Tax payment deadlines sneak up fast for most people. Many delay organizing their documents, postpone contacting their tax advisor, and then hope any potential tax balance due will be manageable. With some proactive tax planning you can reduce uncertainty, potentially minimize your tax liability, and better manage the tax cash flow needed to pay your tax liabilities. The best tool for this is a tax projection.
What is a tax projection?
A tax projection calculates your expected tax liabilities based on various assumptions and is best done before year end. Once an estimate of your tax liability is calculated it is compared to your tax payments year to date and determine tax cash flow needs for estimates or projected balances due with your returns or extensions. Setting expectations for tax cash flow needs can take the sting out of large tax payments due and reduce the shock and surprise that could otherwise be avoided.
You and your investment advisors will need to provide information about your expected income (e.g., paystubs, investment income year to date) and expected deductions (e.g., charity, interest expense) to your tax advisor to facilitate a tax projection. Gathering and organizing your tax information for a projection will help at tax time since you will have gathered some or most of the information needed to file your tax returns, reducing the last-minute scramble to collect all tax documents closer to the filing season.
When do tax projections make sense?
If you have significant variable income, such as self-employment income or investment income, consider having a tax projection prepared on a quarterly, semi-annual, or annual basis. Other instances where tax projections add value are when you have a one-off large income year or a year with significant tax law changes which may affect you.
Executives with total W-2 earnings under $1 million and significant bonus income may also benefit from tax projections. These executives often find themselves under withheld because mandatory bonus withholding tax rates are often far lower than their actual tax rates.
Minimizing tax liability
Your tax advisor can work with you to proactive plan to minimize your tax liabilities before year end utilizing tax projections to model various planning opportunities and scenarios. If assumptions change, the projection can be updated as often as necessary. Many tax planning opportunities require financial decisions be made before year end. When your return is being prepared for filing, it is often too late for many planning opportunities.
Managing cash flow
When you know your tax liability in advance, you and your investment advisor can plan for your tax cash outflow needs, avoiding a last-minute scramble to create liquidity. Knowing your tax liabilities ahead of time allows you to consider increasing your payroll or retirement distribution federal and state withholding or quarterly payments to reduce the one-time significant cash outflows or avoid underpayment of estimated tax penalties.
Advance notice of tax cash flow needs allows your investment advisor to raise cash by selling assets in an opportunistic way instead of just before the tax due date. Selling at the wrong time may cause imbalances in your investment diversification strategies and generate unnecessary realized gains that may affect future tax liabilities. You can end up in a loop of constantly paying taxes for the gains to generate cash to pay taxes! With thoughtful proactive planning, you have time to adjust your spending or create a liquidity plan that allows for careful rebalancing of your portfolio.
Planning for future years
Tax projections can (and often should) cover multiple years. This is especially helpful when planning for retirement. Your tax advisor can help you develop a tax efficient plan to make withdrawals from tax-deferred, non-taxable, or taxable accounts or consider ROTH IRA conversions in lower income years.
With knowledge, comes power! Tax projections should be an integral part of managing your tax cash flow and will help reduce anxiety over meeting your tax obligations. Remember that your tax projection should be reviewed as circumstances change or when tax law changes occur. Call on The Tax Warriors® at Drucker & Scaccetti to help with easing the burden of tax uncertainty and making Tax Day just an ordinary day.