In my experience as a wealth manager, affluent clients frequently make tax mistakes that have a big influence on their financial results. These errors typically result from a failure to use available techniques to reduce their tax burden and from a lack of proactive tax preparation.
In this article, I provide insight into the biggest tax mistakes I come across, including failing to maximize retirement contributions, ignoring estate planning issues, and missing important credits and deductions.
Neglecting Tax-Efficient Investment Strategies
By failing to utilize tax-incentivized funds such as 401(k)s, IRAs, and HSAs, investment returns may be subject to a significant tax penalty. Similarly, ignoring tactics like tax-loss harvesting—selling investments at a loss to offset capital gains—can result in losing out on significant tax savings.
Exclusively Concentrating Wealth in Illiquid Assets
Concentrating all of one’s wealth in illiquid assets, like real estate or private companies, can lead to serious tax issues. It may be difficult to meet unexpected expenses or liquidity needs if these assets can’t be sold quickly. This could lead to unfavorable sales that could potentially trigger large tax liabilities.
Underutilizing Charitable Contributions
Ignoring strategies like using donor-advised funds (DAFs), qualified charitable distributions (QCDs) from IRAs, and charitable remainder trusts (CRTs) can lead to missed opportunities for utilizing tax deductions that could potentially reduce capital gains taxes and increase the impact of philanthropic giving.
Not Proactively Managing Tax Brackets
There could be serious repercussions if you don’t manage tax brackets proactively, especially in years when there are major one-time income events like inheritances, business sales, or sizable bonuses. These situations can force you into a larger tax bracket and result in a significant tax burden.
Utilizing tax-loss harvesting to offset gains, carefully timing income and deductions throughout the year, and looking into ways to lower taxable income, such as charitable contributions, are some smart strategies for decreasing this risk.
Taking Distributions From the Wrong Accounts
In general, it’s most tax-efficient to withdraw funds from taxable accounts first, followed by tax-deferred accounts like traditional IRAs and 401(k)s, and finally, tax-exempt accounts like Roth IRAs. Keep in mind that you can reduce your tax obligation by using funds that have already been taxed or have the potential to grow tax-free.
Failing to Plan for Equity Compensation Taxes
Failing to plan for the tax implications of equity compensation, such as Incentive Stock Options (ISOs) or Non-Qualified Stock Options (NSOs), can lead to substantial tax liabilities. If you mishandle the exercise and holding periods of ISOs, you may trigger regular income taxes, thereby paying tax at your highest marginal rate instead of the more favorable long-term capital gains tax rates.
Similarly, failing to account for the possible tax implications of exercising NSOs, which are usually taxed as ordinary income, can significantly affect your general tax burden. So-called ‘cashless’ or ‘same-day-sale’ exercise methods can produce unintended tax consequences if you are not careful.
Ignoring Estate Tax Implications
If trusts like spousal lifetime access trusts (SLATs) or irrevocable trusts are not established, a substantial portion of the estate could be liable to estate taxes, which would drastically lower the inheritance received by beneficiaries. Similarly, if you don’t use annual gift exclusions to transfer assets to heirs tax-free, the estate’s worth could be diminished due to a larger estate’s tax liability.
Failing to Maintain Cost Basis Records for Home Improvement
When calculating capital gains, you can determine the taxable gain by deducting the home’s cost basis from the sale price. Renovations, additions, and significant repairs are examples of home improvement projects that raise the cost basis and lower the taxable gain.
Homeowners may not be able to support the whole cost basis, however, if correct records of these costs are not kept. This could lead to a larger taxable gain and a larger tax obligation when the property is sold.
Failing to Consult the Right Advisors
It’s true that CPAs provide valuable tax proficiency and estate planning attorneys focus on estate preservation and distribution, but a comprehensive financial plan typically requires a holistic approach.
An experienced financial advisor can provide a holistic perspective by integrating investing objectives, risk tolerance, and tax and estate planning techniques. By fostering a cooperative partnership between these professionals, you can feel confident that your financial plan is comprehensive, tax-efficient, and aligned with your overall financial goals.
Consult the Right Advisor
You can potentially avoid the tax mistakes outlined above by consulting with a professional financial advisor who has the depth of knowledge needed to bridge the disparate parts of effective financial planning.
Our team at Mendoza Private Wealth takes an all-inclusive approach to helping you navigate your financial journey. To get in touch, schedule a Fit Meeting here.
About Iván
Iván M. Mendoza is the Managing Principal and a Financial Advisor for Mendoza Private Wealth, a fee-only boutique, private wealth management practice with a focus on research, planning, and investment management. Working with clients in Miami and throughout South Florida, Iván provides investment and wealth planning advice to individuals and families and to their respective trusts, estates, foundations, endowments, and pension plans.
Iván began his career with Prudential in 1999, where he quickly advanced to Manager of Financial Services, overseeing a team of financial planners. In 2012, he joined Sanford C. Bernstein’s private client group as Vice President and Financial Advisor. Driven by his commitment to providing objective advice, he founded Mendoza Private Wealth in 2016. Iván holds multiple designations, including CFA®, CFP®, CDFA®, CLTC®, CLU®, and ChFC®, and is passionate about creating confidence in clients through sound financial planning and investment strategies.
A first-generation American of Peruvian heritage, Iván resides in Miami with his wife, Ana, and their two sons, Emiliano and Alessandro. He enjoys traveling, discovering new restaurants, all things science, World Cup soccer, and staying active through running and biking. An advocate for education, he draws inspiration from his grandfather, a former Minister of Education in Peru, and supports educational causes in his community. Iván is also a music enthusiast with a wide range of tastes, from jazz to reggae to heavy metal. To learn more about Iván, connect with him on LinkedIn.
