Most people I know do not like paying taxes. Some do not like paying their fair share while most people are fine paying their fair share of taxes. To those who are not interested in paying their fair share… be careful because that can lead to tax evasion. Tax avoidance is cool. Tax evasion is 10-20 years.
The tax complained about the most are income taxes. Income taxes are the taxes calculated annually by reconciling your income and expenses on your tax return. Because it is a reconciliation of your income, it is significantly more transparent on how much tax you are paying.
In reality, there are also sales taxes, property taxes, and employment taxes, which all matter as well. However with sales tax you’re distracted by the product you bought, property taxes with the location you live in, and employee taxes because it’s hidden (unless you’re self-employed). The distraction or non-transparency of those taxes does not seem to bother anybody.
I will not go into detail on how to reduce any of those taxes, but a few ideas would be to:
- Understand what you are buying and I am confident that you will spend less on sales tax.
- Move somewhere with lower property taxes.
- Start a business to control your employment taxes. Although if you avoid too much of this it can lead to wealth avoidance.
To get back to our mission there are really two options to pay less income tax:
- Well thought out tax strategy
- Tax timing
Designing a well thought out tax strategy
If you are going to pay less tax, you simply have to earn less money.
Have you heard that before? While this is factually true, it is definitely not a beneficial tax strategy. A good tax strategy should lead to increased wealth. Earning less money is the opposite of that.
A few important notes about the tax law:
- The internal revenue code is approximately 5,000 pages long. The first portion of the book has approximately 50 pages is dedicated to gross income and tax rates. The definition of gross income is that any money you receive is taxable. The remaining pages are dedicated to reducing your tax. Yes… nearly the whole book is dedicated to reducing your tax!
- The tax law is primarily a series of incentives. If they want you to go to college, they give you a credit. If they want you to donate to charity then you get a deduction. This is all to stimulate the economy. These are carrot and stick motivators for you to take certain actions.
- Congress writes the tax law and wants to incentive you to take certain actions. The IRS is the enforcement team, which is why you are scared of them. Congress
Knowing the tax code is designed for you to pay less tax, you should begin to understand what incentives are in play and take action on those incentives to pay less tax.
Congress has identified three areas as important incentives to growing the economy:
- Real estate
Why? Because businesses create jobs. Investments stimulate businesses. Real estate creates jobs and provide places to live. That is important stuff!
Specific incentives come and go, but those are the three main areas to remember.
To build wealth you should have at least two of the three. To have an effective tax strategy the same applies.
Understand that to pay less tax you need to understand the tax law and follow the incentives. As an employee, you have minimal tax incentives available to you. True tax reduction comes from embracing one of the three pillars of wealth.
In taxes, timing is everything…
Outside, or in addition to, your tax strategy is taking advantage of tax timing. Year in and year out you can save real money by taking advantage of timing opportunities. In years of tax reform, the opportunities can be even larger.
Here is the basic premise of what tax timing is:
- Accelerating a deduction now at a higher tax rate versus taking it later at a lower tax rate.
- Deferring income now at a higher tax rate versus receiving it later to a higher tax rate.
The opposite works for both situations as well.
There are simple strategies available such as bunching up your itemized deductions every other year. This is typically good planning when you will not reach the itemized deduction threshold when paying real estate taxes or making donations at the same time every year. Bunching expenses allows you to take the higher deduction and receive a tax benefit.
Advanced strategies mix in one of the three pillars of wealth. At certain times during your life, there will be larger tax timing decisions available. Here are a few examples:
- Sell a business: Receiving the proceeds in one lump sum potentially leaves you with a very high tax rate. You could spread out your proceeds using an installment sale and taking advantage of lower tax rates.
- Roth Conversions: In lower earnings years, you could convert your pre-tax money to a Roth IRA. Not only are you winning the tax rate game, you are also reducing your RMDs.
- Manage Passive Losses: Owning Real Estate, you may be subject to passive activity losses. In the year of sale, the PALs are released and able to offset all other income. Matching these losses with other gains can be a big win! On the flip side, managing your adjusted gross income to take advantage of current year losses or matching losses with passive income generators.
Tax timing opportunities are endless. However, without a well-established tax strategy and relationship with a qualified tax advisor these tax savings opportunities may pass with the time.
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.