Don’t Let the Tax Tail Wag the Financial Plan Dog

Tax is a huge component of financial planning and tax questions are always top of mind for many folks. It’s our IRS and financial press that focuses on this topic relentlessly. They need to – it’s everchanging. With each Congress taxation seems to change and it can be like watching a tennis match trying to keep up. I’m not sure which I hear most, questions about investments, or tax questions? It’s a toss-up. With that said, you shouldn’t necessarily let taxation be the sole driver of reaching your future goals and your overall financial plan.

None of us like to pay tax. Especially if those taxes are above and beyond what we view as the normal taxation of our regular income. It somehow feels like we are being robbed. Let’s face it, paying the tax can just be painful. What we need to keep in mind, is that it is also a first-world problem. Think about it… if you are paying long-term capital gains tax, or alternative minimum tax (AMT), or Net Investment Income Tax (NIIT) it generally means that you are doing well and have more money coming in than average. We are all on the wealth spectrum from having $0 to being Jeff Bezos, currently ranked as the world’s richest person with $177 billion by Forbes (October 2021). Try to keep that perspective in mind. If you are wrangling with tax decisions, there’s a good reason.

Keeping an eye on tax and mitigating tax is a good step to take. Fixating on taxation and worrying about avoiding every cent of tax payable can be detrimental. For one thing, it takes focus away from your long-term ultimate goals. For another, it’s obsessive and may be preventing you from enjoying your current status in life. That is, you should be focused on and enjoying your success.

Let’s look at a simplified example involving a complicated tax arrangement. Many technology employees receive a form of equity from their company called incentive stock options (ISO). Generally, when the person is eligible to exercise the ISO, they may owe AMT on what’s called the bargain element (the spread between the purchase and grant price) on the amount of shares they exercise. This is actually a good thing because it sets the recipient up for ultimately paying the lowest amount of tax overall, and reaping greater profits, provided their company’s share price continues to rise, and that the recipient does not sell their shares for at least one year from exercise and two years from the grant date. Yes, ISO taxation can be complicated. If the recipient follows this procedure, they can ultimately pay long-term capital gains tax versus the higher ordinary income tax on all of their gain. Thus, lower tax overall.

Another point to keep in mind is that the AMT paid, over and above normal tax, may be recoverable in future years as a credit! Keep in mind that when you pay AMT you are paying the “higher of” between what your normal ordinary tax would be, versus the AMT calculation. Either way, you would be paying the tax and at least with the AMT, you will have a potential future tax credit to use.

What tends to happen is that many recipients focus solely on their current tax year and the AMT. I have actually seen some folks who didn’t exercise options when they vested out of fear of paying AMT. This actually increases the amount of tax they will eventually pay as their share price rises! They also fail to see the bigger picture of their future gain. Sometimes, it’s better to pay the tax.

This is just one example of letting the tax tail rule your financial plan. It paralyzes you and prevents you from taking action and moving forward. The ISO recipient can eventually sell the shares they have, pay the tax and then put that profit to better use; paying down debt, or diversifying investments. Other examples include not selling appreciated assets out of fear of paying capital gains. Again, that can be a good thing depending upon your ultimate goal. Refinancing to a larger home mortgage for the interest deduction is another tax tail-wagger. This is usually not a good idea. The deduction is usually not substantial enough to have a valuable impact.

Sometimes, biting the bullet and paying the tax can be the best thing to do. It may not feel like it, but it clears the path ahead and you can focus on your long-term goals and plan. It is also a decision made that you no longer need to worry about. When compared to potential future gains, it may even make sense to pay the tax and move on.

As an independent CERTIFIED FINANCIAL PLANNER™, I can help you plan for potential tax moves and keep making progress toward your goals.  Contact me and let’s get started. #talktometuesday #education #Hireaplanner #retirement #stressfree #lifeplan #savings #tax #taxplan #IRS #CFPPro