BUSI 489 Week 2 Targeted Financial Plan 2 Example

Targeted Financial Plan 2: Income Tax Planning for the Whitaker Household

Estimated Tax Position

The plan estimates the Whitakers' federal taxable income as follows, using planning assumptions to be confirmed against current-year law.

At this income, a married couple filing jointly falls in the 22 percent federal bracket, and Virginia's top state rate of 5.75 percent applies to most of their income, for a combined marginal rate of about 27.75 percent on each additional dollar. The child tax credit for their two children reduces the tax owed but does not change the marginal rate. Their average federal income tax rate is far lower than 22 percent, because much of their income is taxed at lower brackets or sheltered by the deduction, which is why a deduction is worth the marginal rate, not the average.

Strategies Considered

Analysis

The largest saving comes from raising Daniel's retirement deferral. Each additional dollar deferred avoids about 27.75 cents of current tax, so increasing his deferral by $4,720 a year saves about $1,310 and reduces take-home pay by only about $284 a month. Because the first section made credit card payoff and the emergency fund the top priorities, the plan phases the increase in after the cards are paid, raising the deferral by one percentage point every six months. Thaler and Benartzi (2004) found that a program committing workers in advance to raise their contribution rates with future pay increases led to large, lasting increases in saving, because the increases happened automatically. Madrian and Shea (2001) showed how strongly defaults and inertia shape retirement saving, which argues for setting the escalation up once rather than relying on yearly decisions.

Grace's IRA contribution follows the same logic. Because she has no workplace plan and the couple's income is below the limits that phase out the deduction for a spouse of a covered worker, a traditional IRA contribution is deductible under the assumptions here. A Roth IRA is a reasonable alternative if the Whitakers expect higher tax rates in retirement, and the retirement section will revisit the choice.

The 529 deduction costs nothing: Virginia allows a deduction for contributions up to a set amount per account each year, and the Whitakers' $2,400 a year is well within it. Their last return did not claim it.

The withholding change does not save tax, but a $2,100 refund means the family lent the government $175 a month without interest while carrying 23 percent credit card debt. Adjusting withholding turns an annual refund into monthly cash that can pay down expensive debt now.

Asset Location

The Whitakers hold a bond fund in their taxable brokerage account, where its interest is taxed every year at their full marginal rate, while Daniel's 401(k) holds mostly stock funds. Dammon et al. (2004) analyzed how investors should divide assets between taxable and tax-deferred accounts and showed that, as a general rule, interest-paying bonds are better sheltered inside the tax-deferred account while stock funds sit in the taxable one, since stock gains are taxed only when sold and usually at lower rates. Reversing the Whitakers' arrangement, without changing their overall mix, would reduce annual taxes with no added risk.

Strategies Reviewed and Set Aside

Three other strategies were considered. Itemizing deductions does not help yet: the Whitakers' mortgage interest, state taxes up to the federal cap and $4,800 of annual giving fall short of the standard deduction under current assumptions. Bunching two or three years of giving into one year through a donor-advised fund could push them over the line in that year, but it would strain cash flow while debt remains, so the plan revisits the idea once the emergency fund is complete. A health savings account would offer a deduction, tax-free growth and tax-free withdrawals for medical costs, but only if the family switched to a high-deductible health plan; with two active children and modest savings, the higher deductible is a risk the plan does not recommend now. Finally, harvesting tax losses in the brokerage account, selling a fund at a loss and buying a similar one, can offset gains and up to a limited amount of ordinary income in years when markets fall, and the planner should review the account each December.

Implementation Schedule

• This month: file a new W-4 to reduce withholding; claim the 529 deduction on this year's return.
• This quarter: within the 401(k), shift the bond allocation into the plan and hold broad stock funds in the taxable account.
• Month 11, after cards are paid: start Grace's IRA contributions and the first 401(k) increase.
• Every six months after: raise Daniel's deferral by one point until it reaches 10 percent.

A Christian Perspective

Paul told the Roman believers to pay what they owed, taxes to whom taxes were due and respect to whom respect was due (English Standard Version Bible, 2001/2016, Romans 13:7). Tax planning in this spirit uses the incentives the law offers openly, for retirement, education and saving, and never conceals income or claims what is not owed. Grable et al. (2012) and Lytton et al. (2012) place tax planning within the whole plan for the same reason: its purpose is to serve the family's goals, not to minimize taxes at any cost.

References

Dammon, R. M., Spatt, C. S., & Zhang, H. H. (2004). Optimal asset location and allocation with taxable and tax-deferred investing. The Journal of Finance, 59(3), 999-1037. https://doi.org/10.1111/j.1540-6261.2004.00655.x

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Grable, J. E., Klock, D. D., & Lytton, R. H. (2012). The case approach to financial planning: Bridging the gap between theory and practice (2nd ed.). The National Underwriter Company.

Lytton, R. H., Grable, J. E., & Klock, D. D. (2012). The process of financial planning: Developing a financial plan (2nd ed.). The National Underwriter Company.

Madrian, B. C., & Shea, D. F. (2001). The power of suggestion: Inertia in 401(k) participation and savings behavior. The Quarterly Journal of Economics, 116(4), 1149-1187. https://doi.org/10.1162/003355301753265543

Thaler, R. H., & Benartzi, S. (2004). Save More Tomorrow: Using behavioral economics to increase employee saving. Journal of Political Economy, 112(S1), S164-S187. https://doi.org/10.1086/380085