On the surface, taxes seem to be one of those things in life that we just can not control and have learned to accept. As Ben Franklin famously coined, “nothing in this world can be said to be certain, except death and taxes”.
In reality, optimizing your tax situation is one of the more controllable things in your financial life. We have a set of rules (tax law) that we need to follow and it is our responsibility to operate within those rules and pay our fair share of the pot (and nothing more).
We can’t control the stock market.
We can’t control an untimely pay reduction.
We can’t control the transmission in our car failing.
But we can control our tax burden
Step 1: Reduce Income Taxes
Everyone remembers the day they got their first paycheck. The sense of joy and accomplishment was quickly replaced with panic and confusion. “Where is all my money?”. “This must be a joke!”.
Welcome to the world of income taxes. Far removed from that first paycheck, you may still be wondering what you can do to limit your tax burden. Let’s get into it.
Pre-Tax Investments & Tax Deferral: The first thing you can do is contribute to pre-tax investment vehicles. These consist of things like 401ks, 403bs, IRAs, and Health Savings Accounts. So how does this save you money on income taxes?
- You contribute to these accounts before any taxes are taken out.
- The pre-tax money grows tax free (in most cases, until you reach retirement and need the money).
- You will be taxed on the withdrawals you take later in life.
This process is known as tax deferral. Here’s an example of how you could be reducing your current income taxes.
Let’s say your marginal federal income tax bracket is 32%. This means that for every extra dollar you earn, the federal government will take 32% of it in the form of income taxes (ouch!). Instead of paying that tax, you decide to contribute $10,000 this year to your company’s 401k plan. You just saved yourself $3,200 in federal income taxes this year (nice!). Not to mention the savings on state and local income taxes.
Understand State & Local Taxes: Given that every state and municipality is different, this can get a little tricky. Here are a few things to consider:
- Find out what your state income tax rates are. These can vary tremendously. For example, Pennsylvania has a flat state income tax rate of 3.07% in 2020 while New Jersey has a scale starting at 1.4% and getting as high as 10.75%! If you are someone who has the flexibility to live in any state you want, you may want to use this information to help you make a financially responsible decision.
- Find out what your local income tax rates are. Again, these can vary A LOT. As another example, the city of Philadelphia has a local income tax rate of 3.87% in 2020. You’ll notice the local tax in Philadelphia exceeds the state income tax rate of 3.07%.
- Factor these taxes into your decision to contribute to pre-tax investments. The $10,000 example above will also apply to a reduction in taxes on the state and local level.
Step 2: Reduce Taxes From Investments
Let’s assume you have maxed out all of your retirement account contributions and have chosen to start investing in a taxable brokerage account. What can you do to reduce your annual tax burden as it relates to this account?
Understand Capital Gains Tax: There are a separate set of tax laws to abide by when it comes to taxable investment accounts. Here is an example of how this works:
- You purchase an investment in a taxable brokerage account for $100.
- You sell that investment for $150 and make a profit of $50.
- If you sold that investment within 1 year of buying it, you owe ordinary income taxes on the $50 profit (not good). This is known as a short term capital gain.
- If you sold that investment after holding it for over a year, you will owe long term capital gains tax on the $50 profit (typically 15% but can be as low as 0% or up to 20%).
Tip: If you are going to invest in a taxable brokerage account, try to hold investments for at least a year.
Understand Dividends and Interest: Many companies you invest in will pay you a dividend while most bonds you own will pay you interest (also known as a coupon rate). From a tax standpoint, you’ll want to understand how these payments will impact you.
- Qualified Dividends: Taxed at long term capital gains rates. These are dividends paid by US companies and qualifying foreign companies.
- Ordinary Dividends: Taxed at ordinary income rates.
- Bond Interest: Taxed at ordinary income rates.
Tip: If you are a young investor with a long investment time horizon and high tolerance for risk, look for investments that pay qualified dividends in your taxable brokerage account. You probably do not have a large allocation to bonds so the bond interest should not be a huge factor.
Use Tax Loss Harvesting: This is the process of selling a security that has experienced a loss. You can then use that loss to offset other investment gains. Here is an example of how this works.
- You purchase an investment in a taxable brokerage account for $100.
- You sell that investment 2 years later for $75 and take a long term loss of $25.
- You then replace the investment you sold with a similar investment for $75 and use the $25 loss to offset other gains that year.
When this process is completed, you end up with a similar investment profile and a $25 loss that you can use to reduce your tax burden.
Tip: This is very difficult to implement on your own. You must be wary of wash sale rules that are intended to prevent investors that take this strategy too far. You will likely want to hire a professional to implement this in an efficient and legal way.
Step 3: Diversify Your Tax Profile
So which investment buckets should you be investing in? Pre-tax retirement accounts? Roth accounts? Taxable brokerage accounts? Cash? Unless you know a ton about your tax profile 20, 30, or 40 years from now, diversifying your investments buckets is a great strategy. “Diversifying” your buckets in this scenario simply means investing in multiple types of accounts.
Here is an example of a dual income household in their 30’s making $300,000 per year with $60,000 available to save on an annual basis:
- Roth 401k (Spouse 1): $19,500
- Traditional 401k (Spouse 2): $19,500
- Savings Account for Down Payment (Joint): $11,000
- Taxable Brokerage Account (Joint): $5,000
- Emergency Savings Account (Joint): $5,000
Total Annual Savings: $60,000
In this scenario, each spouse is maxing out their 401k contributions ($19,500 per person in 2020). Spouse 1 contributes to a Roth 401k while spouse 2 contributes to a Traditional 401k. They have a goal of buying a house in 6 months, so they contribute to a joint savings account in order to save for a down payment. Given their goal to buy a home, they wanted to increase their emergency savings account balance (for unexpected expenses) and contribute $5,000. Finally, they take their last $5,000 and contribute to a taxable brokerage account.
Advantages to this Strategy:
- Tax Efficient Contributions: 65% of all annual contributions are in tax advantaged retirement accounts.
- Retirement Flexibility: In retirement, this couple will have multiple sources of income to pull from. For example, if they were in an extremely high tax bracket one year, they could generate income from the Roth 401k tax free. If in the next year their income tax bracket dropped, they could withdraw from the Traditional 401k (and pay less in taxes than they would have the year before).
- Current Flexibility: At any moment, this couple could shuffle this strategy around to match their current situation. Similar to example 2, their tax situation could change right now and they could adjust accordingly.
- Savings Buffer: While retirement account contributions are great, it is still critical to have money saved for a rainy day. The emergency fund and even the taxable brokerage account can soften the blow of unexpected expenses.
As we can now see, there are multiple ways to reduce your tax burden and optimize your tax situation. Use these steps to stop paying more than your fair share of taxes:
- Reduce Income Taxes: Utilize pre-tax investments and gain an understanding of state/local taxes to reduce your current tax burden.
- Reduce Taxes From Investments: Avoid short term capital gains, optimize your dividends/interest, and look for opportunities to “harvest” losses.
- Diversify Your Tax Profile: Give yourself flexibility now and in the future by investing in multiple types of investments with varying tax implications.