Tax Planning is a Key Component in the Financial Planning Process:
At First and Main Financial we have a detailed financial planning process. As part of this process, we collect 2-3 years of tax returns and review them in detail to best understand a client’s full financial situation. Once all their financial information is collected and analyzed, we develop a detailed tax strategy. The goal of the strategy is to include the current tax picture, but also project what a future tax situation will look like. To this end, assets are broken down into 3 separate tax allocation categories.
| Allocation Type | Description | Account Examples |
| Taxable | Post-tax funds are invested – capital gains, interest, dividends are taxed when they occur | Bank, Brokerage, Money Market Accounts |
| Tax-Deferred | Tax-break now, funds grow tax-free, taxes paid at withdrawal | Traditional IRA, 401k, 457, 403b Retirement Accounts |
| Tax-Free | Pay taxes now, funds grow tax-free, no taxes at withdrawal | Roth IRA, Health Savings Account |
We have experienced that many clients can have up to 75-90% of their retirement savings positioned in tax-deferred accounts (ie Traditional IRA, 401k, 457, 403b accounts). This money will continue to compound over time and can create a significant tax bill when the tax-deferred money must be withdrawn via Required Minimum Distributions (RMDs) at age 72. Also, worth noting is that the IRS will charge a 50% penalty based on the full annual distribution amount if the RMD is not taken, so it is imperative to withdraw the full required amount each year. This required withdrawal amount is added to other forms of income (ie Social Security benefits, pension income, real estate rental income, etc) to determine your taxable income each year. Adding in a large RMD amount can significantly increase your tax liability and once you turn 72, your options to help reduce your taxable income are much more limited. This makes it very important to do tax planning prior to retirement, when there are tools and strategies that can help address this situation.
One tax strategy which can reduce future tax liability is the Roth conversion. This strategy involves converting ‘Tax-Deferred’ dollars over to the ‘Tax-Free’ category. You will pay taxes in the year the conversion takes place, but then the converted money will grow tax-free and not be taxed when it is withdrawn. Also, RMDs do not apply to Roth accounts, so the money that is converted will continue to grow tax-free and does not have to be withdrawn. In addition to potential tax benefits, Roth accounts are also a great option for transferring tax-free wealth on to heirs.
Roth contributions can be withdrawn at any time without penalty, while conversion amounts do have a 5-year waiting period before they can be withdrawn. You can also avoid the early withdrawal penalty when the earnings are used for qualified education expenses, but the earnings will be taxable if taken out prior to 59 ½. And lastly, having access to tax-free money in retirement can create flexibility with managing Social Security taxes and Medicare costs. These types of expenses can be impacted by higher taxable income due to higher RMD withdrawals. Accessing tax-free income to help cover large expenses in retirement can help reduce taxable income, as needed.
The laws and tax rates may change over time but it is important to understand the benefits and flexibility of having tax-free money accessible in retirement and how it can be applied to your own financial situation.
If you are looking for financial guidance, whether it be for a one-time financial plan or continuing advice on your investments, we invite you meet with a First and Main financial planner for a free consultation. We would be more than happy to sit down with you, assess your current financial health and review with you our services to help navigate your future.
