Dear Z, E, and T,
So you want to pay less in taxes? There’s sales tax, property tax, real estate tax, payroll tax, income tax, and others. Most people want to know how to pay less in income tax. I would assume you’re no different. There are specific answers to this, but since the tax laws change so frequently they’ll likely be different when you’re ready for advice. Therefore, I’ll give you some timeless advice here and specific advice in a later letter.
So, here are 5 ways to pay less in income tax:
1) Make less money. So this is of course partially a joke, but it’s true. If you make less money, you’ll pay less in income tax. For 2018 the standard deduction for a single is $12,000 and for a married couple it’s $24,000… So if you make that amount or less you can pay ZERO in income tax. With the earned income tax credit, you could actually pay zero income tax AND still get money back if you qualify. I doubt this will be your favorite strategy, so moving on…
2) Live in the right state. Typically people think about their federal return, but state tax rates can be drastically different. Live in Alaska, Florida, Nevada, South Dakota, Texas, Washington, Wyoming, New Hampshire or Tennessee and pay no income tax on your wages. California however has a top tax bracket of 13.3%. You need to also factor in sales tax and property tax if you want to be really savvy. Again, you likely won’t choose where you live based on income tax rates, so what’s next?
3) Utilize tax advantaged savings. There are several ways to do this… Start with your retirement account and put money into a 401(k) or IRA. Even if you opt for the Roth option you’ll pay tax now but you’ll save later. Set up an HSA for medical expenses. Even if you don’t spend it all on medical it can be used in retirement. Saving for your kids’ college in a 529 plan can save taxes. Hang onto investments for at least 1 full year… long term capital gains tax rates are less than short term. You could potentially even pay zero on long term capital gains depending on your tax bracket. These may not be timeless since they could change… but I expect the general advantages of these to be available for a while even if the specifics change a little.
4) Have a few kids. Please don’t have kids to save on taxes. Have them because you want kids of course. Plus, this one will cost you more than it saves, but it will save you some taxes thanks to the child tax credit (assuming you don’t make so much that it phases out. If that’s the case, stop complaining about taxes because you’re probably doing alright).
5) Use a CPA to prepare your taxes. First of all, it’s their job to know the tax law. You’ll save time because you won’t have to do the research yourself. You’ll sleep better at night knowing a professional prepared your return. They also will know more about potential deductions and tax saving strategies. I’ll write to you later to give you tips on picking a good tax preparer, because they are not all good.
There are some other tax saving strategies out there that you’ll hear about, but to be honest, they aren’t as great as everyone will tell you. Buy a home with a mortgage, don’t pay off student loans, give to charity, and more…. Here’s my advice: Do these ONLY if there is another reason to do so and NOT for the sole purpose of paying less income tax.
Look, if you are needing more cash flow there is NO WAY AT ALL to increase your cash flow by saving in income taxes. If you’re in the 20% tax bracket a deduction of $5,000 will save you $1,000 in income taxes… BUT you had to spend $5,000. So as far as cash flow goes you are minus $4,000. Tax credits are generally a little better, but you’ll still never decrease your taxes by more than you shell out.
It’s nice to take advantage of tax saving strategies. I wouldn’t recommend saving on taxes as the reason for doing anything, but certainly take advantage of the ones available to you and don’t miss any you qualify for due to lack of awareness. If you’re looking for a way to improve your financial situation I recommend going back and reading my letter 8 principles to avoid financial anxiety.
They say the two things no one can avoid are death and taxes. You can minimize your taxes sometimes, but it’s rarely a good reason on it’s own to make a decision. Hope this has been a little helpful. As usual, I tried to keep it simple and practical.