What Happens to Your Tax Liability with Proper Financial Planning?

Proper financial planning can help reduce your tax liability. But what exactly is proper financial planning? It looks at the buying and selling of assets with an eye towards tax liability reduction. This involves the timing of selling and buying, and the types of accounts assets may be held in. Let's dig into the details.

Retirement Planning

Retirement planning generally utilizes 401(k)s, IRAs, investment properties, and business ownership. Each presents different tax benefits, and not all are available to everyone based on income.

A 401(k) is common among those still earning a wage, assuming the employer offers a 401(k). These plans contribute part of an employee's paycheck directly to the 401(k) account. Contributions go into the account as pre-tax dollars. Money then grows without any tax impact. 

However, 401(k) funds are not tax-free. Instead, they are tax-deferred. Once distributions are taken in retirement, taxes must be paid on the withdrawals. Withdrawals are taxed at the retiree's current tax rate.

Traditional IRA contributions also go in as pre-tax funds. Withdrawals are taxed the same as a 401(k). The main difference between a Traditional IRA and 401(k) is that anyone can set up a Traditional IRA, assuming they qualify. IRAs are commonly not tied to employer retirement plans. IRAs also offer more investment choices than a 401(k). However, unlike a 401(k), there is no employer match with an IRA.

A Roth IRA is different from a Traditional IRA. Money that goes into a Roth is after-tax dollars. However, that money grows and can be withdrawn tax-free. In other words, tax deferment doesn't play a role with Roth IRAs.

Investments such as stocks and bonds held in any of the above accounts will be tax-sheltered from year to year. Those taxes will come due for 401(k)s and Traditional IRAs once distributions begin.

Potential Penalties For Early Withdrawal

IRAs and 401(k)s have penalties for early withdrawals. If money is taken out of the account before age 59.5, a 10% penalty will be incurred. 

There are some cases where an early withdrawal is allowed. These include reimbursed medical expenses, higher education, or a permanent disability. It’s best to work with your tax advisor on the eligibility of early withdrawals.

Reducing Tax Liability

A 401(k) and Traditional IRA both help reduce your tax liability during wage-earning years. However, this tax advantage mustn't be negated by making an early withdrawal. Remember that these types of retirement accounts utilize tax deferrals rather than tax-free advantages. 

The Roth IRA may benefit someone who expects a higher tax rate during retirement. This is because money goes into a Roth IRA using after-tax dollars. If your wage earnings years are expected to have a lower tax rate than your retirement years, the Roth IRA may be a good strategy.

Real estate investing is another area that offers opportunities to reduce your tax liability. Real estate investors know that selling real estate at a gain can trigger a large tax bill. Having the property in a tax-sheltered account, such as a self-directed IRA, can shield it from taxes. A 1031 exchange is another tax shield consideration. 

A 1031 exchange allows an investor to exchange into a like-kind property and defer taxes owed on the relinquished property. The investors can continue doing 1031s, delaying the tax liability in the process.

Tax reduction is a complicated topic, and there are usually many rules that must be followed. For those reasons, it's best to consult your tax advisor on these topics.