Don’t Be a Grasshopper: The Importance of Proactive Tax and Estate Planning
In Aesop’s fable, “The Ant and the Grasshopper,” a family of ants prepares for winter. Bustling about in the sun, the ants dry out the grain they gathered over the summer. Meanwhile, a starving grasshopper who spent his summer playing music instead of storing food begs one of the ants for something to eat. The ant, surprised by the grasshopper’s lack of preparation, turns him away, leaving him to face the consequences of his actions.
You likely have approached work like the ants, diligently saving for retirement. You already understand the fundamentals of investing and saving. To take it one step further, let’s delve into two areas where, like Aesop’s ants, you can be even more proactive: tax planning and estate planning.
Keeping More of What You Earn
Chris Plagge, tax growth leader at Savant Wealth Management, has dedicated four decades to helping individuals and families integrate holistic tax planning into their retirement plans. A common question he receives is, “How can I lower my tax bill?” Understanding the difference between ordinary income and capital gains is a first step. Ordinary income is typically subject to higher taxes compared to long-term capital gains, which are taxed at lower rates. This distinction explains the frustration some of us experience when we realize we are paying more taxes on our income than a retiree with more assets.
“Saving on taxes isn’t just about how much money you make but how much you keep,” says Plagge. “For example, if you’ve built up $5 million pre-tax, you’ll owe taxes eventually. However, if that $5 million is in a Roth IRA (after-tax), you’ll likely keep a bigger slice of your savings,” he adds.
Plagge emphasizes the importance of understanding the various retirement vehicles in your portfolio. Many individuals diligently save into insurance products, only to face surrender charges or ordinary income taxes on products like annuities.
Another way to help keep more of what you earn is by recognizing income proactively. This strategy involves paying more taxes today to save later. For instance, if you’re between jobs and in a lower tax bracket today, you might consider converting a portion of your traditional IRA to a Roth IRA. Plagge calls this strategy of optimizing the tax bracket you are in today with thought toward what your tax bracket could be later, the “bracket racket.” Just like a tennis match, playing with the right equipment and preparation can help you make the most of tax planning.
Upcoming Tax Law Changes
One significant tax law to be aware of is the impending sunset of the Tax Cuts and Jobs Act (TCJA), reverting tax brackets to pre-2017 levels unless Congress acts. This shift could result in higher ordinary income tax brackets in 2026. Therefore, it’s wise to consider tax planning strategies that optimize the current tax rate environment. Proactive planning can help protect against higher future taxes, helping you keep more of your hard-earned money.
Your advisor can work with you to apply tax-efficient investment management strategies like tax-loss harvesting, in which you can use losses from the sale of one investment to offset gains you realize from other investments. This proactive approach can help prevent unexpected large tax bills.
The Importance of Proactive Estate Planning
Estate planning helps ensure your assets will be managed and distributed according to your wishes, regardless of your financial situation. Everyone needs an estate plan in place. Alaina Davalos, a wealth transfer advisor with Savant, highlights the need for proactive estate planning to help secure your financial legacy and provide for your loved ones.
“At its core, estate planning involves creating a legal framework to manage your assets if you become incapacitated or pass away,” Davalos says. “Essential documents include a financial power of attorney, medical power of attorney and a will.” A financial power of attorney (POA) designates someone to handle your finances if you cannot do so yourself. A medical POA allows you to choose someone to make healthcare decisions for you in the event you are unable to do so. This helps ensure your wishes are followed and eases the burden on your loved ones. The best practice is to provide a copy of your medical POA to your primary care physician and designated agent. A will outlines asset distribution after your death. Proper estate planning can also avoid the costly and time-consuming probate process. Holding assets in a revocable living trust can help your heirs bypass probate, streamlining estate management.
High-Net-Worth Considerations
For those with substantial assets, proactive planning is even more critical. If your estate faces potential federal or state tax issues, early planning can help minimize these burdens. Assessing your current and future financial status with an advisor can reveal whether you are nearing estate tax exemption thresholds. Consider strategies like a dynasty trust, an irrevocable trust that enables you to pass your wealth to future generations while shielding assets from estate taxes across generations. This approach minimizes the estate tax burden on your descendants, protecting your family’s wealth for years to come.
Irrevocable trusts can also manage and protect assets while potentially reducing estate taxes. For example, placing assets into an irrevocable trust can freeze their value for estate tax purposes, effectively removing them from your taxable estate. This strategy can potentially help save your family significant amounts in taxes.
Preparation and Communication
Effective estate planning requires open communication with your family and key advisors. Ensure your beneficiaries know who to contact and understand your wishes. It would be prudent to consider sharing a copy of your estate planning documents with your financial advisor so that they are aware of your intentions, beneficiaries are properly assigned and the correct financial accounts are opened. Once you have a solid estate plan in place for you and your loved ones, remember the last step of communicating this to those you trust. Making the decision on how transparent you want to be with the next generation about what you have saved over the course of your life, and figuring out when to share this information, can be challenging. Taking no action on building and communicating an estate plan is also a decision – and one that could hurt you and your family in the long run. Working with an estate attorney and financial advisor in tandem to evaluate your specific situation could give you the extra boost you need to overcome the hurdle of inaction.
Like the ants in Aesop’s fable, being proactive in tax and estate planning helps you prepare for the future. Whether it’s understanding tax efficiency, using various retirement vehicles, or establishing a comprehensive estate plan, taking these steps now can help secure your financial legacy and help you stop worrying about the future. By planning ahead, you can help face the “winter days” of the markets and life events with confidence.
Edward K. McDougal
Financial Advisor
CFP®