How the Tax Code Gives with One Hand and Takes with the Other

The tax deadline is quickly approaching. A lot of questions are swirling around taxes this time of year. What will my refund be? How much will I owe? How do I adjust my withholdings to make things better for next year? What can I do to save more on taxes?

The truth about tax planning is that it’s not a specialized game involving shell companies, loopholes, and secrets. Tax planning can involve a few niche rules or loopholes when the numbers get large, but it’s mostly understanding how your deductions work and how to make sure you’re maximizing them for your situation. Tax planning also involves understanding some likely outcomes in your future financial situation so you can make the best guess at when the right time to save taxes is. Saving taxes this year may sound nice, but almost all the ways you can save taxes in one year mean you will need to pay more future taxes.

Example 1: Taxes and Retirement Savings

When considering whether to save in a Roth 401(k) or a Traditional 401(k), clients often laud the present-day tax savings of a Traditional 401(k). Those can be very exciting! It’s a deduction from your present day income that could be tens of thousands of dollars. The trade-off is that while you are setting this money aside and not paying taxes on it this year, you will have to pay taxes on the saved money and its growth as regular income when you withdraw it in retirement. In theory, you’ll be at a lower tax bracket then, but we can never know for sure. Roth contributions by contrast would be taxed today, but will not be taxed regularly in the future.

We can still mitigate this future tax burden by intentionally converting your Traditional 401(k) to Roth dollars in an early retirement scenario or otherwise low income year, such as a sabbatical. It’s a common mitigation technique that does require some planning. So it’s not always just better to save in Traditional 401(k)s if you don’t bear this understanding in mind.

Example 2: Taxes and Rental Property

Similarly, when claiming depreciation on a rental property, you do get a tax deduction in the year that you claim it. However, when you sell the property your basis may be reduced by the depreciation. If you sell the rental property and don’t use the funds to immediately buy another, you may need to pay taxes based on the profit. If this is the case, your depreciation will be factored into the taxes you pay then. Say you bought the property ten years ago for $150,000. Now it’s worth $500,000. You took $75,000 in depreciation over the 10 years. When you sell it, you will owe capital gains based on $425,000

(500 sale, minus 150 initial cost, plus 75 depreciation.)

We can potentially mitigate this by keeping the funds in property using a 1031 exchange. This is to say that you use the profit from selling the property to buy another. This is a common tool for real estate investors that comes with specific rules around it, so be careful to follow them so that you don’t have to pay taxes anyway.

Conclusion

As you can see, there are a lot of places where the tax code gives you a deduction in one year and asks for the taxes back the next. Knowing the common practices, their rules and pitfalls, and a competent team of financial professionals can help you avoid a lot of headache come tax time. The key, as with anything financially, is to plan the best you can and adapt as your circumstances change.

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