In 1789 Ben Franklin wrote in a letter that “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”
Now, over 200 years later, we’re not sure so about the inevitability of death and taxes can be reduced or illuminated with the right planning. We’ll leave the topic of life extension for another day. For now, let’s focus on reducing taxes.
Taxes are necessary to keep the government running and providing important services like schools, roads and defense. However, I agree with Arthur Godfrey when he said,
“I’m proud to pay taxes in the United States; the only thing is, I could be just as proud for half the money.”
I don’t think it’s wrong to want to less in taxes. Like most people, I wish the government used our tax revenues more efficiently, but there’s nothing I can do about that timeless complaint. What I can do it be productive and reduce the taxes I pay so I can make the best use of the money I’ve earned.
An oft-quoted U.S. district judge seems to agree with me. Judge Learned Hand (his real name) wrote in a tax case titled Helvering v. Gregory (1934),
Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes and public duty to pay more than the law demands.
If you disagree and feel it’s your patriotic duty to pay more in taxes, then head over to this IRS website to make your contribution to reduce the national debt.
reduce your taxes Legally
Tax-deferred 401(k) and Traditional Roth
There are several types of 401(k) plans, depending on the size of your employer and what they elect to offer. These include the SIMPLE 401(k) for businesses smaller than 100 employees, the Safe Harbor 401(k) that allows employees to own 100% of the money an employer contributes, the Traditional 401(k) and Roth 401(k).
Any money you contribute to a traditional 401(k) reduces your taxable income, saving you taxes today. The contribution limit for 2019 is $19,000. You don’t pay taxes on that money as it grows. You will however, pay tax on the money as you take it out in retirement, which you can do after age 59.5 and are required to start doing at age 70.5. There are ways around that eventual tax though.
A Roth 401(k) or Roth IRA work differently, where the money is taxed as you put it in and you withdraw it with no taxes. It grows tax-free, but you get no reduction in taxable income when you contribute. 1
Traditional IRA or Roth IRA? The eternal debate.
You need a bit of a crystal ball to answer this question. It depends on what your income will be when you retire. If you think your income will be lower after retirement (or early retirement), then a Traditional is a better option than a Roth. For more on this, check out the great article by Mad Fientist.
Health Savings Accounts (HSA)
While not a retirement account, it can be used as one to great benefit. The HSA account is designed for people with high deductible health insurance accounts, which thanks to Obamacare, is just about everyone. The average deductible is about $4,000 to $7,000 depending on the plan.2
We can contribute money to an HSA plan pre-tax and can withdraw money from the account tax-free, if it’s used for medical expenses. The HSA provides the best benefits of a Traditional IRA an Roth IRA! It can be completely tax-free. The money goes in before tax, grows tax-free and can be taken out tax-free. There’s no reason you shouldn’t max out this account every year!
If you own your own business you know all about the tax deductions available to business owners, such as being able to write off your home office, related business expenses like equipment, cell phones and driving miles. If you work for a company, you may want to even look into starting your own business just for the tax breaks.
Tax loss harvesting
Sometimes we lose money in the market. Tax loss harvesting is way to use those losses to your advantage to reduce your taxable income by selling stocks that have gone down in value. Here’s how it works:
Let’s suppose you invested $10,000 into a mutual fund in 2017 and in 2018 it was worth $5,000. You could sell that fund at a loss and claim the $5,000 loss. You can use up to $3,000 of that loss per year to reduce your taxable income or you can offset capital gains. Whatever you don’t use in that year you can roll over into following years.
Keep that $10,000 in cash or invested in another fund for at least 31 days to avoid a Wash Sale, which is selling the stock and then buying it back, just to recognize the loss. The IRS requires you wait 30 days to avoid that because they don’t want to encourage people to sell and quickly rebuy just to get the tax benefits.
For more on Tax loss harvesting, see this article on Bogleheads.
Tax gain harvesting
This strategy locks in gains without paying taxes and makes tax-loss harvesting more effective because your harvesting more losses. If you sell with a gain, this increases your cost basis and those funds are now tax-free forever more.
Although to be effective, you need to be in the 0% tax bracket for qualified dividends and capital gains, which is possible if your AGI is below $100,000 or you’re retired and living on a low retirement income. It’s important to hold stocks for at least a year so you’re in the lower long-term capital gain tax rate and not the higher short-term capital gain rate.
Since your paying taxes in this scenario, you don’t have to worry about avoiding a Wash Sale.
There are tons of tax benefits to real estate investing. If you love real estate, then it’s worth looking into. I don’t like the hassle of real estate, so I don’t get into it.
Mega Backdoor Roth
This is a strategy that requires its own article. In short, it’s a way to contribute $36,000 per year into your Roth IRA, rather than the $6,000 limit. If you’re interested in this or any of the other strategies above, comment below or email me and I’ll post my research.
Do you use any of these strategies? What do you do to reduce your taxes? Please share in the comments below what has worked for you.