The Big Role Taxes Play in Achieving Financial Independence

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The Big Role Taxes Play in Achieving Financial Independence


There are many uncertainties on the road to financial independence. You can’t know what rate of return your investments will earn over the coming decades. And you certainly don’t know exactly how long you’ll live.

That old cliché is true: the only certainties in life are death and taxes.

So, we control what we can. And we try not to worry about the things we can’t control. From experience, this is easier said than done.

Tax is one variable over which we have a modicum of control. No, we cannot control how the government changes the tax code. But we can plan our lives and investments in ways that will affect how much tax we owe – both now, and in the future.

Strategic tax planning isn’t just for the wealthy. Unfortunately, it’s true that billionaires seem to benefit most from it. But, in fact, there are some simple things nearly everyone can do that may end up saving you tens of thousands of dollars in taxes – or more – over your lifetime.

Here, I’m going to show you what they are. I’ll begin with tax moves that will be available to most people. Some of the strategies that come later will only be relevant once you’ve taken advantage of the basics or earn a certain amount of income.

Take advantage of retirement accounts

The Big Role Taxes Play In Achieving Financial Independence - Take advantage of retirement accounts

Are you tired of hearing about the importance of saving for retirement using a 401(k) or IRA? Well, there’s a reason that guys like me go on and on about them. These accounts represent a huge gift from Uncle Sam to taxpayers including you and me.

In a traditional IRA or 401(k), contributions are tax-free. Then, your earnings grow tax-deferred until retirement.

Every year, investments generate dividends, interest, and – if you sell investments at a profit – capital gains. In a traditional taxable investment account, you pay taxes on that investment income every year.

With a traditional 401(k) or IRA, you can invest pre-tax dollars now and you don’t pay taxes on any of that investment income until you begin withdrawing money in retirement. With a Roth IRA, you must invest after-tax dollars now, but all of the investment income you earn over the years is tax-free. With either type of account, the money you save by not paying taxes on investment income each year can continue compound growth. The earlier you start putting money in these accounts, the more you’ll save.

A modest example – consider the following situation

A 29-year old in the 25% tax bracket contributes $5,000 every year to an IRA for 30 years and retires at age 65. She earns an average of 6% annual interest. At retirement, her IRA is worth $631,341 before taxes. If the money had been invested in a taxable account, it would be worth only $337,655. That’s a significant difference! But, since this is a traditional IRA, she still has to pay taxes on withdrawals.

After paying taxes on the IRA, she’s left with $473,505. That’s still a savings of $135,850 over investing in a taxable account!

Everybody needs to put as much money as they can afford to into these kinds of retirement accounts. Not only is it smart planning for your future; it’ll save you a bundle on your taxes.

If you need help managing your 401(k) or IRA, I’d highly recommend checking out blooom. They can manage your account for you, taking into consideration your retirement goals, and rebalance your portfolio as needed.

Get an HSA or FSA

Flexible spending arrangements (FSAs) and health savings accounts (HSAs) are accounts that allow you to use tax-free dollars for medical expenses. The largest difference between them is that FSAs are owned by employers while HSAs are controlled by individuals.

HSAs are the better option, in my opinion. But to qualify for an HSA, you need to be enrolled in a qualifying high-deductible health plan.

What are health savings accounts (HSAs)?

You can contribute up to $3,450 pre-tax dollars per year ($6,900 per household) to an HSA. These funds can be withdrawn at any time to pay for qualifying medical expenses tax-free. There’s no need to “use or lose” HSA dollars, as unused funds roll over every year.

Like traditional IRAs and 401(k)s, early withdrawals that aren’t used for medical expenses are subject to a 20% penalty and income taxes. After you turn 65, however, you can withdraw HSA funds for any purpose (not just medical expenses) penalty-free. (You will owe income taxes on withdrawals not used for medical expenses).

HSAs are great for saving on medical expenses now. But they’re even better if you invest dollars in HSAs and let them grow to pay for medical expenses later in life. If you invest the funds in your HSA, the money will grow tax-free (just like an IRA.)

But when you withdraw money later in life to pay for medical expenses, you pay no taxes at all on both the dollars you contributed and your earnings. No IRA is truly tax-free. With a traditional IRA, you pay taxes on withdrawals but not deposits. With a Roth IRA, you pay taxes on deposits but not withdrawals. When used for medical expenses, you don’t have to pay any taxes on the money you put into or take out of an HSA.

Whare are flexible spending arrangements (FSAs)?

Flexible spending arrangements are another type of account that provides tax-free dollars for medical expenses. FSAs are set up by your employer and go away when you change jobs unless you contribute your health insurance through COBRA.

FSAs have lower contribution maximums ($2,650 for individuals and $5,300 for households).

The trickiest part of FSAs is that they are “use it or lose it” accounts. You can roll over up to $500 every year, but all other funds in an FSA expire at the end of the year (with a two-and-a-half-month grace period). This can lead employees to scramble at year-end to line up routine doctor appointments and even stock up on prescriptions or qualifying OTC pharmacy purchases!

Since you can’t usually have access to both an HSA and an FSA at the same time, take advantage of either if you can. If you find yourself in the unusual position of having the option between the two, choose the HSA.

Avoid tax penalties and interest

The Big Role Taxes Play In Achieving Financial Independence - Avoid tax penalties and interest

It should go without saying, but I’ve seen enough to know that it needs to be said: pay your taxes! Equally as important, do not ignore or procrastinate on any tax problems that arise.

The IRS charges penalties and interest any time you don’t pay enough tax by the relevant deadline. This can occur for lots of reasons, but most commonly it happens when:

  • You don’t have enough taxes withheld from your paycheck (W4 error).
  • You earn money through a business or self-employment and do not make or underpay quarterly estimated payments.
  • You file a tax return extension and fail to pay any estimated amount due. (An extension to file is not an extension to pay).
  • You simply pay late!

The longer you go with a balance due to the IRS, the more interest accrues. And a tax debt is the worst kind of debt to have. The IRS has the power to garnish your wages, seize future tax refunds, attach your assets, and even reduce Social Security benefits when you retire.

You probably know that donations to qualified charities are tax-deductible. 

But you can only claim the tax benefits of charitable donations if it makes sense for you to itemize your deductions. With the standard deduction standing at $12,000 for individuals and $24,000 for couples, a minority of taxpayers itemize.

Does this mean charitable donations can’t help you if you don’t itemize? No! Keep reading…

If you do itemize deductions, cash charitable donations reduce your taxable income dollar-for-dollar up to 60% of your income. Go ahead and make them every year.

You can also donate appreciated stock to charity can be a win-win. The charity gets their donation and you get a tax deduction equal to the stock’s fair market value (not its cost basis). You can deduct up to 30% of your income this way.

If you don’t regularly exceed the itemized deduction amounts, you can still make charitable donations work for you by either grouping your deductions in certain years or, better yet, making occasional large gifts to a donor-advised fund.

Donor-advised funds

A donor-advised fund is an investment account to which contributions are tax-deductible in the year you make them. You can contribute cash, appreciated assets, or investments held more than a year. Then, you can make donations from the fund whenever you want. Donor-advised funds are a great way to give because you can give your money a chance to grow and yourself years to choose the best way (and time) to allocate your charitable funds.

To give you an example of how this might work, let’s say you give $1,000 to charity a year, on average. Your total tax deductions, not including your donations, total about $10,000. Even adding the donation will keep you under the $12,000 individual standard deduction.

So, rather than donating $1,000 every year, you set $1,000 aside in a savings account every year for five years. In the fifth year, you put that money into a donor-advised fund and add $5,000 to your itemized deductions. This gets you a $3,000 additional deduction ($15,0000 itemized – $12,000 standard) in your taxes that year.

Be tax-savvy about where you live

The Big Role Taxes Play In Achieving Financial Independence - Be tax-savvy about where you live

If you’re serious about paying fewer taxes, you’ll want to consider living in a low-tax state.

When it comes to state and local taxes, not all states are created equal. Far from it. According to data from the Tax Policy Center, the difference in tax burden between the state with the highest burden (New York) and the state with the lowest burden (Alaska) is 7.12%. If you’re a New Yorker, you might be thinking about what you could do with an extra 7% of your income right now!

A handful of states attract an outsized share of entrepreneurs and other wealthy residents because of their 0% income tax rate. Although I personally can’t imagine moving across the country solely for tax purposes, I do know people who’ve done it. There is an argument to be made that a lifetime of state tax payments invested is an amount of money too significant to ignore.

For example, let’s say you will earn an average of $100,000 a year over 50 years (not that you have to work 50 years…income can include other sources like dividends). Over those years, you pay an average state income tax rate of 5%. If you could skip the tax payments and instead invest that money in the stock market at an average annual return of 7%, you would be sitting on just over $2 million ($2,032,660 to be precise).

And, now, seeing those numbers, I’m about to call my realtor.

Be a tax-efficient investor

When you own stocks and bonds outside of a retirement account like a 401(k) or IRA, you will owe taxes on the interest, dividends, and capital gains earned from those investments.

Although you do not need to not pay capital gains taxes until you sell an investment at a profit, most investments will pay you interest and dividends each year. Whether you spend that money or reinvest it, you will owe taxes on it.

There are two schools of thought when it comes to taxes and investing. Most investors try to minimize the tax consequences of their investments whenever possible. Some, however, argue that taxes should take the backseat to whatever investing strategy will get the best return. I think the answer lies somewhere in between.

Whatever your view, some of these ways to reduce taxes on your investments just make sense.

Take credit investment losses

If you own investments (stocks and bonds or even real estate) and sell them at a loss, you can write-off your losses.  This can be an incentive to exit a losing investment if you suspect it’s never going to recover its value. But this tactic can also be used strategically as a part of routine portfolio re-allocation. When used in this way it is called “tax-loss harvesting”.

You can deduct up to $3,000 per year for stock investment losses, but you can carry-forward losses to future tax years. For example, if you had a $9,000 capital loss, you could deduct $3,000 a year for three years.

You may also be able to deduct up to $25,000 of rental real estate losses if your adjusted gross income is $100,000 or less (or a portion of that amount if your AGI is up to $150,000).

Hold bonds and dividend-paying stocks in retirement accounts

Bonds and dividend stocks will generate taxable investment income every year. Growth stocks that do not pay dividends, however, do not. If you have a taxable investment account and want to own both kinds of investments in your portfolio, put the income-generating investments in your IRA or 401(k) and buy non-dividend stocks with your taxable account.

Use ETFs instead of mutual funds

Exchange-traded funds can be more tax-efficient than traditional mutual funds. Both can generate capital gains and dividends, but ETFs are structured in a way that minimizes tax liability for the investor.

Invest in municipal bonds

If want to pay even fewer taxes on your investment income, consider tax-exempt municipal bonds. Municipal bond earnings are exempt from federal income taxes. The government makes interest on these bonds tax-free to encourage investment in local and state projects.

These bonds (called munis) yield less than corporate bonds before taxes but are competitive, and sometimes better when you compare after-tax returns.

Use a business to reduce your tax bill

The Big Role Taxes Play In Achieving Financial Independence - Use a business to reduce your tax bill

Starting a business takes you to the next level of tax breaks. You don’t even need to create an entity like an LLC. If you earn money outside of a salary (W-2), you can call yourself a sole proprietor.

To deduct business expenses and take advantage of other business tax breaks, you’ll need to do two things:

  • Keep an accounting of your business income and expenses separate from your personal accounting.
  • File a Schedule C with your tax return.

In addition to deducting business expenses and, potentially, the use of part of your home as an office, you can also take advantage of some special retirement savings accounts.

The Solo 401(k) and SEP-IRA both allow much higher contributions than traditional 401(k)s and IRAs. For 2020, you can contribute up to the lesser of $57,000 or 25% of operating profits to a SEP-IRA. Otherwise, the SEP works like a traditional IRA: money in is tax-deductible and your money grows tax-deferred until retirement.

Summary

Nobody wants to pay more taxes than they have to. Everybody should take their taxes seriously and seek professional advice when they need it.

If you’re intent on achieving financial independence as quickly as possible, reducing taxes will likely be a large part of your plan. The methods described above will be invaluable.

As you begin implementing them, just remember not to let your life be dictated by paying as little tax as possible. At a certain point, the law of diminishing terms will apply. There are probably uses of time that will be more profitable in the long run!

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