5 things you should know about saving on taxes

At a time when top combined federal and California state income tax rates approach nearly 50%, and many tax breaks are set to expire soon, understanding the basics of tax planning is crucial if you want to secure your financial future.

Drawing from over three decades of experience, I have distilled the top five tips my affluent clients have embraced to mitigate their tax burdens. These are not just tax angles but empowering tools designed to help you grow your wealth.

Learn how to think about taxes

To keep more of what you earn, you need to do the following: reduce taxable income, defer taxable income, increase deductions, accelerate deductions, and reduce the rate you pay. Every tax planning technique meets one or more of those objectives. Let’s use a simple retirement account as an example.

You increase deductions and reduce taxable income when you contribute to retirement plans such as 401(k)s or IRAs. For instance, if someone earns $100,000 and contributes $10,000, their annual taxable income is reduced to $90,000. Simple, right?

Since you are not taxed on the retirement income until you pull it out, you are also deferring taxes on the investment income and will also pay at a lower rate when you are retired, when your income is supposed to be less.

Therefore, with a simple retirement plan, you are increasing your deductions, decreasing taxable income, deferring taxable income, and paying taxes at a lower rate! Now, imagine what you can do with more complex planning.

You must invest

You can also defer taxable income when you buy assets like growth stocks or real property because you often do not pay taxes until you sell the assets. In many cases, even if you dispose of the assets, you can eliminate all or part of the income tax on the disposition with tax and charitable gift planning.

You reduce your tax rate by having investment income because the regular top federal tax rate is 37%, but the rate on sales of assets and most dividends is only 0-20%.

Deferring tax and paying a lower rate is how the wealthy can own millions in assets but pay very little in taxes. Many of their investments have other tax advantages, including tax credits and accelerating deductions.

In fact, a good indicator of your financial health is that your net worth is high, but your effective tax rate has remained low. A lower tax rate indicates that more of your income is from investments than your labor. You want to aim for that.

Just remember, before investing, whether in the stock market or housing market, consider that all markets are subject to economic cycles. Never forget the timeless principle of buying low and selling high.

Don’t make a move without considering taxes

It is unfortunate when someone makes a significant change, such as moving, divorcing, or selling their business, and does not reach out to a tax professional for advice before the event.

So much tax planning can be done before you make a move, and very little can be done to save on taxes afterward. My clients know to call us first.

For instance, one potential client had a seven-year plan to sell his business, and because he reached out to his attorney and us early, he could exclude 100% of the proceeds from the sale from income taxes with planning. We also helped him grow the value of the business in the seven years up to his retirement, and his estate planning attorney helped legally shelter some of the proceeds from estate taxes.

Simplify your personal tax return

You might assume that wealthy clients have complicated returns. Although they hold diverse investments and own business ventures, their personal tax filings only contain summary information.

Rather than reporting a rental property on a Schedule E or their business on a Schedule C on their individual return with all the details, they prefer to hold their rental property and other business activities in other entities like trusts, corporations and LLCs.

This strategic approach serves several purposes: First, there is less information on their personal return for the IRS to examine. Second, incorporating their businesses or holding rental properties in an LLC provides for various legal tax benefits. Also, utilizing entities can offer additional non-tax advantages such as asset protection, increased privacy, and simplified ownership transfers.

Their income is reported as a few lines on a K-1 or 1099 form, streamlining the information on their return.

And if you think about it, doesn’t it make sense that business activities should be reported on a business return and not a personal return?

Have high-level discussions

Years ago, a mergers and acquisition attorney said, “After our high-level discussion about this, I want you to help me get the client up to speed so he can also talk about this.” What he said was so powerful. We should all have high-level discussions about finances with our families and the people we consult.

My clients will tell you how much they learn from their professionals. I send complicated tax and legal journal articles with notes of ideas to my clients to discuss. They keep up with business news, the markets, and tax changes.

While some clients had advanced degrees,  others did not finish high school. Regardless of their formal education, they learned enough about tax planning and business development and what strategies worked for them to succeed.

Planning is not just for the wealthy. Even if you are just starting out or do not own that much, a licensed advisor can meet with you, often for a nominal fee or free of charge, to help get you started and to encourage you to invest in your future.

Michelle C. Herting is a CPA, accredited in business valuations, and an accredited estate planner specializing in succession planning and estate, gift, and trust taxes.