Reviewing tax returns for inefficiencies can yield some significant savings

When you review your income tax returns, there are a few things you'll want to scrutinize. Obviously, you'll want to start by looking at how much you had to pay the IRS or how big your refund was. This helps you get a feel for your current tax situation. You'll also want to compare your current taxes to prior years that you've filed. Notice any changes in taxes owed or refunds received. Are they explainable by changes in the tax code or changes in your income? Or, do these changes show that inefficiencies have crept in to you tax plan?

If your tax payment was painfully large, or substantially larger than in years past, you'll want to dig a little deeper to see if you can make any adjustments to counteract this in future years. For instance, review your current selections and procedures for:

• Tax withholding from your paychecks
• Exemptions election
• Estimated tax payments, if you're self-employed

These are all items that you can modify as your circumstances change. For instance, it's possible that you've lost an exemption because your child moved out of the house or graduated from college, but your tax withholding didn't get updated. This would cause you to inadequately withhold taxes, leading to you owing more in taxes than you would otherwise.

Even if your actual exemptions haven't changed, you can elect to have more money withheld from your paychecks if you receive W2 wages. You would do this in an attempt to reduce the amount you had to pay the IRS with your tax return for the next year. Having to cut too large a check can be harmful for a couple of reasons. If you're not allowing for this expense, you might not have the cash to pay your amount due. In this case, you'll have to get the cash from somewhere, which could mean dipping into savings or investment accounts, or even putting the tax bill on a credit card. If you tap into an investment account to pay your tax bill, you could actually owe taxes on the money you liquidate, which of course just makes matters worse.

On the other side of the coin, a large tax refund may also indicate inefficiencies. You've probably heard it said that when you get a refund from the IRS, you're essentially extending the government an interest-free loan. You might want to consider if this is the best use of your money. If you lowered your withholding, reduced your exemptions or lowered your estimated tax payments, you could keep more of your weekly and monthly cash flow in your pocket. This extra cash could be used for savings or investment. By keeping the money yourself and investing it regularly during the year, you can take advantage of dollar-cost averaging. This tool isn't available if you let the government hold on to your excess tax payments until tax time. Another point here is that there have been reports of staffing and other administrative issues at the IRS, which could delay your tax refund.

The next thing to analyze is the amount of capital gains or other investment-related tax you paid in prior years. Look for amounts on your return related to these items:

• Short-term capital gains
• Long-term capital gains
• Dividend income
• Interest income

These kinds of income are a double-edged sword. It's great that you're earning money on your investments, but they pack a tax punch, actually a double tax punch. In some cases, you pay a direct tax on these gains (generally in the form of capital gains tax), but these amounts also add to your taxable income, which can push you into higher tax brackets. This means that you'll be paying more in taxes on each dollar that you earn during the year.

The tax burden relating to these kinds of investment gains can hamper your ability to save more money for retirement. Of course, the less money you currently have to invest, the less investment growth you can experience over the years before your retirement. The dollars that you send the IRS cannot also be invested in the market.

These kinds of investment-return taxes come from having money in taxable accounts. This is also a bit of a double-edged sword, because you've already paid money on these funds once (in the form of income taxes). Now, you're also paying taxes on the gains you're receiving from these funds. A better strategy is to make maximum use of tax-deferred or tax-free investment accounts, a concept we will explore at the end of this article.

As you consider the tax impact of your investments in taxable accounts, you'll want to do some projecting to your future retirement. In retirement, you'll likely need to provide income for your living expenses and lifestyle ambitions. Social Security will likely not be enough. What kind of investments are going to provide this income?

Is your nest egg invested in traditional investment vehicles like:

• Savings accounts
• Bonds
• Investment accounts

If so, you will probably get a tax bite when you liquidate these (or receive interest and dividend payments from them) in order to provide monthly cash flow for your retirement. While it's a common statement that you'll need less income in retirement, and that you'll therefore be in a lower tax bracket, you can't assume this to be true. Tax rates may change. You may desire to live a luxurious life, actually spending more money in retirement than you currently do.

If you're not thinking about the tax implications of generating retirement cash flow from taxable accounts, you could be setting yourself up for a disappointing retirement. For example, if most of your nest egg is in a 401(k) account, when you take distributions from it in retirement, every penny you receive in income will be taxable. That's because 401(k) plans are tax-deferred; you don't pay taxes on the money you put into the plan, or on the investment gains you make in your plan, until you withdraw money from it.

Another example that we've already looked at is a taxable investment account. Let's assume that you own large holdings of blue chip stocks in this account. You want to fund your retirement for the year by liquidating some of your positions. Since this is a taxable account, you'll end up owing capital gains on the shares that you sell. If you've owned them for many years, the gains could be quite large. This will push up your tax liability in retirement.

This kind of activity can create a negative feedback loop. You receive cash from an ill-positioned account for your retirement. This distribution or liquidation causes a taxable event, pushing up your tax liability. You have to liquidate more money to pay the taxes, which then creates a further tax liability. There are other secondary effects, too. Take Medicare. You're likely to save a lot of money on health insurance with Medicare, even when you consider the cost of a Medicare supplement plan. However, you also have to consider your Part B premium. If you're taking substantial amounts of income to fund your retirement, you may well run afoul of IRMAA – Income Related Monthly Adjustment Amounts. IRMAA adds to your monthly Part B premium payment. At the highest level (for 2022), you could be paying an additional $408 per month. If you're married, you could both end up paying this additional amount, adding a total of $9,792 to your annual expenses.

Of course, it's probably not possible to live a lavish retirement and pay zero taxes. You might be able to live a frugal retirement without worrying about taxes too much. But, if you aspire to something more comfortable, you'll always have some kind of tax liability. The thing to do is work hard, now, to minimize it.

The key to a successful retirement is to make a realistic plan and stick to it. By starting with a tax return review, you can use the results to inform your overall strategy for retirement. By working to reduce current taxation, you can free up money for saving and investing that will grow over time, allowing you to have a bigger nest egg. You can take this to the next level by finding ways to make the tax code work for you.

By working with a trusted financial professional, you might want to craft a strategy that uses a blend of tax-deferred accounts, like qualified retirement plans and after-tax accounts that shield investment gains. For qualified retirement accounts, you can use:

• 401(k) profit-sharing plans
• Traditional IRAs
• Defined-benefit plans (if self-employed or a business owner)

As to after-tax accounts with the ability to shield account earnings, consider:

• Cash-value life insurance
• Annuities
• Roth IRAs

An efficient retirement will likely include both types of retirement savings. Tax-deferred accounts can help lower your current year taxable income, allowing you to save more and shield the earnings from those dollars for years. One potential strategy would be to contribute to your 401(k) up to the point that any employer match is maxed out. Beyond this amount, you might want to put money to work in an after-tax account.

These after tax investments would include Roth IRAs if you qualify for them, and also assets from insurance companies like life insurance and annuities. Life insurance in particular can be a very efficient asset if you also need to protect against the early death of a bread winner. By using a specific type of insurance known as cash-value life insurance, you can accomplish all of these tasks with one product:

• Protect against financial harm resulting from your early death
• Provide liquidity to your estate as part of your estate plan
• Build a tax-shielded accumulation value
• Provide a way to pay for the cost of long-term care if you should need it later in life, without tapping into your nest egg

This kind of insurance coverage can come from two types of policy:

• Whole life insurance
• Indexed universal life insurance (IUL)

With both of these types of life insurance, you're able to build cash value over time. The more time you have until retirement the better, of course. The truly wonderful thing about this cash value is that you have the opportunity to borrow from it or take partial withdrawals tax-free. Amounts borrowed may become taxable upon your death, but this would still allow you to use a portion of your life insurance benefit while you're still alive on a tax-advantaged basis.

When you combine cash value life insurance with fixed annuities, you can also greatly optimize your retirement income potential. Annuities are designed to pay streams of income, generally for life. This makes them perfect vehicles for putting your retirement dollars to work for you. By contributing to annuities and funneling other investment dollars through them, you can structure a large stream of income that's guaranteed to last as long as you live. This kind of consistent income can help make your retirement planning smooth and successful.

Annuity payments also come with tax advantages. Of the amounts you receive as income, only the portion that comes from interest earnings is taxable. There are established formulas for determining the taxable amount of your annuity income. Under current law, these distributions are treated more favorably than other vehicles like 401(k) plans.

Structuring these assets is a technical task that requires professionalism and expertise. You'll want to work with a financial professional who is experienced in these matters. Make sure you are on the same page regarding your goals and current financial status.

Most importantly, you'll want to make sure you're meeting regularly to track your progress. As you conduct your income tax review each year, keep your financial professional informed. If you think changes are in order, make sure you consult with them before changing up your asset mix. A thoughtful financial professional will also help you keep your plans on track if or when tax and retirement laws are changed.