More Money, More (Tax) Problems?
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If you’re one of the many people who feel with more money, come more tax problems but don’t know what to do about it, here are some tax strategies that you should consider, and one you should avoid.
Tax Strategies That Actually Work… and One to Avoid
Conflicting priorities are a fact of life. Sometimes you know your priority is to slim down, yet you just can’t resist another slice of chocolate cake. You’ll have to make a choice about which of your two priorities, enjoying a delectable or taking care of your health, wins out. If your tax strategy isn’t working, it’s probably because you have some conflicting priorities. The hard truth is: if your goal is to make more money, that’s also likely to conflict with paying less in taxes. The only way to truly win the tax game is to align your strategy with your priorities.
Most people would jump at the opportunity to pay less in taxes, considering 50% of people believe the amount of federal income taxes they are paying is too high. However, the ‘strategy’ part starts with figuring out how to reduce your tax liability. The thought of taxes and how complex they are is overwhelming for most people, so they opt to maintain the status quo. In fact, 47% of people are bothered a lot by the complexity of the tax system.
But why should you accept the complexity of taxes as a necessary evil? When instead, you can actively create a strategy that will actually work for you.
If you’re one of the many people who feel with more money, come more tax problems but don’t know what to do about it, here are some tax strategies that you should consider (and one you should avoid):
Tax Strategies and Priorities Attached
For starters, tax strategies are not synonymous with tax avoidance. Although it might sound appealing to keep 100% of your money rather than paying a portion of it to the government, taxes are the dues we pay to live in civilization.
A tax drag is the reduction of income due to taxes, so ideal tax strategies aim to reduce the tax drag as much as possible to ensure your money has more power to grow.
For most people, retirement is typically the number one priority when it comes to financial goals. The idea of having a ton of money to spend without having to worry about a job, a schedule, or a boss is appealing. However, in order to get this nest egg, you have to save.
There is no tax strategy that can help you get around the saving discipline, but there is a strategy to ensure you’re saving efficiently by using tax-advantaged accounts.
If you are currently employed, the first place you should be saving is in your 401k or 403b. This allows you to save money on a pre-tax basis, hence, allowing that money to grow tax-free. If you’re self-employed, you can set up a SEP IRA, SIMPLE IRA, or a solo 401k in order to be able to take advantage of the same tax benefits. In both scenarios, these advantages contribute to combating the tax drag.
Healthcare expenses are also a strong financial priority for most. Health is a universal concern that affects every single person, so it’s only natural for this to be prioritized in your finances.
So how can you take advantage of taxes within your healthcare? The most advantageous strategy is to use a Health Savings Account (HSA). HSAs have three strong advantages:
- Savings with pre-tax dollars
- Growing tax deferral
- Tax-free qualified distributions
It’s rare to get triple benefits on anything, so leveraging an HSA should be top of the list for your tax strategies.
One way to reduce your tax liability is to reduce your income. Making less money means paying fewer taxes, but how is this actually beneficial? Reducing your income doesn’t mean you need to stop working now in order to avoid taxes, there are ways to defer income until a later date to postpone the taxes due.
Your employer may offer a deferred compensation plan that allows you to defer, say 10% of your salary or bonus until a later date. The benefit of this is that you don’t actually receive this income, so you don’t have to pay taxes yet. Some companies will even have a match (like on a 401k).
This may seem easy, safe, and beneficial, but there’s a catch. First, if your company goes under, your money is at risk. Second, when you defer it you have to pick when you want to receive it. So if you pick to get the money in 5 years, and a year after you change your mind, most likely you won’t be able to do anything about it.
A tax credit is a value you are able to subtract from the taxes you owe, rather than reducing your taxable income. It’s very simple: Let’s say you owe $800 in taxes and you have an $800 tax credit, this means your tax liability drops to zero. But what if you have a tax credit for $1000? Depending on the type of credit, it could be refundable! If it is, then your tax liability still drops to zero, and additionally, you may receive a $200 refund.
There are many types of tax credits you could qualify for, especially if you have children, are going to college, or buy an electric vehicle. Once you figure out your eligibility, you can apply them to your strategy to make the most of your reduction.
Reduce Taxes on Capital Gains
A capital gain is a profit you make from selling an asset for more money than what you paid for. However, investments work similar to regular income, you have to pay a cut of your earnings as taxes.
It’s important to point out that you don’t owe taxes for any investment, until the moment you sell it. So if you buy stock for a company that has increased 20% in value, if you’re still holding the stock, you owe nothing. If you sell it and make money from it, you will need to pay a tax from those gains, also referred to as the capital gains tax (CGT).
Two ways to take advantage of these capital gains are
- Long-term capital gains: if you hold your investments for more than 365 days, they may be eligible to be long-term capital gains once sold, meaning the percentage you pay in taxes will be lower.
- Gain and loss offset: If you earn money with one asset but lose with another, this may help balance out your total capital gains leaving a smaller portion for taxes. The strategy is to sell positions intentionally while they are at a loss, rather than holding them to see if they bounce back, and pairing that with selling positions that are at a gain to lock in the growth. By considering both sides of the equation, you can safeguard the tax benefits and don’t create lower investment returns.
Tax Refund: The “Tax Strategy” You Should Avoid
Getting a refund from your tax filing in April is NOT a tax strategy, so if your entire tax goal is dependent on getting a large refund, you’re not making the most of your tax strategy and should probably re-evaluate.
Consistently getting a refund in April might be a symptom of incorrect tax withholding. This should be addressed so you can get more money throughout the year rather than waiting for the IRS to send that direct deposit.
Tax Strategies In Summary
Having a strategy is by no means a way to avoid paying taxes. On the contrary, it is a way to understand exactly how much money you owe and figure out what you can do in order to maximize the reduction in your tax bracket.
Laying out your financial priorities is a key aspect of developing a tax strategy because once you have those in check, you can ensure you are benefiting from the priorities in your tax strategy.
The best way to understand your tax strategy options and eligibility is to speak to an expert. A financial advisor is the best person to tell you how you can maximize the benefits of your tax strategy and align it to your financial priorities.
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