Lowering your tax bill this year is one of the most common goals I hear from millennials. But is it the right goal to be so focused on THIS YEARS taxes?
No! And let me tell you why.
Historically, taxes are as low as they have ever been. If you look back between 1915 and now, the top federal income tax rate has generally been far higher. Take a look at the chart below.
Note: It was 92% in the 1950s, 70% in the 1960s and 1970s. And now it’s 37%.
If we take a look at the economy and all the debt we have as a country, it’s hard to imagine a future where tax rates go down. It’s possible, but in my mind it is not probable.
Knowing taxes are about as low as they have ever been and that taxes are probably going to go up, why would you want to defer taxes this year to pay them later on in the future?
You wouldn’t in most cases.
Even if you assume taxes stay the same but you know you are early on in your career and are likely to make more in the future, then it may make sense to pay tax today so you don’t have to pay those taxes later on at a higher tax rate.
So how exactly do you pay tax now instead of deferring to the future?
You all have probably heard of 401(k)’s by now and what 401(k)’s do is they reduce your taxable income today (same with an IRA) but then in the future you will pay tax when you pull the money out. Let’s say you make $100,000 and put $10,000 into your 401(k), your taxable income is now $90,000. So you save in taxes by reducing your taxable income by that $10,000.
$10,000 x .24 = $2,400 in tax savings. That is a pretty good amount to save.
However, if you defer that money to later on when you are in the 32% tax bracket, you will just pay tax at a higher percentage than you would today.
32% > 24%. You would much rather pick the lower percentage.
So what’s your other option so you can hopefully pay tax at the lower rate?
It is to use ROTH accounts. There are both ROTH 401(k)’s and ROTH IRA’s. With ROTH accounts, if you make $100,000 and put $10,000 into your ROTH 401(K), your taxable income remains $100,000. There is no reduction. You are choosing to use those after tax dollars.
But this $10,000 gets invested, grows tax free, and then you can pull out the money tax free in the future. You are essentially choosing to pay tax today at the rate you are at, instead of in the future at an unknown rate where you should be making more money.
This strategy especially makes sense for someone who is early on in their career and knows they will make more and move up tax brackets in the future.
Conclusion: As you go about trying to decide between ROTH and traditional, think about your future income and what you think will happen with future tax rates. The name of the game with tax planning is to try and lower the tax bill over your lifetime. Not just taxes this year, but truly taxes over your lifetime. It’s a long term game.
Other Tax Planning Tools
Now besides ROTH and traditional, you have other tax planning tools that can help lower your tax bill.
Let’s go through some of the most common tax deductions and credits. (If you want to learn more about tax deductions and credits, check out this article.)
Common Tax Deductions
1. HSA – this is a health savings account. You can put up $3,600 as a single or $7,200 as a family. This will give you a deduction for this year. Check out how this account can be used in the mix of accounts for your family here.
Using the example above: You make $100k and put in $3,600 in your HSA.
You save $3,600 x .24 = $864 on taxes this year if you are in the 24% tax bracket. The HSA is one of the most powerful accounts as it reduces taxes this year, grows tax deferred, then can be used tax free in the future on health care costs.
Other popular ones include:
2. Property Taxes
3. Mortgage Interest
4. State Taxes Paid
5. Real Estate Expenses
6. Charitable Contributions
7. Medical Expenses
Now let’s go over common tax credits:
If you don’t remember, tax credits give you a dollar for dollar reduction of your tax liability. If you owe $20,000 in taxes but have a $10,000 tax credit, then you now only owe $10,000 in taxes.
What are some common tax credits?
1. Child Tax Credit
2. Credit for other dependents
3. Child and Dependent Care Credit
4. Earned Income Tax Credit
5. The Retirement Contribution Savings Credit
6. American Opportunity Tax Credit
7. Lifetime Learning Credit
Other great tax planning opportunities:
Roth Conversions which essentially move pre-tax money over to ROTH money by paying tax today. You may want to do this if you are in a low income year (loss of job, started a business, retired but aren’t drawing out assets yet). You get to pay tax on these dollars at a low bracket so in the future you don’t have to at a higher bracket. This is what tax planning is all about, taking advantage of the opportunities you have so you can pay the least amount of tax over your lifetime.
Not just this year!
Be forward thinking.
If you want help with your tax planning strategies, here is a link to book your first free meeting with us.
Disclaimer: talk with your CPA or financial planner before implementing any of these strategies. None of this should be seen as advice, it is just for informational purposes