How Taxes Affect Your Long-Term Financial Planning Goals

When one is looking to invest money, the potential returns they could earn from the investment play a critical role in their decision. However, the amount of returns you end up taking home depends upon the type of investment you chose and the taxes involved in that investment. You may end up paying a significant amount in taxes based on which investment you decide to go with. Thus, it is crucial that you factor in the effect of taxes when undertaking financial planning. This may involve selecting tax-friendly savings options, grasping the difference between short-term and long-term capital gains taxes, figuring out how to reduce your estate taxes, and so on.

Understanding Tax Planning and Financial Planning

In order to comprehend how taxes affect you, you need to understand how tax planning differs from financial planning. While financial planning, you make a plan for your savings, investment, income, etc. which also includes your expenses and your budget to ensure that you reduce your outflow of money.

Tax planning, on the other hand, refers to the analysis of a financial plan designed primarily to reduce your tax liability. Under tax planning, the main aim is the maximization of returns by making investments and savings from the point of view of your taxes, ensuring that you do not lose out on taxes at the time of maturity of your investment.

Let’s look at how taxes can affect your financial planning in the long term and how you can lower or eliminate its impact:


  1. Choose the right retirement savings account
  2. When it comes to retirement savings, there are a number of accounts an individual can choose from. First, you may already be having an employer-sponsored retirement account such as the 401(k) account; however, you also have the option to choose from an Individual Retirement Account (IRA), a Roth IRA, a Roth 401(k), among others. The taxability of the retirement account you choose should be a deciding factor for you. In a traditional 401(k) or IRA account, you are taxed as per your ordinary income. The contributions are made by pre-tax dollars with the funds benefiting from tax-deferred growth. Roth accounts, on the other hand, are funded with after-tax dollars, enabling your money to grow tax-free. Your withdrawals are tax-free, provided the money is used for a qualified expense and as long as you adhere to all the rules and regulations of the IRS.

    Your retirement income is determined by the long-term impact of taxability on these accounts, which can affect the way you carry out your financial planning. If you withdraw funds from a traditional account in a year where your gross income is high, you may lose a large portion of your income to taxes, as you belong to a higher tax bracket. Situations like this can be avoided by going for a Roth retirement account.

    The correct way to go about selecting your retirement account is by taking into account your total retirement income. First, consider all possible sources of retirement income - pension accounts, Social Security benefits, inheritance money, returns from investments, among others - to assess your future retirement income. If your retirement income would be more than it is in the present, you should opt for a Roth account, as the withdrawals would be tax-free in retirement, and having a higher income would not impact your taxes. But, if your present income is higher than what you expect in retirement, it would be wise to go for a traditional retirement account, as your withdrawals will be taxed while your money will continue to grow tax-deferred.

  3. Dispel the misconception that social security benefits are not taxed
  4. It is often assumed that social security benefits are not taxed. If your total yearly income is too low to be taxed, then your social security benefits will not be taxed as they are your only source of income. However, if you have other sources of income, which would likely raise your total gross annual income, then your social security benefits are likely to be taxed. The taxes on social security benefits are assessed based on your combined income.

    The breakdown of your combined income is as follows:
    50% of Social Security benefits + Adjusted Gross Income (AGI) + Tax-exempt interest income

    Adjusted Gross Income or AGI refers to your total income that includes salary, dividends, withdrawals from a retirement account, etc., for the current financial year minus the tax deductions.

    Your social security benefits are taxed as shown below:

    Combined income Individual return
    $0 to $24,999 0%
    $25,000 to $34,000 Up to 50% of SS may be taxable
    More than $34,000 Up to 85% of Social Security benefits may be taxable

    Combined income Married return: Joint
    $0 to $31,999 0%
    $32,000 to $44,000 Up to 50% of Social Security benefits may be taxable
    More than $44,000 Up to 85% of Social Security benefits may be taxable

    Combined income Married return: Separate
    $0 and beyond Up to 85% of Social Security benefits may be taxable

  5. Be aware of the tax dues on your estate
  6. Estate planning does not simply mean divvying up your income and assets among your heirs. It also involves planning the division in a manner that helps avoid high taxes for the inheritors. If you are not prompt with the management of tax liability on your estate, it is likely that the money you’d saved up for your heirs may never reach them. Instead, it would most likely end up being used in paying off inheritance and estate tax.

    As of 2021, the threshold limit for federal estate taxes has been raised to $11.7 million up from $11.58 million in the previous year. For married couples, the limit clocks in at $23.4 million - twice as much compared to individuals. However, if your estate value is higher than this limit, you’ll have to pay federal estate taxes on your assets such as real estate, cash, retirement accounts, investments, etc.

    Let’s take a look at estate taxes liable to be paid in 2021:

    Estate Value Amount Estate Tax
    $1 – $10,000 18%
    $10,001 – $20,000 20%
    $20,001 – $40,000 22%
    $40,001 – $60,000 24%
    $60,001 – $80,000 26%
    $80,001 – $100,000 28%
    $100,001 – $150,000 30%
    $150,001 – $250,000 32%
    $250,001 – $500,000 34%
    $500,001 – $750,000 37%
    $750,001 – $1 million 39%
    $1 million and above 40%


    Just to reiterate, you’re only liable to pay estate taxes if the amount exceeds the threshold of $11.7 million for individuals and $23.4 million for married couples.

    It is paramount that you take into account the effect of these taxes on the overall value of your estate. Consult with your financial advisor and explore your options such as charity, giving gifts, etc to lower your taxes. You may also consider moving to a state with no inheritance tax. While it may sound like a big step to take, it can be a feasible option in the case of large estates.

  7. Know how short-term and long-term capital gains taxes are calculated
  8. Tax rates vary when it comes to short-term and long-term capital gains, which end up affecting your net income from investments. To put it simply, the returns that you earn on investments held for more than a year are termed as long-term capital gains while the returns earned on investments held for less than a year are known as short-term capital gains. Any profit earned on an asset is deemed as your capital gain whereas any loss incurred on an asset is termed as a capital loss.

    On the other hand, if you sold your asset within a year of its purchase, you’d be liable to pay a short-term capital gains tax on your earnings. These earnings would be added to your ordinary income and you’ll have to pay income tax according to the tax slab you’re placed in.

    The short-term capital gains taxes in the United States for the year 2021 will be charged as follows:

    Rate of tax charged Single taxpayers filing individually and married taxpayers filing separately The head of the household Married taxpayers filing jointly
    10% $9950 or less $14,200 or less $19,900 or less
    12% Over $9,950 Over $14,200 Over $19,900
    22% Over $40,525 Over $54,200 Over $81,050
    24% Over $86,375 Over $86,350 Over $172,750
    32% Over $164,925 Over $164,900 Over $329,850
    35% Over $209,425 Over $209,425 Over $418,850
    37% Over $523,600 Over $523,600 Over $628,300

    The long-term capital gains taxes in the United States for the year 2021 will be charged as follows:

    Rate of tax charged Single taxpayers filing individually The head of the household Married taxpayers filing separately Married taxpayers filing jointly
    0% Up to $40,000 Up to $54,100 Up to $40,400 Up to $80,800
    15% $40,000 to $45,850 $54,100 to $473,750 $40,400 to $250,800 $250,800 to $501,600
    20% Over $45,850 Over $473,750 Over $250,800 Over $501,600

    It would be more prudent and tax-efficient to hold on to your assets for another year or more to lower your tax outflows. This would assist in boosting your investment returns and improve your savings for the future.

To conclude

Taxes have a long-term impact on your investment returns and affect them to a great degree. This makes it vital to factor them in when you are planning your finances. Merely looking at your returns will not yield the desired outcomes as it can prove to be misleading in the long run. Therefore, tax planning and financial planning should ideally go hand in hand to ensure you hold the reins when it comes to managing your finances.

If you need further clarification on how taxes can affect your long-term financial planning goals, use our free tool to get matched with 1-3 vetted financial advisors that can guide you and help manage your finances.

Get matched with the best Financial Advisors to guide you towards your financial goals in your area.