By Nicholas Gertsema, CFP®, ChFC®, RICP®, AIF®, CEO and Wealth Advisor
When it comes to tax planning, there’s no shortage of widely held beliefs and misconceptions about the tax code. Given its complexity, it’s no wonder that certain myths have spread. Here are five of the most common I have heard in my career as a financial planner.
Your tax bracket determines how much taxes you pay on all income
The term “tax bracket” gets thrown around regularly and sometimes gets misinterpreted. When we start tax planning, we usually start by discussing the current tax brackets and do a brief overview of how they work. But just because you are in a particular tax bracket does not mean that is the rate you pay on all of your income.
The United States’ tax brackets are progressive. That means you only pay the rate for the income that falls in that particular bracket. So, if only $1,000 of your taxable income falls in the 22% tax bracket, you will pay 22% on the $1,000 that is in that bracket, not on all of your income. In other words, you may have had $1,000 that you paid 22% federal income tax on, but your average income tax rate could be under 10%, which is appealing for some people.
If you’d like to get an idea of what percentage of your income you are paying in taxes, take the amount you paid in taxes over your total income. This will give you your average tax rate – most of the time, this is much lower than the highest tax bracket you are in.
Getting a bigger refund means you paid less in taxes
The size of your refund or the amount you owe when you file your taxes has to do with the amount withheld and your total tax liability. The size of your refund is the difference between the amount withheld and the amount you owe. If you withheld more than you owe, you will be entitled to a refund. If you did not withhold as much as you owe, then you may have to make a tax payment.
If you find that you owe taxes every year when you file, it may be a good idea to increase your withholdings. In any situation where you are dealing with withholdings or making changes to your tax plans, it is a good idea to consult with a tax professional. Your tax professional will have a good idea of what changes you could make so that you do not owe at filing every year. It could be as easy as making estimated payments throughout the year so the tax burden doesn’t hit all at once.
Tax-free investments are always a good idea
In the investment world, tax planning can sometimes be confused with tax-efficient investing. If you want to save money on taxes, that doesn’t necessarily mean you need to move all of your investments to municipal bonds or investments that offer tax deferral. It’s important to look at the whole picture. Does the investment offer a lower rate of return than other alternatives would offer after you pay taxes? Does it make sense to defer taxes?
Tax planning does not mean avoiding taxation. The idea is planning when, how much, and who pays the taxes. If you are investing in something to defer the taxes until you pass, then will your beneficiaries wind up paying more taxes than you would have? Would the rate of return on a tax-free investment be lower than your required rate of return to meet the objectives of your financial plan? Is your desire to be more tax-efficient the result of sound tax planning, or is it more of a sticker-shock reaction to seeing how much you owe in taxes?
Inheritances are taxable
In most instances, inheritances are not considered taxable income to the beneficiary. That doesn’t mean there will be no tax paid. If the estate is large, there may be an estate tax charge to it. That would not be charged to the beneficiaries, but to the estate. In 2022, the size of the estate would have to be over $12,060,000 for a single person or $24,120,000 for a couple. There are also some other circumstances (i.e. generation skipping) that may cause the estate to have to pay taxes, but not the beneficiaries.
If you were to inherit an IRA or qualified plan and you were not married to the person who passed, you would more than likely be liable for taxes, as you took withdrawals from the account. With the 2019 SECURE Act, a limit of 10 years was set for beneficiaries to take the money out of these accounts. In our experience, this has made tax planning more important for those who want to pass on assets to the next generation.
I don’t need to do tax planning
We’ve heard clients say they don’t feel like they have enough money to have to worry about tax planning. But when we put the numbers together, choosing when to pay taxes can have a substantial impact on your financial plan. You have spent years working for your money and being smart with it. I have never had a client concerned they were going to leave enough money to Uncle Sam.
Having a long-term tax plan is a critical component of any comprehensive financial plan. I do not feel comfortable giving investment, estate planning or retirement income advice without having a good idea of what impact taxes are going to have on the plan. If you’d like to add tax planning to your financial plan, please book an appointment with us directly at calendly.com/gertsemawealth.