Protect your income from Uncle Sam to maximize your cash flow
If you drive a car, I’ll tax the street,
If you try to sit, I’ll tax your seat.
If you get too cold, I’ll tax the heat,
If you take a walk, I’ll tax your feet.—The Beatles
Taxes are one of the greatest frictions people encounter in pursuit of financial peace of mind and material well-being. How can we minimize that friction, maintain control over more of our earnings, and thus live more abundant lives?
Maximize your Retirement Accounts
Perhaps the best place to start is maximizing your contributions to tax-deferred retirement accounts. In 2019, people age 49 and younger can contribute $19,000 to a 401K and $6,000 to an IRA. Those 50 and older can contribute $25,000 and $7,000 respectively. Of course, you will pay taxes on this money once you begin collecting it in retirement, but it’s also likely you’ll be making less money and so may fall into a lower tax bracket. Another option to diversify your tax liability in retirement is to contribute to a Roth IRA, which has the same contribution limits.
“Executives for larger companies may also have access to a deferred compensation plan,” says Jeff Hall, financial planner at Rather & Kittrell Capital Management. Instead of taking one’s full compensation when it is earned, these employees can allow their company to hold on to the money and invest it. This enables them to grow their money tax free and to receive it later on, often in retirement when subject to lower tax brackets.
Cash balance plans are another option—and a particularly attractive one for small business owners. “These plans are kind of like a hybrid between a 401K and a traditional defined benefit plan, such as a pension,” says Hall. As with 401Ks, employees have individual accounts and make pre-tax contributions that compound over time. But, the contribution limits for cash balance plans are far higher than those of 401Ks. For someone nearing retirement, contributions can be well above $200,000 and even closer to $300,000. And like a pension, the employee gets a defined benefit upon retirement, which he continues to receive for the rest of his life. Hall adds, “On top of that, the business gets a pre-tax deduction. If you’re a small business owner—an architect, attorney, accountant, medical professional, etc.—that’s a huge tax deduction for the business, and the owners and employees get great retirement benefits.”
Independent contractors have several great options as well, including self-employed pension plans (SEPPs) and solo 401Ks. “We have some early retirees that do consulting work, and the solo 401K is just a layup for them—it’s just a no-brainer,” says Hall.
Consider Investing in Real Estate
Real estate investments offer a range of great tax benefits and, generally speaking, real estate tends to steadily appreciate in value. Daniel Messing, officer and tax leader at Pugh CPAs, says, “My rule of thumb is that if you’ve got time, real estate is usually a pretty good investment, especially in the Knoxville area.” Mortgage interest on mortgages of up to $750,000 is tax deductible, and at least some portion of property taxes are deductible in most situations.
Business properties offer these benefits—and more. For instance, you can deduct certain expenses for maintenance and upgrades to business properties, whether a sky rise you lease to another business or a beach house you rent on Airbnb. And because such properties wear out with time and use, the IRS allows you to “depreciate” their value. You can claim this loss in value on your tax return, which lowers your taxable income. And, Messing points out, whereas both the purchase and the depreciation reduce the amount you pay at relatively high-income tax rates, any profits you make when you decide to sell the property might be taxed at the lower capital gains rate, depending on the situation.
Which brings us to another benefit of real estate. If a stock you own appreciates in value and you decide to sell it in order to buy another, you’ll pay capital gains taxes on the sale. “But with business real estate,” Messing explains, “you can defer gains by rolling the proceeds of the sale into other properties. If I sell a property, it doesn’t matter how big my gain is, as long as I do what’s called a like-kind exchange.”
Consider Investing in Municipal Bonds
Municipal bonds, offered by cities as a means of funding government and public projects, typically pay investors less in interest than those offered by private companies, but that interest is usually tax exempt. The federal government doesn’t tax interest earned on municipal bonds, and states generally don’t tax interest on bonds issued by municipalities in that state. Paul Fain, president of Asset Planning Corporation, says, “There’s a simple formula for comparing taxable and tax-exempt yields, and usually tax-exempt bonds work out for higher-income tax payers.” Messing adds that, “You’re never going to get huge returns on municipal bonds, but they are usually decent and consistent. So, they enable you to know what your returns are going to be and minimize your taxes.”
Appearances to the contrary, one’s tax burden is not entirely immutable. If you want to minimize financial friction and maintain control over more of your earnings, you have some tools at your disposal. Make the most of them!
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Consider Giving to Charities
Of course, one means of lowering your taxable income is simply to give some of it away to organizations that promote your values. Hall says that “If philanthropy is important to you, then there are plenty of tools out there that enable you to transfer assets.”
One such tool is a donor-advised fund. Fain explains, “The donor-advised fund can sell your appreciated assets tax free and distribute the proceeds at your direction to charities you choose. And you get 100 percent of the value as a tax deduction.”
This can be better for you than just writing a check to the charity. Fain continues, “The benefit from the perspective of wealth managers is this: Say we need to rebalance the portfolio. If we’re going to sell something to rebalance, we’re possibly creating a capital gain. But we can hit two birds with one stone in the realm of wealth enhancement, because we can rebalance the portfolio with minimal tax friction through the charitable giving strategy. It’s an excellent tool for people with charitable intent.”
Pay Attention to Timing
All strategies for reducing your tax burden ultimately hinge on timing, but some require more forethought or are subject to more time-based rules than others. For instance, if you sell an investment security you’ve held for less than a year, the profit is considered a short-term capital gain and is taxed at your normal income tax rate, which—at the federal level alone—can be as high as 37 percent, depending on your tax bracket. Add in the investment income surtax and that rises to 40.8 percent. But if you sell the same security after having owned it for twelve months, the profit is considered a long-term capital gain and is subject to different rates, the highest being 23.8 percent (including the aforementioned surtax), the lowest being 0. Hall says, “If you’re a high-income earner, and you hold an asset for just over 12 months, you could reduce your capital gains tax liability by almost half.”
Another less intuitive strategy is to sell poorly performing securities for a loss. Fain says, “It’s kind of an annual forensic exercise. If you’re frustrated with an investment doing poorly, look at it through a different lens as a possible candidate to be sold to create some losses you can use on your tax return. Even if these are assets that you want and need in your portfolio, there are ways to harvest the losses and restore the portfolio positions in pretty short order.”
One word of caution: Do not buy that same security within 30 days of the sale—not even in another trading account. If you do so, the IRS’s “wash-sale rule” prohibits you from claiming the loss, because tax authorities don’t want you both claiming a loss and immediately reinvesting to take advantage of a stock’s appreciation.
Another time-based strategy entails bunching two years’ worth of tax-deductible expenses into one. Each year, taxpayers must choose whether to accept the IRS’s standard deduction (currently $24,000) or to itemize deductions, and it only makes sense to itemize your deductions if their sum is greater than the standard deduction. As Messing says, “You don’t want to end up with deductible expenses such as charitable contributions and real-estate taxes that total $22,000, because you could have gotten $24,000 worth of deductions without doing anything.” By bunching two years’ worth of tax-deductible expenses into one, you may be able to take advantage of a higher itemized deduction every other year while continuing to use the standard deduction in off years.
Minimizing Friction
Appearances to the contrary, one’s tax burden is not entirely immutable. If you want to minimize financial friction and maintain control over more of your earnings, you have some tools at your disposal. Make the most of them!
