6.5: Taxes and Financial Planning
- Page ID
- 112071
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\(\newcommand{\avec}{\mathbf a}\) \(\newcommand{\bvec}{\mathbf b}\) \(\newcommand{\cvec}{\mathbf c}\) \(\newcommand{\dvec}{\mathbf d}\) \(\newcommand{\dtil}{\widetilde{\mathbf d}}\) \(\newcommand{\evec}{\mathbf e}\) \(\newcommand{\fvec}{\mathbf f}\) \(\newcommand{\nvec}{\mathbf n}\) \(\newcommand{\pvec}{\mathbf p}\) \(\newcommand{\qvec}{\mathbf q}\) \(\newcommand{\svec}{\mathbf s}\) \(\newcommand{\tvec}{\mathbf t}\) \(\newcommand{\uvec}{\mathbf u}\) \(\newcommand{\vvec}{\mathbf v}\) \(\newcommand{\wvec}{\mathbf w}\) \(\newcommand{\xvec}{\mathbf x}\) \(\newcommand{\yvec}{\mathbf y}\) \(\newcommand{\zvec}{\mathbf z}\) \(\newcommand{\rvec}{\mathbf r}\) \(\newcommand{\mvec}{\mathbf m}\) \(\newcommand{\zerovec}{\mathbf 0}\) \(\newcommand{\onevec}{\mathbf 1}\) \(\newcommand{\real}{\mathbb R}\) \(\newcommand{\twovec}[2]{\left[\begin{array}{r}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\ctwovec}[2]{\left[\begin{array}{c}#1 \\ #2 \end{array}\right]}\) \(\newcommand{\threevec}[3]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\cthreevec}[3]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \end{array}\right]}\) \(\newcommand{\fourvec}[4]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\cfourvec}[4]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \end{array}\right]}\) \(\newcommand{\fivevec}[5]{\left[\begin{array}{r}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\cfivevec}[5]{\left[\begin{array}{c}#1 \\ #2 \\ #3 \\ #4 \\ #5 \\ \end{array}\right]}\) \(\newcommand{\mattwo}[4]{\left[\begin{array}{rr}#1 \amp #2 \\ #3 \amp #4 \\ \end{array}\right]}\) \(\newcommand{\laspan}[1]{\text{Span}\{#1\}}\) \(\newcommand{\bcal}{\cal B}\) \(\newcommand{\ccal}{\cal C}\) \(\newcommand{\scal}{\cal S}\) \(\newcommand{\wcal}{\cal W}\) \(\newcommand{\ecal}{\cal E}\) \(\newcommand{\coords}[2]{\left\{#1\right\}_{#2}}\) \(\newcommand{\gray}[1]{\color{gray}{#1}}\) \(\newcommand{\lgray}[1]{\color{lightgray}{#1}}\) \(\newcommand{\rank}{\operatorname{rank}}\) \(\newcommand{\row}{\text{Row}}\) \(\newcommand{\col}{\text{Col}}\) \(\renewcommand{\row}{\text{Row}}\) \(\newcommand{\nul}{\text{Nul}}\) \(\newcommand{\var}{\text{Var}}\) \(\newcommand{\corr}{\text{corr}}\) \(\newcommand{\len}[1]{\left|#1\right|}\) \(\newcommand{\bbar}{\overline{\bvec}}\) \(\newcommand{\bhat}{\widehat{\bvec}}\) \(\newcommand{\bperp}{\bvec^\perp}\) \(\newcommand{\xhat}{\widehat{\xvec}}\) \(\newcommand{\vhat}{\widehat{\vvec}}\) \(\newcommand{\uhat}{\widehat{\uvec}}\) \(\newcommand{\what}{\widehat{\wvec}}\) \(\newcommand{\Sighat}{\widehat{\Sigma}}\) \(\newcommand{\lt}{<}\) \(\newcommand{\gt}{>}\) \(\newcommand{\amp}{&}\) \(\definecolor{fillinmathshade}{gray}{0.9}\)- Trace the tax effects of life stages and life changes.
- Identify goals and strategies that provide tax advantages.
- Identify tax advantages that may be useful in pursuing your goals.
- Discuss the relationship of tax considerations to financial planning.
You may anticipate significant changes in income or expenses due to a change in job or career, or a change in life stage or lifestyle. Not only may the amounts of income or expenses change, but the kinds of income or expenses may change as well. Planning for changes in relation to tax obligations is an essential part of personal financial planning.
Tax Strategies and Life Stages
Although everyone is different, there is a typical pattern to aging, earning, and taxes, as shown in Table 6.5.1 .
| Young Adulthood | Middle Adulthood | Older Adulthood | Retirement | |
|---|---|---|---|---|
| Source of income | Wages | Wages/investment | Wages/investment | Investment |
| Asset base | None | Accumulating | Growing | Depleting |
| Adjusted Gross Income | Low | Higher | Highest | Lower |
| Deductions | Low | Higher | High | Low |
In young adulthood, you rely on income from wages, and you usually have yet to acquire an asset base, so you have little income from interest, dividends, or capital gains. Your family structure does not include dependents, so you have few deductions but also low taxable income.
As you progress in your career, you can expect wages, expenses, and probably dependents to increase. You are building an asset base by buying a home, possibly saving for your children’s education, or saving for retirement. Because these kinds of assets are encouraged by the government, they not only build wealth but also create tax advantages, such as the mortgage interest deduction, retirement savings exemption, or education savings exemption.
As an older adult, you may begin to build an asset base that can no longer provide these limited tax advantages, or you may create taxable income, such as interest, dividends, or rental income. In retirement, most people can anticipate a significant decrease in income from wages and a significant increase in reliance on income from investments such as interest, dividends, and capital gains. Some of those assets may be retirement savings accounts, such as an Individual Retirement Arrangement (IRA) or a 401(k), which are tax-deferred savings plans. These create tax advantages while growing, but will also cause tax obligations when income is drawn from them.
Generally, at the stages of your life when your income is higher, so are your deductions and exemptions. Deductions and exemptions will tend to decrease as your income decreases. Although your incomes change over your lifetime, your tax obligations change proportionally, so they remain relative to your ability to pay.
The tax consequences of such changes should be considered when evaluating financial strategies. Because the tax code is a matter of law, it does change, but because it is also a matter of politics, it changes slowly and only after much public discussion. You can usually be aware of any tax code changes far enough in advance to incorporate them into your planning.
Tax Strategies and Personal Financial Planning
Tax advantages are sometimes created to support personal financial strategies that encourage specific goals. In the United States, as in most developed economies, specific goals—such as homeownership, retirement savings, and education and health financing—are viewed as personal objectives that benefit both society and the individual.
In most cases, tax advantages are created to encourage progress toward those goals. For example, most people can only buy a home if they can use debt financing, which creates additional costs. So, mortgage interest, that added cost, is tax-deductible (up to a limit) to make home financing and, therefore, home ownership more affordable and attractive.
Retirement savings are encouraged, so some savings plans, such as an IRA or a defined contribution plan like a 401(k) or 403(b) (named for the sections of the Internal Revenue Code that represent them), offer tax advantages. The deposits made to those plans may be used to reduce taxable income, although there are limits to the amount of those deposits. There are also retirement savings strategies that do not create tax advantages, such as saving outside of a tax-advantaged account. There are limited tax-advantaged savings accounts for education savings and health care expenses as well.
When you have a choice, it makes sense to use a strategy that will allow you to progress toward your goal and realize a tax advantage. However, your enthusiasm for the tax advantage should not define your goals. Taxes affect the value of your alternatives, so recognizing tax implications should inform your choices without defining your goals.
Unanticipated events, such as an inheritance, a gift, lottery winnings, casualty and theft losses, or medical expenses, can also have tax consequences. They are often unusual (and therefore unanticipated) events, and may be unfamiliar and financially complicated. In those circumstances, it may be wise to consult an expert.
Your financial plans should reflect your vision for your life: What you want to have, how you want to get it, and how you want to protect it. You will want to be aware of tax advantages or disadvantages, but tax consequences should not drive your vision. For example, you would not buy a house only to get the mortgage interest deduction. However, if you are buying a home, you can plan to do so in the most tax-advantageous way.
- Tax strategies may need to be adjusted as life stages and family structures change.
- Some personal finance goals may be pursued in a more or less tax-advantaged way, so you should evaluate the tax effects on your alternatives.
- Tax strategies are a means to an end, that is, to achieve your personal finance goals at a minimal cost.
- Review your list of personal financial goals. For each goal, how does the U.S. Tax Code help or hinder you in achieving it?
- Research online to investigate tax strategies that would benefit you in your present life stage. What tax strategies would benefit you in your next life stage?