Taxes and Your Financial Plan

Tax concept with text of tax related words (real estate taxes, tax return, etc) and question markWhile taxes are inevitable, there are ways to minimize your overall tax burden. A well-built financial plan can help you shelter more of your income from taxes before and after retirement, and even after death. 

This guide addresses the role taxes play in each aspect of your financial plan and how you can make taxes a less painful fact of life, a process that can be especially helpful in high-tax states like California. 

Chapter 1

Taxes And Your Estate Plan

Taxes are an important consideration for any estate plan. There are a couple levels of taxation that could be levied on your estate: Federal estate taxes and state-level estate taxes. 

At the federal level, estate taxes are levied on everything you own or have interests in at the time of your death plus the value of lifetime gifts you made less certain deductions. If this combined value is more than $11.7 million in 2021, you could be subject to estate taxes. Any estates valued at less than $11.7 million aren’t subject to federal estate taxes.

What this looks like: 

If you owned an estate valued at $7 million at the time of your death and had made $8 million in lifetime gifts, your estate would be subject to federal estate taxes on the combined $15 million. At the 40 percent estate tax rate, this would mean your estate could owe more than $5.9 million in taxes. On top of this, your estate could also be subject to state taxes, depending on where you live.

While federal taxes apply to all U.S. taxpayers, each individual state can choose to impose its own estate tax laws as well. For example, several states, like Washington, Oregon and New York, impose state taxes. Luckily for Northern California residents, California is not one of them.

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Chapter 2

Taxes And Your Retirement Plan

Unfortunately, taxes don’t end when you stop working. Even in retirement, your income may be subject to federal, state and local taxes. For some retirees, their tax bill becomes their largest retirement expense. This is why it’s important to incorporate tax-mitigation strategies into your retirement.

Your Social Security benefits, pension income and any money you withdraw from a pre-tax retirement account such as a Traditional 401(k) or IRA are all potentially subject to income taxes. The amount you’ll owe depends on your overall retirement income and where you live.

California doesn’t tax Social Security income but it does tax other forms of retirement income. The state also imposes a 2.5 percent penalty on early withdrawals from retirement accounts and annuities, on top of the 10 percent federal penalty for early withdrawals. With this in mind, make sure you have enough income from other sources so you don’t need to withdraw from your pre-tax retirement accounts before you turn age 59-½. You can then look at ways to use both Roth and after-tax assets in conjunction with your taxable income sources to help mitigate your overall tax burden.

If you’re unsure on how this is done, talk with a financial advisor who specializes in tax planning and how it relates to retirement. 

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Chapter 3

Taxes And Your Investments

One of the greatest benefits of retirement accounts is the tax shelter they provide. Any earnings within a retirement account are not subject to taxes until you withdraw that money. This is not the case with general investment accounts. In non-retirement brokerage accounts, you must pay taxes on any investment proceeds the year in which they’re earned, even if you leave the money in the account.

The amount of taxes you may need to pay on your investment income depends on the type of income it is. There are three categories of taxable investment income: Capital gains, dividends and interest.

Capital gains are the proceeds from the sale of an investment. For instance, if you buy a share of stock for $100 and later sell it for $120, you’ll owe taxes on the $20 you earned. Capital gains are subject to different tax rates depending on how long you owned the investment before selling it. Investments held for one year or less are taxed at ordinary income rates, while investments you own for more than one year are subject to the lower long-term capital gains rate, which depends on your income bracket.

Dividends are payments companies or fund managers give to shareholders. Like capital gains, dividends are taxed at different rates, depending on your income level. Dividends also fall into two categories for tax purposes: Qualified and non-qualified. Qualified dividends are taxed at the lower capital gains tax rates of 0, 15 or 20 percent, depending on your income level. Most dividends from U.S. companies are qualified as long as you’ve held the stock for more than 60 days. Non-qualified dividends are taxed at your ordinary income tax rate.

Then there is interest income from investments. Interest is income paid by CDs, bonds and money market accounts, as well as your bank account. While some government bonds receive special tax treatment, such as municipal bonds, which are not taxed at the state level for state residents, most interest income is taxed at your ordinary income rate.

As you can see, taxes can easily eat into your investment income. This is why some investors try to strategize where they hold their investments, such as by keeping more heavily taxed investments in retirement accounts and investments that are subject to lower taxes, like municipal bonds, in their non-retirement investment accounts.

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Chapter 4

Taxes And Your Healthcare

The healthcare law also impacts your taxes, depending on how you obtained health coverage during the year. Health insurance can be one of American’s largest monthly expenses, especially in retirement. The good news is you may be able to reduce your cost through tax deductions on some medical expenses.

If you received health insurance through an employer plan and had your premium paid through a payroll deduction, your premium is probably not tax-deductible since it was made with pre-tax dollars. That said, you may be able to deduct your premium if your total healthcare costs are more than 7.5 percent of your Adjusted Gross Income (AGI).

If you purchase your health insurance on your own and pay for it using after-tax dollars, however, you may be able to deduct some of your premium. In 2021, taxpayers can deduct any qualified unreimbursed healthcare expenses if they’re more than 7.5 percent of your AGI. Qualified expenses include your health insurance premium and out-of-pocket expenses for treatment for yourself, your spouse or your dependents.

Self-employed individuals may also qualify for a tax deduction on their health insurance premium, even if their healthcare expenses are not more than 7.5 percent of their AGI. You can make this deduction regardless of if you itemize your deductions, provided you’re not eligible to participate in an employer’s plan, do not have another job that offers health coverage, and are not eligible to receive health insurance through a spouse’s employer-sponsored plan. Self-employed individuals also cannot deduct more than their business income for the year.

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Chapter 5

Taxes And Your Cost of Living 

Cost of living is how much you pay for your basic living expenses, including housing, food, healthcare and taxes in a certain area. Most people know that housing varies widely across the country. For instance, a four-bedroom house in California could cost significantly more than one in Mississippi. What you may not realize is the degree to which taxes impact your cost of living.

California has the highest state-level sales tax of 7.25 percent. Some cities and counties also impose local taxes on top of the state-wide rate, so the cost of living can vary even within a state. For instance, San Francisco has a total sales tax of 8.625 percent, while San Diego has a total tax rate of 7.75 percent.

Often times, if it costs more to live somewhere, the average wages in the area are higher to compensate. But this is only helpful if you’re working. Once you retire, the cost-of-living adjustments you receive may only come from your Social Security income. Otherwise, your income will largely depend on how your investments perform, which is why tax planning is such an important part of any financial plan.

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For more on what to expect when retiring in Sonoma County specifically, take a look at our retirement guide: Navigating Retirement in Sonoma County.