often not significant in dollar terms, penalties can be a source of frustration, akin to getting a parking ticket. However, there is another way to look at penalties. If you think of a tax penalty as a "convenience fee" for keeping your money longer (and possibly earning interest), they can seem much less punitive. Some taxpayers prefer this approach.
You can also have a "positive surprise", meaning a large refund. A common reason is your tax advisor (or tax software) instructs you to pay the "safe harbor" amount based on last year's tax liability (generally, either 100% or 110% of the prior year amount, depending on your situation) to avoid penalties. This amount could be much more than this year's liability; thus, unknowingly paying in too much. While almost everyone prefers a refund versus owing more, again, some taxpayers don't like to tie up their money with the IRS. And, with the recent spike in interest rates, "loaning" your cash to the IRS is getting more costly.
In an ideal situation, a taxpayer withholds enough taxes quarterly (or makes estimated payments) to avoid penalties and knows the amount of any additional tax due in April. However, tax obligations can change significantly from year-to-year making perfect foresight difficult (if not impossible). Since managing your taxes well can be time consuming and costly, tax preparers will usually keep calculations simple and conservative to avoid negative surprises. Unfortunately, that may still result in a negative surprise though, to the chagrin of the first type of taxpayer, or a large refund, to the chagrin on the second type of taxpayer.
Wealth advisors, however, are uniquely positioned to help both types of taxpayers manage their tax payments as well as strategically plan for both the near and longer-term. These types of advisors typically have not only experience with and knowledge of taxes, but they manage your financial plan and take a more comprehensive view of your overall financial health. In addition, wealth advisors can coordinate with your tax preparer to ensure accuracy and consistency with their tax filing approach.
Give us a call the next time you're thinking about taxes. We're ready and willing to help.
Setarcos Wealth Advisors LLC ("Setarcos") is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Setarcos and its representatives are properly licensed or exempt from licensure.
The information provided above is for educational and informational purposes only and does not constitute tax advice and it should not be relied upon as such. Setarcos and its advisors do not provide legal, accounting, or tax advice. Consult your attorney or tax professional.