Creating a Financial Plan 4 – Tax Planning

“I’m proud to be paying taxes in the United States. The only thing is, I could be just as proud for half the money.” ~ Arthur Godfrey

Taxes are often the largest expense any of us will pay. Unlike a home (often thought of as the largest expense), most of us will not be able to “pay off” our taxes and cease to owe them anymore. We will pay taxes for the rest of our lives.

Tax Planning is the attempt to pay as little tax as possible over one’s lifetime. This is separate from Tax Preparation, which typically looks only at last year.

Tax Planning vs Tax Preparation

Tax Preparation is looking backward on what happened last year. It is the gathering of tax forms, the historical record of income earned and expenses paid, and compiling it to ensure that the correct amount of taxes were paid last year.

Tax preparation is often focused on how to reduce taxes paid in one year. Preparers that only focus on one year (whether DIYers or paid preparers) typically will make moves to reduce taxes in the year they are filing, even if it means paying more taxes over a lifetime. For example, they may contribute to a Traditional IRA to lower their gross income for the year, when they should have contributed to a Roth IRA instead.

Accurate Tax Preparation is critical. But it does not go far enough.

Tax Planning is looking forward. It is using current tax law and best guesses to estimate what future taxes will be. It is incorporating the other parts of your financial plan to determine how to have the best chance of paying the least amount of taxes not just this year, but over your lifetime.

If taxes are your largest expense and they can be reduced, you must plan to do so. If you can’t plan it effectively yourself, you must hire someone to do it for you.

Generally your tax preparer will not know enough to do proper tax planning. Not that their technical knowledge is insufficient, but rather their knowledge of you is inadequate. A good CPA may have the long-term tax planning knowledge (though many don’t look past a few years). But most will have between 300-500 clients that they are trying to prepare returns for over two months. They don’t spend enough time with you and don’t pull all the information necessary to do the tax planning. Have they ever asked you for your 401(k) statement? Exactly.

Learn effective tax planning yourself, or hire a Certified Financial Planner™ Professional to do it for you. Here are some of the strategies used in Tax Planning.

Tax Planning Tactics

Pre-Tax, Post-Tax, Tax-Free, Taxable

One of the major strategies in Tax Planning is determining the proper type of account to minimize lifetime taxes. There are three stages an account can be taxed at:

  • Contribution – When the money goes into the account.
  • Realization – When the money in the account earns interest, dividends, or capital gains.
  • Distribution – When the money comes out of the account.

Different types of accounts are taxed at different points, and there are strategies for when each account should be used.

There are taxable accounts (which we’ll talk about at the end) and tax-deferred accounts. In all tax-deferred accounts, the “realization” of taxes while the money is in the account is deferred. Meaning you pay no taxes on the money as long as it’s in the account. Then there are options to eliminate one of the other taxes.

Tax-deferred accounts can be further broken down into Pre-Tax, Post-Tax, and Tax Free.

Pre-Tax accounts eliminate the tax on the contribution. 401(k), Traditional IRAs, and the like can be contributed “pre-tax”, meaning you don’t pay taxes on the earned income you contributed to the account. You save taxes on the front end, the taxes in the middle are deferred, and you pay all the taxes at the end.*

Post-Tax accounts are contributed to after you’ve already paid taxes on the income. Annuities are one option (not covered in this article for time), but a Roth account is the most common type of Post-Tax tax deferred account. You pay the taxes on the front end, the taxes in the middle are deferred, and if you wait until after 59 1/2, the distributions are tax free!*

For both Pre-Tax and Post-Tax (Roth) accounts, you save taxes on two of the three places you can be taxed.

Tax-Free accounts save you taxes in all three. The “Triple Tax Advantage” of savings the tax on the front end, earnings grow tax deferred, and the distributions are tax free (if used for a qualifying expense). Right now, the only Tax-Free account is a Health Savings Account.* Keep an eye out for a future episode on these super accounts.

*NOTE: All of these accounts have different requirements and restrictions, benefits and drawbacks. You should be aware of all of them before attempting to use any of these accounts. Information on these requirements and restrictions is widely and freely available, and is beyond the scope of this article.

To do Tax Planning effectively, you must understand all these accounts and the ramifications of investing in one over other. Let’s look at a common question next that is responsible for either a lot of extra tax saved… or paid.

Roth vs Traditional

Deciding whether to invest your funds into a Roth or a Traditional is one of the crucial questions of tax planning. And it isn’t one that can be answered for all people for all time. The answer to this question is the that forever frustrating answer: it depends.

Depends on what?

There is a key factor you should look at when planning.

The key factor in determining Roth vs Traditional is: Your tax rate now vs what will it likely be when you are retired.

Many people in comments sections and discussion boards, as well as some financial personalities, will tell you to do all Roth always.

If you put a bunch of money away into a Traditional IRA, and then at retirement you had $1 million in that account, do you really have $1 million? No. Because you still owe taxes on all seven figures.

But if instead you had saved that money into a Roth IRA and had $1 million there, do you really have a million? YES! Tax-free baby! Every dime of it is yours.

Therefore, invest in Roth, not traditional. A popular financial radio host and financial class personality teaches that you should only invest in a traditional account if it is a 401(k) that is getting a match. “Match beats Roth, Roth beats traditional.” Meaning get the match, of course, but everything over that should go to Roth accounts.

If your goal is to have the most money in tax-free accounts in retirement, this is true. But if your goal is to pay the least amount of taxes over your lifetime, and therefore have the most after-tax money in retirement, then it’s too simple.

This analysis ignores half the equation. It looks only at the taxation and distribution, while ignoring the taxation at contribution.

Let’s take a simple example.

You have $1,000 to invest and you will put it either into a Roth IRA or a Traditional IRA. That will be invested into the same well diversified equity portfolio, and it compounds over 30 years or so to $20,000. Tax free.

If you invested the $1,000 into a Traditional IRA, the $20,000 would be taxable. So the after tax amount would be less. So Roth is better, right? Not so.

For simple math, let’s say you are in a 20% tax bracket right now and this money has already been taxed. If you put $1,000 into an IRA, you can deduct that from your taxes, saving you $200 in taxes. That $200 could then be contributed to the IRA, saving you another 20% in taxes, or $40. Which could then be put in again, and so on, and so forth. Eventually you end out at $1,250.

For you, at 20% taxes, contributing $1,1250 to a Traditional IRA has the same effect on your available cash as contributing $1,000 to a Roth IRA.

So for a fair comparison, we must compound $1,250 over the same period and rate. Result: $25,000

Final results in a true comparison:

Roth IRA: $20,000

Traditional IRA: $25,000

Yes, the Roth IRA is tax free. But there is more in the IRA. So what now? It depends on the tax brackets when you retire.

Let’s say the tax brackets are the same in retirement: 20%.

If you paid 20% taxes on the $25,000, you get $20,000.

If tax rates don’t change, the result is the same AFTER TAX.

It does not matter how much you have in pre-tax vs post-tax accounts. What matters is how much you have after tax.

So that brings us to our key Tax Planning issue. What do you believe, calculate, and guess your taxes will be in retirement?

If your taxes will be higher in retirement than right now, you should be investing in Roth.

If your taxes will be lower in retirement than right now, you should be investing in Traditional.

One more “It Depends.” Social Security.

You may need to consider your taxable income’s effect on the taxation of Social Security. Some people may be better off paying the taxes now, even though their rates may be lower in retirement, because it will lower their taxation on their Social Security, and thus increase their after-tax money.

Correctly understanding the implications of Roth vs Traditional, and picking the right one on any given year, can mean tens of thousands of dollars in savings.

Enroll in a Tax-Planning course or hire someone to put a tax plan together for you. If paying $1,000 now can increase your after-tax retirement dollars by $50,000 through tax planning, you may be better off investing that cool grand in a tax planning now than investing it in the stock market.

Taxable Investing

The last category is an old fashioned non-retirement account. These accounts do not offer the tax advantages of the other accounts.

Taxable accounts are contributed to with money that has already been taxed, you pay taxes on interest, dividends, and realized capital gains while in the account, and when you eventually want cash out, you have to sell and realize gain and are thus taxed on the back end.

But there are some tax planning opportunities here.

One key difference is ordinary vs qualified dividends. Qualified dividends are taxed at Capital Gains rates, which are 15% for most people, and 0% for some. Ordinary dividends are taxed as Ordinary Income, or your highest marginal tax rate. Qualified dividends are better.

Many international funds and high turnover funds produce Ordinary dividends, while many U.S. index funds produce qualified dividends.

If you wanted international funds in your portfolio, one tax planning idea is to increase the international holdings of your retirement accounts (where all the taxation is deferred) and remove your international holdings in your non-retirement accounts. Your total diversification mix will be the same, but you’ll swap out ordinary dividends for qualified.

You may also want to move interest paying investments (taxed at ordinary income) into retirement accounts and only have appreciating equity funds in your taxable accounts. Tax is only paid when the funds are sold, so if you buy and hold equity growth funds, you are effectively deferring the tax for a long time.

There are many tax planning opportunities that can undertake, and it pays to know them all. Or it pays to pay someone else to know them for you. Learn the tax laws, or get a good tax planner on your team. They can often save you much more than they are paid.

Action Items

  • Learn the Restrictions and Requirements for all tax favored accounts.
  • Perform an analysis of your current and projected tax brackets and shift contributions to Roth or Traditional accordingly.
  • Evaluate the merit of reallocating taxable account investments to reduce ordinary dividends and interest. Consider shifting those holdings to retirement accounts.


  • Hire a proficient tax planner do conduct all this for you. It may be a better investment that an additional contribution to an investment account. More on that in three weeks.

This article is educational only and is not intended to be investment, legal, or tax advice or recommendations, whether direct or incidental. Again, this is not investment advice. Consult your financial, tax, and legal professionals for specific advice related to your specific situation. Never take investment advice from someone who doesn’t know you and your specific situation. All opinions expressed in this article are the opinions of the people expressing them. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.