Tax Series: Understanding Your Tax Reality

Tax Series Part 1: Understanding Your Tax Reality | www.TheHeavyPurse.comTaxes probably rank as Americans least favorite season of the year. Even though it is something we know happens every year, we still moan and groan about paying taxes until April 15 passes. It also happens to be one of my busiest times of the years too, and I’m not a CPA, but my tax savvy clients know that good tax-planning can make a significant difference in their tax bill now and in the future.

Because taxes are so dreaded and often misunderstood, I really want to shine a light on on how they work and demystify them for you. Knowledge is power, my friends. It’s not my goal to turn you into a tax expert but to help you understand the basic mechanics behind taxes and most importantly, how they affect you and your financial goals.

What Is the Most Common Tax Mistake?

I see this one regularly and it can be costly.

You Have No Ongoing Tax Strategy

Most people view taxes as a chore they complete to avoid the wrath of the IRS. Once filed, they forget about taxes until next year. This is a mistake. You need to think about taxes year-round if you want to reduce your tax burden today and in retirement.

Many people get caught up in wealth creation and overlook taxation. This frequently leads to tax sticker shock when they get ready to retire and start withdrawing assets. The sad part is retirement is where we have the greatest control over our taxable income stream, but it requires advance planning. A good retirement planning strategy equally considers how to grow your wealth and how it will be taxed.

The Solution: Educate Yourself and Enlist Professional Assistance

Thankfully this mistake is also extremely easy to fix. Your CPA and financial advisor would be delighted to help you better understand your tax situation and devise strategies to help you ongoing. I collaborate with many of my client’s CPAs to make sure we’re singing from the same page and our strategies complement one another.

What Is Your Current Tax Reality?

Just like you need to understand your financial reality, you need to understand your current tax reality in order to implement (or approve) strategies to lower your tax burden. Some of you may wish for an easier solution, but there is no tax fairy who can make your taxes disappear. You can, however, choose to educate yourself so you are empowered to make good decisions that can help reduce your taxable income.

PLEASE NOTE: For this series, I am discussing the U.S. Tax System. I apologize to our friends around the world, but I assume the basic concepts may still apply to you. Please speak with your CPA and/or financial advisor for guidance.

1. Understand How You Pay Taxes to Lower Overall Tax Bite

I often hear people say, “I am in the X% tax bracket”. But most don’t really understand how tax brackets work. Let me give you a simplified explanation.

In this example, you’re married, filing jointly and your taxable income (after all deductions) is $100k, which puts you in the 25% tax bracket. Thus, most assume you would pay $25k in federal taxes. This is incorrect. Tax brackets work like a step ladder.

  1. The first $18,150 you earn is taxed at 10%.
  2. Your additional earnings from $18,151 to $73,800 are taxed at 15%.
  3. The remaining $26,200 (to reach your $100k taxable income) is taxed at 25%.

In our example, your federal tax bill for 2014 would be $16,712.50 or 16.71% of your taxable income. Don’t Forget: There are also state and local taxes to take into consideration in the United States as well.

You can see the 2014 and 2015 tax brackets, here. Please note the tax brackets vary depending on how you file (single, married, etc.) and adjust slightly every year.

Simple Ways to Reduce Taxable Income

Now that you understand tax brackets, you can watch your income and take steps to prevent “creeping” into higher brackets when it makes sense. Here are a few basic considerations to potentially lower your taxable income. Many of these will be discussed in more detail in upcoming posts as part of my tax series and will only be highlighted here.

Increase Contributions to 401K | IRA | Flex Spending Accounts

Your first and most obvious choice. Increasing your contributions lowers your taxable income and gives a nice boost to your investments. A real win-win. I’ll be sharing more on maximizing employee benefits in an upcoming post.

Maximize Tax Credits

Tax laws are always changing along with tax credits. It can be confusing to know what you do and do not qualify for and what tax credits have expired. Many don’t take full advantage of all the tax credits available to them because they are simply unaware they exist. This is where a tax professional can be helpful.

Itemize Deductions Over Standard Deductions

Don’t automatically take the standard deduction, but consider itemizing your tax return. It takes more work, but it’s worth the effort if your deduction exceeds the standard one. Itemized expenses could include home mortgage interest, state income taxes or sales taxes (but not both), real estate and personal property taxes and charitable giving. They may also include large casualty or theft losses or large medical and dental expenses that insurance did not cover. Unreimbursed employee business expenses may also be deductible.

Harvesting of Tax Losses and Gains

We may not like it when our investments lose money, but it can be used to our advantage too. I will show you how in next week’s post.

Defer Compensation to a Lower-Earning Year

If you have a job where your income is varied, you may want to consider deferring some income in a higher earning year to a lower-earning year. Please keep in mind this option does carry some risk too. If your employer declares bankruptcy, you will likely lose your compensation, so consider the financial stability of the company first and your ability to weather such a loss, if it should occur.

Shannon’s Tax Break Tip

None of us want to pay a penny more in taxes than we are legally required to do. Most want a quick and easy solution. I’ve shared the easiest and most common and will go into more detail in upcoming posts on how to best utilize a few of them. However, where I find you benefit the most is not looking for that quick fix, but making conscious choices on how you build your investment portfolio with taxes in mind.

2. Know What Investments You Own and How They Are Taxed

It always surprises me how many investors don’t even know what investments they own or why. Most focus solely on growth, with very few even concerned about how their investments gains are taxed. It’s time to get clear on what investments you have and build a tax strategy around them. Because the last thing you want to do is build the wealth you need to fund your retirement goals to only turn around and give it to the government.

  1. Walk through every investment you own with your financial advisor and understand why it is in your portfolio.
  2. Identify which investments are Qualified (tax-deferred) and which are Non-Qualified (currently taxable). Both affect your taxable income at different times of your life. You need to understand the tax implications so you can make informed decisions to buy or sell your investments while fully understanding the tax consequences.

Carefully crafting your pre-retirement and post-retirement investment strategy can make a huge difference in your taxable income and eliminate any tax-time surprises. Again, this bears repeating because so many miss this opportunity: Your ability to reduce your tax burden is the greatest with your retirement income, but it requires advance planning and constant tending as tax laws will always continue to evolve.

Phantom Income — The Most frustrating Tax of All!

Most people recognize there are tax implications when you sell an investment, but did you know that you could be responsible for capital gains on an unsold investment? It is called phantom income. The most common and frustrating form is the capitol gains and dividends inside of mutual funds.

Fund managers (unless it is a tax efficient fund) want high performance for their investors and do not usually think about tax efficiency. They buy and sell stocks when they think they should. You may not have sold shares of the mutual fund, but as a shareholder in the fund, you are still responsible for your share of the gains.

Many investors are unaware of this, but funds are required to pass through any capital gains and dividends to you. So what should you do? Do you just avoid high performing managers or only use tax efficient mutual funds? I would argue that you build an asset allocation strategy with taxes in mind. Next week, I’ll show you exactly how to do that.

I’ve covered a lot today, and it can get a bit technical. Please feel free to ask questions in the comment section below, and I’ll do my best to answer them.

PLEASE NOTE: I am not a CPA or your financial advisor (in most instances). This information isn’t intended to be specific advice to your personal situation. Please consult your CPA and financial advisor to discuss a suitable tax strategy for your personal situation.


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February 16, 2015  •  22 Comments  •  Taxes

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  1. Monday, February 16th, 2015
    Great tips Shannon! We all want to pay less in taxes. But one piece of advice I heard long ago has always stuck with me...never make a financial decision based SOLELY on taxes. We view saving on taxes as a side benefit of making the best decision possible in the first place. In other words, if a financial decision also helps us save some on taxes it's just an added benefit.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      Great advice and you've got the right attitude, Brian. Taxes need to be considered but it shouldn't be the ONLY consideration.
  2. Monday, February 16th, 2015
    Excellent post Shannon! I ran into people all the time in my old day job that had no idea about phantom income, or worse yet, that they had tax responsibilities for selling a holding. There were also times I was accused of making it up, or getting mad at the IRS, but that's a different story for a different day. :) That said, this is why planning and knowing what you have going on throughout the year and planning for beyond is so important. We already did a fairly good job of that, but having our own business has increased that tenfold. We usually sit down and talk through taxes at least once a quarter, if not monthly so we can be prepared for the end of the year and see how we're doing for the long haul.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      Thanks, John. It's so unfortunate how many people don't understand their investments and how they are taxed. I can imagine you had plenty of interesting calls. :) It's smart that you and Nicole stay so on top of your taxes, especially being a small business owner. You don't want to be surprised at tax time!
  3. Monday, February 16th, 2015
    The more complicated our financial lives get, the more complicated our taxes and I don't think people take enough time to try to understand them. I advise clients to try to give TurboTax or a home program a go before sending their information to accounts. For $19.99 they can get a great education on the types of tax situations that apply to them and how they impact their taxes. If you only spend an hour or two with the program, you will learn a lot.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      I agree, people need to spend more time understanding their taxes. Tax software is a great way for them to get some basic knowledge so they better understand what their accountant or CPA is talking about. Taxes aren't ever going to go away, so it's important we figure out how they work!
  4. Monday, February 16th, 2015
    I love the topic, Shannon! Victoria and I made some big mistakes the past couple years not planning properly. The first year wasn't "terrible" as we owed $1.5k, but the next year we owed a whopping $7k! It was a combination of my side hustle income and her part-time employers not taking out enough money from her paychecks. Ultimately, though, it was bad tax planning. While we haven't filed our taxes this year yet I am 99% sure I planned properly for all our various income streams. Doing quarterly checkups REALLY helped as I ran some numbers and calculated whether we had set aside enough to cover what our projected tax liability would be.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      Thanks, DC! It sounds like you and Victoria learned your lesson the hard way, which happens to almost all of us. When you have multiple income streams that way you do, it can be a bit difficult to initially figure out taxes, but it can make it tough at tax time when you haven't calculated properly. Quarterly check-ups are definitely a must in your situation.
  5. Monday, February 16th, 2015
    I don't like taxes but love to read about tax strategies. I count my CPA as one of my biggest allies. Thanks for covering a difficult topic in an easy to understand way.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      Me too, Kim. My CPA is definitely one of the most important members of my financial team!
  6. Monday, February 16th, 2015
    These tips are really helpful for me, because while I do think it's important to have an accountant, I think there is value in knowing what's going on yourself (in addition to having a pro do your taxes).
    • Shannon Ryan
      Sunday, February 22nd, 2015
      I'm glad you found the tips helpful, Natalie. It is very important, whether or not you have a professional helping you with your taxes, that you understand how they work. You want to be a part of the conversation and strategy.
  7. Tuesday, February 17th, 2015
    Thanks Shannon. I am not that educated when it comes to tax, I just pay it that's it. I think you covered the most salient points that are needed by newbies like me.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      I'm glad you found it helpful, Jayson! Most people just focus on paying/filing taxes, but there is more to understand, especially if you want to reduce your taxable income.
  8. Tuesday, February 17th, 2015
    Keeping taxes on my mind year round helps so much. When it comes time to file, I have an impeccable record of my spending and receipts.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      That's great, although not surprising, Stefanie! You are very organized. :) ANd it really does make a huge difference when it's time to file your taxes and helping to understand your tax reality when you stay on top of it.
  9. Tuesday, February 17th, 2015
    I'm really loving this series. I think many people are intimidated by taxes and fearful of an audit, even people who's taxes aren't too complicated. It's great that you are educating your readings on some of the basics here. It is important to understand taxes being that we all have to pay them and file them annually! I'm going to try and boost our 401k that tax free savings! I contributed to my flex spending plan as well. Most of my investments are in my 401k (well 457) plan or Roth IRA, but I also prefer index funds because they're generally more tax efficient.
    • Shannon Ryan
      Sunday, February 22nd, 2015
      Thanks, Andrew! Yes, many people fear taxes and an audit. I find much of that fear stems from not understanding taxes, so they don't feel very confident about the decisions they make around them. Taxes is something that affects everyone of us, and we owe it to ourselves to learn the basic mechanics so we can make the best decisions possible.
  10. Wednesday, February 18th, 2015
    Every year I get a little bit better about organizing my taxes for my accountant and keeping track of write offs and expenses. It's still my least favorite time of the year though. I once read that accountants have low stress jobs…I seriously can't see how that is true. :)
    • Shannon Ryan
      Sunday, February 22nd, 2015
      Organizing everything for taxes some days feels like it could be a full-time job! :) I would think tax-time would be pretty stressful for most accountants too. The ones I know are very busy this time of the year.
  11. Friday, February 20th, 2015
    I'm glad you explained and shared the tables about the tax brackets. I never understood how that works. Very interesting!
    • Shannon Ryan
      Sunday, February 22nd, 2015
      I'm glad you found it helpful, Kayla. It's especially important as your income continues to grow, thanks to all your freelance work!
  • Meet Shannon

    "As a Certified Financial Planner, it is my passion to help individuals and families build a healthy relationship with money. I look forward to helping you raise financially confident kids.” - Shannon Ryan