Financial planning is not an exact science. Plans are best when they are flexible and frequently reviewed for needed changes. Sometimes you may need to change in response to external conditions, while at other times, you may want to change your plans because of changes in your circumstances. Either way, continuous review and updating are part of a good planning process.
What Goes into a Financial Plan?
Of course, financial planning means different things to different people. For some, it is about planning for retirement, while for others, the plan may be to create wealth to share with future generations or a favorite charity. But in most cases, a solid financial plan will incorporate these elements:
- Financial goals, including specifics like retirement or wealth accumulation.
- Current net worth statement.
- Income and expenditure statement.
- Debt management plan.
- Retirement planning.
- Risk appetite.
- Risk tolerance.
- Emergency savings requirements.
- Insurance coverage.
- Estate planning.
Tax Management Is Critical at Every Stage of Life
For investors, pursuing gains is usually a primary goal. Another is strategically approaching tax liabilities. That can mean deferring and managing. For example, if an investor sells a security that they have held for less than a year, any gain is considered short-term and taxable as ordinary income, which is a higher rate than long-term capital gains.
A capital gain (or loss) is the difference between the adjusted basis of the capital asset and the sales price. The basis is the original purchase price and any out-of-pocket expenses. If the investment is property, the adjusted basis also includes the cost of capital improvements the investor has made. Keep in mind that an investor can deduct the amount of a loss from the amount of a gain. If they don’t have a gain to offset a loss in the same year, the loss rolls forward for later use.
If the investor holds an asset for more than one year, any gain is long-term, and they will owe a lower tax rate than if the growth is classified as short-term. Again, this applies to property or securities. Suppose the capital asset is an investment property. In that case, the investor can defer the realization of the taxes by executing a 1031 exchange to sell the targeted property and reinvest the proceeds in a replacement.
What Is a 1031 Exchange, and How Does It Affect Tax Management?
A 1031 exchange refers to Section 1031 of the Internal Revenue Code, dealing with the sale of commercial property held for investment or business use. If an investor wants to defer the recognition of the tax on capital gain, they can do so using this tool. The investor must not directly manage the sale but instead uses a Qualified Intermediary to administer the transaction and account for the proceeds. The IRS has issued rules to govern the process, and an investor must adhere to the timelines and requirements for the transaction to be eligible for tax deferral. Investors can sequentially defer capital gains by using the 1031 exchange and reinvesting property appreciation as it grows.
Do Taxes Affect Retirement Planning as Well?
Building retirement assets and income is a critical financial planning goal for most investors. Fortunately, saving for retirement is often possible on a tax-advantaged basis. Taxpayers can set aside funds using IRAs and other savings vehicles, depending on their current and future financial needs and expectations about their tax obligations after retirement. Decisions that the investor makes today may have a significant impact on future assets as well as what is available for their heirs.
