Tax-Efficient Wealth Strategy: Why What You Keep Matters
Here is something that comes up all the time. The income is good. The business is doing well. The investments are growing. But the tax bill feels higher than expected, and it is not clear why.
It's not necessarily because the CPA is doing something wrong. Most CPAs are doing exactly what they are hired to do: prepare an accurate return based on what happened last year. That is their job and they typically do it well.
The challenge is that keeping your tax bill in check isn't just about last year. It involves decisions you make this year, before December 31, that may change what the number looks like. And those decisions tend to fall between your CPA, your financial advisor, and your attorney, three people who may not always be talking to each other.
Tax Prep and Tax Planning Are Not the Same Thing
Tax prep is looking backward. You bring in your documents, the numbers get entered, and the return gets filed.
Tax planning is looking forward. It is about decisions you make throughout the year that may change what the return will look like before you ever sit down to file it. Things like:
How much to put into which retirement account. Whether to sell an investment this year or in the future. Whether moving money from a traditional IRA to a Roth makes sense right now. How to set up your charitable giving for potential tax efficiency. Whether your business structure still fits what you're doing.
These decisions typically must be made before December 31. Once the tax year closes, opportunities may be limited.
The gap between prep and planning is where opportunities may be missed and money can get left on the table. Not through any single big mistake, but because decisions were not evaluated in a coordinated way.
Where Your Investments Live Matters, Not Just What They Are
Many people know about asset allocation. That is the mix of stocks, bonds and other investments in your portfolio. Fewer people think about asset location, which is about which investments sit in which types of accounts.
For example, investments that generate ongoing taxable income—such as certain bond funds—may have different tax consequences depending on whether they are held in a taxable account or a tax-advantaged account like an IRA.
Similarly, long-term growth-oriented investments may be treated differently in taxable accounts versus Roth accounts, depending on individual circumstances.
This isn't a one-size-fits-all rule. Everyone’s situation is different. But for people with multiple account types, such as IRAs, 401(k)s, Roth accounts and brokerage accounts, it may be worth asking whether each investment is aligned with your objectives.
Roth Conversions: The Timing Matters
A Roth conversion means moving money from a traditional IRA to a Roth IRA. You generally pay income tax on the amount you move, and then that money grows and qualified withdrawals are tax-free in retirement.
Whether that trade-off makes sense depends on your situation. The years that tend to work best are the ones when your income is lower than it will be later. That might be the early years of retirement before Required Minimum Distributions kick in. It might be a year when business income dropped. It might be a year when a big charitable gift reduced your taxable income.
In some cases, lower-income years—such as early retirement or years of reduced earnings—may present planning opportunities. However, converting too much in one year may result in higher tax brackets or potential Medicare-related surcharges, while converting too little may limit potential benefits.
Evaluating this strategy typically requires a comprehensive review of overall income and tax considerations.
Charitable Giving Strategies
Many people write a check to their church or a charity, take the deduction if it is big enough, and move on. There are a few other ways to give that may stretch your money further.
If you own appreciated stock, donating those shares directly instead of selling them first may reduce your the capital gains exposure, while still supporting charitable goals.
If your giving is not large enough to itemize every year, a donor-advised fund may allow you to bunch several years of giving into one year. You get the deduction when you contribute to the fund, then send the money to charities over time.
These strategies all require some advance planning and are subject to IRS rules and eligibility requirements. You can't donate stock you already sold and you can't bunch giving you already spread out. It helps to think about this before the end of the year, not in December.
Business Structure Tends to Evolve
The business structure that made sense when you started may not be the right fit anymore. An LLC that worked fine at $200,000 in revenue might be costing you in unnecessary self-employment taxes at $600,000. An S-corp election that was smart five years ago might look different now that your compensation, retirement plan, or revenue has changed.
This doesn't mean you necessarily need to be restructuring constantly. Changing entities takes time, money, and legal work. But a check-in every few years, especially after a big jump in revenue or a change in how you pay yourself, might surface whether the current structure still aligns with current business objectives.
Capital Gains Planning Is a Year-Round Job
A lot of people think about capital gains once a year in December when their advisor mentions tax-loss harvesting. That's a start, but it is only part of the picture.
Capital gains planning may also include deciding when to sell appreciated positions, how to use losses from prior years to offset this year’s gains, and which specific shares to sell when you have bought the same investment at different times and prices.
Tax Efficient Wealth Strategy
If you've been earning well for years and wonder whether your tax bill is higher than it needs to be, that might be worth looking at. The question usually isn't whether there's a better way. It is whether anyone has ever looked at your investments, your income, and your tax situation at the same time. That is what we strive to do. If you want to see how it fits together for you, our financial planning page is a good place to start.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, investment or tax advice. You should consult with appropriate counsel, financial professionals, and other advisors on all matters pertaining to legal, tax, investment or accounting obligations and requirements.