Distributing income into the most tax-efficient environment

Reallocate money using strategic tax environments to get more bang for your buck.

A strategic tax plan is one of the most important steps to accumulating wealth, and it is something our financial planners spend a lot of time on with their clients.

Most individuals have a basic understanding of the different types of savings vehicles like a 401(k), IRA or 529 Plans—vehicles which can provide potential tax advantages depending on factors such as age, income levels, state of residence, etc. What individuals may not know is when and how to get their income into these vehicles in the most tax advantageous way. This knowledge is so important because ensuring your income, investments and debt are positioned in the most strategic tax environment can give you a head start in reaching your long term goals.

Individuals that walk through our door don’t need to be the expert on tax efficiencies, but our financial planners work on educating new clients so they can follow and understand the strategy behind their newly proposed financial plan.

Financial Planner Scott Clynch believes a greater understanding of this concept can leave clients empowered with a greater understanding of how their financial plan works.

“The Five Tax Environments is the core concept that guides many of the personal and business recommendations I will make throughout the day with a client,” he said. “With their basic understanding of the categories, I can create strategies they understand and believe in, which save them a considerable amount while also reaching their goals in ways they had not considered.”

Scott visualizes the ideas of the different tax categories in a unique way. In illustrating the concept, he asks doctors to imagine a wooden barrel filled with water.

“The water inside this barrel is your income,” he says. “Imagine that there are holes drilled in the barrel—the smallest holes at the bottom, but gradually larger as you move up. These holes represent the IRS tax brackets. If you leave all your income in this one barrel it will leak—slowly from the bottom but then more quickly as you continue to put more income into it.”

Water leaking from the income barrel is inevitable to some extent—as everyone must pay taxes. But, if you envision the tax environments as additional buckets, with no holes in them, that you can transfer some of your water to, they are now a strategy to allow you to retain more of your income.

The Five Tax Environments:

Personal: Without any action, this is where all your income defaults to. This environment represents the main barrel. This is where each person spends the bulk of their money out of. The personal tax environment covers the income you need for basic human necessities like food, shelter, entertainment and non-tax-deductible debt payments.

If you are bringing in more than that, the question then turns to how can you allocate that excess in a tax efficient manner, so that it doesn’t unnecessarily leak—or go toward taxes.

Corporate: As a business owner, this is where you should start. You can fill up this bucket by taking advantage of this environment with S-Corp, C-Corp or LLC perks and general corporate deductions like your cellphone, car or other necessities you can through the business. Once it is full to the extent the IRS allows, you should move on to the next bucket.

Tax Deferred: When it comes to saving for retirement, it needs to be invested in the most tax efficient manner first. Examples are pre-tax 401(k) contributions, SEP plan contributions and defined benefit plans. Keep in mind that these buckets are not bottomless, there are funding caps on each one. The IRS determines how much income you can defer in each program and can be based on a dollar amount or a percentage. It’s best to consult your CPA for your individual limits based on income level.

Tax Advantaged: Scott refers to these as the “no brainers.” Home mortgage interest, charitable contributions, residential property taxes all add up to help reduce the tax burden. Although seemingly obvious, Scott reminds that it’s a good rule of thumb to ensure that your CPA is appropriately accounting these items on your tax return.

Tax Free: If you still have income left over, the tax-free environment can be used as another supplemental savings tool. Examples are municipal investments, 529 plans, Health Savings Accounts and Roth IRAs.

Download our five tax environment resource by clicking here. 

In certain instances where taxable income may be low, due to age, starting or buying a practice or tax saving strategies implemented by an advisor, it may make sense to use this environment as a primary versus a supplemental tool. Consult your advisor for personal advice.

Although it’s never too late to get on the right path, Scott stresses the importance of saving income in these environments as early as possible. It’s not just knowing what each environment is, but also the how, when and why it may be appropriate to transfer the income from one environment to another. There are complexities to each situation, which is why it’s good to have financial professionals on your team.

“Far too often, business owners are not educated on the different opportunities each environment presents,” he said. “I’ve met clients who have been out of school for 10 years and still have an unnecessary amount of money going to taxes. Not for lack of trying—just for lack of knowledge.”

Better allocation of your money means that you don’t have to make more money in order to have more money to save. Without adding one additional dollar of production, you can leverage your current income level and reallocate it into a more tax efficient environment.

Is water leaking too quickly from your income barrel? Reach out to our CWA team—we’ll bring the buckets.