Benjamin Franklin was known for many things, not the least of which was his numerous maxims regarding every aspect of life. One of his most popular quotes was taken from a letter written to French scientist Jean-Baptiste Le Roy. According to the National Constitution Center, “After asking about Le Roy’s health and events in Paris for the past year, Franklin gives a quick update about the major event in the United States: the Constitution’s ratification a year before and the start of a new government under it. ‘Our new Constitution is now established, everything seems to promise it will be durable; but, in this world, nothing is certain except death and taxes,’ Franklin said.”

And right he was – taxes are a certainty for us all.  Tax season serves as a yearly financial reckoning that brings to light just how disruptive taxes are – and can be – to the wealth potential of individuals. After all, taxation and fees are the two greatest inhibitors of wealth. Income taxes, payroll taxes, sales taxes, state-level taxes—there are myriad ways your money is taxed. Fees are incurred when implementing a financial plan and purchasing financial products—they are embedded in every product out there. It doesn’t matter as much what the taxes or fees are; what matters is understanding the effect they are having on your wealth.

So, as much as you may be dreading tax season, it’s important to address it head-on and with an understanding of how to minimize the disruption taxes and fees can have on your wealth potential.

Your Financial Strategy Must Be Tax-Aware

When it comes to taxes and fees, most financial strategies are missing the fundamentals, leaving you to pay much more than you should over your lifetime. A lot of investments are driven based upon some sort of tax or fee savings. Maybe you’ve seen the ads out there trying to get everybody into a tax-free or low-fee retirement plan? Well, they may have tax-free or low-fee components, but they’re rather extreme and very risky. For example, a quick tax law change, and the entire strategy can be gone—poof, just like that.

Everyone has a slightly different mix of income sources, and those dictate and modify how you’re being taxed and the fees you are paying. Because of that, the strategy for you is not the strategy for your brother, your neighbor, your best friend. Your dynamics are different. But there are some fundamental concepts of taxes and fees that apply to the financial planning process. The goal is for you to have multiple sources of retirement income that balance out taxes and fees. That way, if one or more of the sources dries up, or if tax law changes a source or two, then the impact on your portfolio will be minimal.

Understanding How You Get Taxed

Before you can minimize the damage that taxes can do to your wealth, you need to understand how you will be taxed. One of the fundamentals to understand is the difference between marginal and effective tax rates. Essentially, the marginal tax bracket is the tax paid on the last dollars of income, and the effective bracket is how much tax you paid overall divided by your income.

Take, for instance, married filing jointly on a current tax sheet. Currently, there are seven tax brackets—these are considered marginal tax brackets. Bonus income, interest income, dividend income, and so on, are taxed in the marginal bracket. A deduction such as a mortgage interest or from a 401(k) also occurs in the marginal tax bracket.

In 2019, if your income was over $612,350, the last dollars were taxed at 37 percent. But the money from zero to $19,400 was taxed at 10 percent, from $19,400 to $78,950 at 12 percent, and so on. These are marginal taxes.

The effective tax bracket is, in essence, where income falls in this and the average amount of tax paid across all of those tax brackets. If you make $100,000 and pay $15,000 in federal income tax, your effective bracket is 15 percent. But if you make that $100,000 in the marginal tax bracket from $78,951 to $168,000, all those last dollars are taxed at 22 percent.

If you understand both of these numbers, you can begin to understand how to reduce the taxation of your income down into another bracket so that it’s occurring at the marginal bracket, not at your effective bracket.

The problem is, tax brackets and rates are moving targets.  What may benefit you today, many actually mean additional taxes in future years. At the same time, there are other taxes putting pressure on your financial strategy.  For instance, dividends, interest, and capital gains are considered to be earned income—money that is subject to tax. And while you might be able to take advantage of itemized deductions on your tax return, deductions are always changing—since the 1980s and 90s, many of them have been lowering or are being phased out.

So, What Can be Done with Taxes?

Your financial strategy is directly impacted by taxes, so what can you do about it?  One strategy involves tax deferral.  Tax deferral strategies are intended to defer paying taxes on certain assets based on the concept of moving from a higher tax bracket to a lower tax bracket at some date in the future. So instead of paying taxes on $10,000 today, when you are in a higher tax bracket, you will pay taxes on that $10,000 later when you are in retirement and reporting in a lower tax bracket. That’s the idea anyway, but there is much debate in the industry about whether it’s a good idea to defer taxes until a future date. Deferring, some argue, allows you to have the money to spend today to invest in other vehicles. But if you defer and don’t end up in a lower tax bracket, what do you really gain? The debate has gone on for years and shows no signs of stopping. There are financial strategies that can help mitigate taxation so that deferral is part of a plan, but not all of it.

Ultimately the best tool you can leverage when it comes to combatting taxes is in-depth planning and information. Understanding where you are in your bracket, where your assets are, and how they are being taxed arms you with the information needed to make better decisions.  I want you to know where you are in your bracket. I want you to understand where your assets are. As you approach tax season this year, consider taking a more involved role and become better informed of how taxes are impacting your wealth potential.  Learn more tax strategies and tips by listening to my Wealth Curve Talk podcast or by visiting my business website, Smallwood Wealth Associates.