Tax season may seem far off, but it’ll be here before you know it. I like to advise my clients to start prepping for it toward the year’s end, so they won’t have any surprises in the new year. It’s a great time to get in touch with your financial planner or advisor and ensure that you’re getting the most out of your tax plan. Now is the time where you can see what deductions you are missing out on, what exemptions you could be filing, etc. It’s one of the easiest ways to make smarter financial choices without working harder or longer. I like to advise my clients to try to use the Tax Savings Effect for their benefit and see how they can be benefitting from their taxes.
I find the best way to explain the Tax Savings Effect is through an example. Let’s say that you have a few million dollars put away, but, because of various expenses, you can’t save any more than $50,000. You also know that you have to save $100,000 a year to achieve your financial goals. You might think the only way to make up the missing $50,000 is to work harder at your job. But if we’re honest, by working harder, you would probably earn $30,000 more at most. And you won’t really get all of that money because of what you’ll owe in taxes. You’ll owe more on taxes with this increased income and will have made more money only to add to your tax bill. You’re getting closer, but it seems as though no matter how much work you pile on, that 40 percent tax bite undoes your efforts. The more money you earn, the more taxes you’re going to pay. This is the tax effect.
However, let’s say you find a way to shelter that $30,000 from taxes so that you can make (or beat) your savings goal. One way is to contribute the extra earnings to a pension plan. Sheltering those earnings in a pension plan turns them from a tax liability into a tax deduction. The $30,000 is now subtracted from your taxable income rather than added to it. If you’re earning $500,000 and you put this $30,000 into a pension plan, your taxable income is now only $470,000. So now, if you’re saving 40 percent of $30,000, that’s the Tax Savings Effect.
For more information about reviewing your taxes before tax season, visit tswealth.com.