Tax Diversification – How to Stabilize the Ever-Changing Tax Rules
The tax code is complicated and getting more so all the time. No matter how much investors try to adapt to the changes, there's usually no way to stay on top of everything all the time. There’s an art to lowering your tax liability (largely through tax diversification), but there’s also a limit as to how far you can and should go. To help stabilize the ups and downs of tax laws, consider this tax diversification strategy.
Never Underestimate the Complexity of the Tax Code
The rule in business, sports, politics, and warfare is, Never underestimate your opponent. And so it is when it comes to taxes. Never assume you have a greater level of understanding of the tax code than you really do.
The U.S. tax code is incredibly complicated, so much so, there's no single human being on the planet who understands its entirety.
For that reason, be very wary of topical advice including general rules. The tax code is riddled with exceptions and special provisions. This means any general rule may not apply to your specific circumstances. In fact, a single variation in your tax situation from the norm could change the entire way a tax regulation applies to you.
Before you do anything different, unusual, or out-of-the-box, make sure you proceed only with good advice from trusted sources.
>>Start with the basics with our 2023 Federal Income Tax Guide
Get Close To Your Tax Advisor
If your tax situation is anything more complicated than a W-2, interest, and dividend income, and maybe itemizing your deductions, you may need to engage the services of a tax professional. This is even truer if you own rental real estate or your own business.
Yes, there are a lot of tax-preparation software packages out there, but there’s another time-honored saying you need to be cognizant of: Garbage in, garbage out, or GIGO. This term actually originated in the computer field to describe unexpected outcomes that were the result of incorrect input. That’s exactly what can happen when preparing your income tax return, even when using the best tax software.
The advantage of having a tax professional on your side, particularly a CPA, is they prepare income taxes for a living. So it's highly likely they know the updates on the changing laws and can recommend moves for you to make based on your specific situation. CPAs usually have an established review practice as well designed specifically to catch errors. You’ll need to have this working for you if your return is fairly complicated.
Sooner or later you will come up against a tax gray area where you will have questions that need to be answered. Many such tax issues are hardly the place for DIY. You should have a tax professional to discuss such matters with, so you avoid creating problems in the first place.
Pay Attention to Tax Changes and Make Adjustments
If the tax code was a static body of law, there’s more than a remote chance ordinary people would be able to master it. But that’s hardly the case. Every year the tax code includes updates, revisions, additions, and deletions.
And every decade or so, the code undergoes more significant changes. If you want to stabilize the impact of tax rules on your life, you should have at least a loose idea of what those changes are going to be.
This is another excellent example of why you need to have a close relationship with a tax professional. As I mentioned, it’s that person’s job to keep abreast of changes taking place in the tax code. You should have a general idea of what is happening with taxes, but you need to have a resident expert to turn to, preferably one with intimate knowledge of your own personal tax situation. Then be prepared to make the suggested changes that professional recommends.
Move Your Money to Tax-Favored Activities and Investments
In an effort to control both economic policy and social behavior, Congress routinely adjusts the tax code to increase the chance of certain outcomes, while decreasing the likelihood of others. This is why certain financial activities are more tax-favored than others.
Here are some examples of where the tax code favors certain activities over others, particularly in regard to investments:
- Wages/W-2 source income is favored over self-employment and 1099-type income sources, since no self-employment tax (both sides of the FICA tax) is assessed against it, and the likelihood of an audit is much lower.
- Capital gains income is favored because it carries a lower tax rate than ordinary taxable income.
- Index funds are favored because they generate less in the way of both dividends and capital gains.
- Tax-deferred retirement accounts are favored over other investment types because they a) are generally tax deductible when taken, and b) don’t produce any immediate tax consequences in regard to investment income.
You can streamline your income tax situation, as well as reduce your tax liability, by doing your best to emphasize tax-favored activities and investments in your income profile.
>>Find out more about Tax Efficient Investing: Which Investment Types Are the Most Recommended Ones?
Don’t Push the Envelope Too Hard
Once you have a good understanding of exactly how complicated the tax code is, you can use that to your advantage in one of two ways. You can either understand the complexity to give yourself gray-area loopholes or play it as straightforwardly as possible to avoid problems.
Understand that pushing the envelope in any one area of your taxes is what usually causes the red flags we read so much about. IRS computers are programmed to sift out tax activities that look unusual or are out of proportion to the tax situation. If you push too hard in this area, you may lower your taxes in the short run, but you could be setting yourself up for a well-deserved ambush by the IRS at a later date.
It’s much easier to get into a tax jam than it is to get out of one. Realizing this fact should make you a little bit more cautious about taking chances when filing your taxes.
Yes, there are all kinds of strategies out there to lower your tax liability, but be careful not to get too aggressive. One of the best ways to avoid problems is to use these methods conservatively. Take advantage of the best tax strategies you reasonably can, but don’t get carried away.
Using these tips to diversify where you invest and finding a tax pro who can be an asset to your entire financial portfolio will help you navigate the ever-changing field of taxes and how it affects your investments.