Everyone wants to keep more of their hard money. But the problem is that most think the only way to do this is by reducing taxes this year. When in reality, the focus should be on decreasing your lifetime effective tax rate.
Your goal should be to have your lifetime effective tax rate low as possible while making as much money as possible.
Here’s what you need to know it and 8 strategies to reduce it:
Understanding your Lifetime Effective Tax Rate (LETR) can help you make smarter financial decisions.
So…what is Lifetime Effective Tax Rate (LETR)?
Your LETR is the total tax you pay over your life divided by your total lifetime income. It gives you a full-picture view of your tax burden.
Why does it matter?
Knowing your LETR helps you understand the true cost of taxes on your wealth-building journey. It can guide your financial planning and tax strategies.
Like I said above, there is way too much focus on lowering this year’s taxes. When the focus should be focusing on lifetime taxes.
An example:
If you earn $5 million over your lifetime and pay $1.5 million in taxes, then Your LETR is 30%.
This means 30% of your income goes to taxes. That is a lot.
So how do you lower it?
There are a ton of ways to go through:
Contributing to tax-advantaged accounts like 401(k)s, IRAs, and Roth IRAs can be a great way to do this. These accounts offer tax deferral reducing your taxable income) or tax-free growth (reducing future taxes).
Choosing between Roth and traditional is huge decision and it can really impact your lifetime taxes.
Deferring at the highest rates so you can withdraw at lower rates is a great way to do this. And so is paying tax at lower rates so you never pay tax again.
This goes hand in hand with #1.
In early retirement, before RMDS and social security, many have a great opportunity to fill up low brackets and convert from pre to post tax.
If you can defer at 37% then convert through 24% at an average rate of 20%, you are significantly reducing your lifetime tax rate.
But plan for those taxes as you have to pay for them in cash or incur a 10% penalty.
Using tax-efficient investments like ETFs, municipal bonds, etc. can lower your lifetime tax bill. And make sure to tax-loss harvest to offset gains with losses. Direct indexing can be a great way to do this.
You also want to focus on proper asset location. This is placing the right investments in the right type of accounts for tax purposes.
Think: - bonds in pre-tax - high growth assets in Roth - tax efficient in taxable
Health Savings Accounts (HSAs) and 529 college savings plans offer great tax advantages. Contributions are often tax-deductible and withdrawals for qualified expenses are tax-free. And the biggest benefit…no capital gains.
Many of my high income clients pay 28%-35% on capital gains. If you put $150k in and that grows to $300k, you would owe a ton in capital gains tax. Losing that much to capital gains tax can hurt.
These accounts help you with that.
Donating to charity can provide significant tax deductions, but many do not do it in the most efficient way.
Consider donating appreciated assets through a donor advised fund to avoid capital gains taxes and get a deduction for the full value.
Another great option is to lump charitable giving into 1 year vs spread over 2. This can help you get above the standard deduction and benefit more.
Using strategies like gifting, trusts, and charitable donations can reduce estate taxes.
Proper estate planning ensures more of your wealth goes to your heirs. No one wants to pay the 40% estate tax if they don’t have to.
Real estate comes with a ton of tax benefits. Whether its from: - depreciation - cost seg studies - offsetting active income when tests are hit - 1031 exchanges - tax deferred growth - capital gains exclusion on your primary residence
Real estate can help lower your taxes over your lifetime.
Being a business owner leads to a ton of tax advantages. This could be via: - QSBS - QBID - Self employment taxes - cash balance plans - retirement accounts - etc.
You have way more tax planning here than as a w2 employee. Take advantage of it.
Remember: Every dollar saved in taxes is a dollar that can be invested, spent, or saved for your future.
Start planning today to optimize your lifetime tax bill. Think long term.
Financial Advisor