An effective and repeatable strategy to save on taxes
You are comfortable contributing your fair share of taxes - though, do not feel the need to necessarily overpay. Part of the reason for this is that if you keep more of your money then you can either spend it on things you enjoy now or save it for the future - in both cases, your wealth increases. Although this is fairly straightforward, there is a lack of clarity on exactly how to save on taxes and who can take advantage.
Different ways to save on taxes
First, let’s take a look at a few methods of how you can actually reduce the amount of taxes you pay over your lifetime. It is important to note the savings does not necessarily need to occur right now - contrastingly, you can set yourself up to reduce taxes later.
Tax deduction - a reduction of your current year income, which can put you into a lower tax bracket (rate). Either way, you do not pay as much tax since there is less income as part of the calculation.
Tax deferral - while funds stay in an account, you do not pay any taxes. This is a big benefit since compounding interest is accelerated. In other words, there is a higher ongoing balance in the account for you to earn interest on.
Tax free withdrawals - no taxes when you take money out of an account, including the growth. For example - if you invest 100k and earn 10% per year for 5 years, at the end you have about 160k. You do not have to pay any tax on the 60k of growth.
Misconceptions around who can reduce their taxes
Now that you have an understanding of different ways to decrease tax paid, you may be thinking this is not for me and only applies to the following…
You need to have a lot of money
Saving on taxes does not mean you need to become Robert Kiyosaki (Rich Dad, Poor Dad). If you are unfamiliar, Robert has built a fairly impressive portfolio of income producing assets (mostly real estate) and hired a team of experts (attorneys, accountants) to help structure business entities in such a way that he can take specialized tax deductions. Although this may be effective if you have millions of dollars, it is not practical for everyone. The approach implies that you first need to be rich in order to save on taxes, which is not true.
You must own a business
You may be under the impression the only way to save on taxes is by taking business deductions on your tax return. For example, you probably have heard of section 179 - acquiring a vehicle over 5,000 lbs, which then allows you to reduce your income by the entire purchase amount (if you meet certain qualifications). Sounds appealing, right? Yes - though, this is not something you can repeat each year. In reality, how many G Wagons do you need?
How can everyone save on taxes?
In lieu of the rather exclusive categories above, there is a more repeatable approach to saving on taxes that is accessible to everyone. Surprisingly, it is tied to your savings (pun intended). Expanding on this, you can use tax advantaged accounts that are specific for each of your goals instead of a High Yield Savings for everything. This way, you pay less in taxes on the growth of your savings and are therefore left with a higher net amount at the end. The other benefit to this approach is that you know exactly what each of your accounts are for and can easily monitor progress towards the target for each goal - allowing you the ability to adjust contributions over time and stay on track.
Examples of goals and related accounts to use
Saving for college
529 plan - while rules differ from state to state, most plans allow you a state income tax deduction upfront and tax free withdrawals later if the funds are used for education expenses.
Setting money aside for retirement
401k (pre tax) - tax deduction when you contribute and tax deferral until you pull monies out later.
Roth IRA - opposite of above. Instead of a tax deduction upfront, you get tax free withdrawals later. Tax deferral is also apparent as it is in the (pre tax) 401k.
Covering medical expenses
HSA/FSA - tax deduction when you contribute, tax deferral while the funds stay in the account plus tax free withdrawals when you pull monies out.
Please note - balances in an FSA must be used before the end of the year or they are potentially lost.
Buying a home
Brokerage - a lower tax rate on growth (long term capital gains) if positions are held in the account for more than a year.
Conclusion - how to pay less tax and keep more of your money
Everyone can save on taxes - you do not need to already have a lot of money or be a business owner. You do this by using your ongoing savings and establishing different types of tax advantaged accounts for each of your goals. The first step is to define your goals and ensure they bring your core values/beliefs to life. Next, you create a savings plan that considers your income, expenses and various goals (creating balance between them and/or potentially prioritizing one over others). Lastly, a Financial Planner can be a great partner in the process, guiding you along the way so that you don’t miss anything and stay aligned with what’s most important to you.