For many business owners, taxes can be their largest single expense—larger than qualified plan contributions, larger than their mortgage, and sometimes even larger than the kids’ college education. If taxes take the biggest bite out of your nest egg, your tax strategy should be upstream from your investment policy statement.

Taxes Should Be Job #1

Many Americans overpay their tax obligations. Often, this is the result of simple mathematical error. Another major cause is a misunderstanding and a misapplication of the available tax laws. This overpayment is called the reverse tax gap, and it’s a big deal.

The “tax gap” is an accounting term of art that refers to the shortfall of timely collections of estimated taxes due, also known as the “tax liability.” This is not a trivial amount of money; in 2021, the tax gap, per, was $625 billion. The Inflation Reduction Act contained an additional $80 billion in extra funding to the IRS specifically to close, or at least narrow, the gap.

Yes, the IRS wants to reduce the tax gap—the shortfall in taxes collected versus what’s owed—but here’s a surprise: more examinations (what you would call audits) will likely yield more refunds for thousands of Americans.

According to the Tax Foundation, 16,305 of the 452,515 examinations closed in 2020 resulted not in a tax bill plus penalties but in an average refund of approximately $50,000. By comparison, the average amount underpaid was only $12,230. The IRS exerts a significant effort to target suspect returns—they don’t want to waste time going after random returns—so we can reasonably conclude that millions of Americans overpay their taxes.

Some Simple Things You Can Do

The causes of this reverse tax gap—the overpayment of tax—are many. We suspect that the biggest culprit is the conflict that exists among the army of competing salespeople from insurance companies, banks, and broker/dealers. All of these people have their own skin in the game, an incentive at odds with the most tax-efficient investment options.

Tax-inefficient investing is widespread in America, as demonstrated by the fact that 68.6 million American households own mutual funds. Mutual funds are arguably the least tax-efficient vehicle in the investing universe. As a rule, there is nothing a mutual fund can offer that can’t be less expensive or more tax efficient than an ETF, and while over 80% of actively managed mutual funds fail to equal or outperform their index, an indexed ETF will virtually always provide marketlike returns.

Run proposed solutions by a strategic tax professional. A simple “tax expert” may not have the requisite knowledge and experience to look past the tax forms for the best option. By putting tax strategy first, a portfolio can be structured for maximum after-tax compounding.

Get more than advice; get active tax management. Employing ongoing tax-smart practices like withdrawal management and loss harvesting can have a massive impact on your nest egg over time. Vanguard has estimated that a money manager can add 1.8% per year to a portfolio by employing tax-aware discipline.

Insist your various advisors work as a team. Financial pros tend to be very competitive, and will fight it out for control of your strategy. The wealthiest families avoid this problem through the use of a family office, an entity they own and control. So-called normal American families can enjoy this same benefit by working with a multi-family office that puts their best interests first.

Resist the pitch. When you sense you are being “sold,” it’s because you are. Salespeople use urgency to spur action, but we would remind you that a solid financial plan takes decades to reach full fruition. There is no emergency and no product in short supply. Only when your inner voice is calm and confident should you move ahead with a proposed solution. Human beings have evolved to sense danger; use that spider-sense.

Are you overpaying your taxes? Our guess is that your tax preparer gets the forms and the arithmetic correct, but that’s not the full answer. Have you employed the right strategy to minimize the tax bite on the sale of a highly appreciated asset? Was a trusts and estates professional consulted? Do you fully understand the risks you’re exposed to?

For every family, there is an ideal investment allocation. If you’re not sure that yours is ideal for you, we strongly urge you to invite your tax professional for a second opinion. It’s what the billionaire class does, and it’s probably a good idea for you, too.