4 Strategies to Lower Your Tax Bill
“I am proud to be paying taxes in the United States. The only thing is I could be just as proud for half of the money.” – Arthur Godrey
To significantly lower our tax bill now and in the future, we need to plan ahead.
When I was studying for the certified financial planner certification, I was amazed at the volumes of strategies we are allowed to take to reduce our tax bill. Most of them involved setting up trusts, but unfortunately, they only make sense for those who have several million dollars tucked away.
We middle-class folks need to take advantage of what’s available to us, so we too can be good American citizens and pay taxes, but just not that much. Consider these four strategies:
Max out your 401(k) if possible If you are in the 32% tax bracket and you contribute the maximum for 2018 ($18,500) towards a pre-tax 401(k), your federal taxes can be lowered by almost $6,000. For small business owners, lower your tax bill by saving through either a SEP IRA, SIMPLE IRA, or an individual 401(k). If you are a consultant who makes $100,000 a year, you might be able to save up to $18,500 in a SEP IRA, $15,200 in a SIMPLE IRA, and $36,500 in an individual 401(k); and reduce your income tax bill in the process. For small business owners who generate a significantly high income, you can create your own pension plan. We have clients who are dentists, and they are setting aside $70,000 to $100,000 a year towards a pension plan – lowering their tax bill by up to $40,000 a year! They couldn’t believe it when they first heard about it, but it’s true.
Consider switching future contributions to a Roth 401(k) If you are in the 24% marginal tax bracket under the new & lower tax brackets, and you can absorb a slight reduction in your take home pay, consider switching all your future contributions from pre-tax to a Roth 401(k), if it’s an available option. This way, you will be able to pay taxes while your tax bracket is low, and thus avoid paying higher taxes when tax rates go back up. It’s possible that tax rates in the future will further escalate, since someone has to pay for the $1.5 trillion tax cut that the Trump administration recently passed. It is important to consult a certified financial planner to know if this is advantageous for you.
Maximize Roth IRA contributions If eligible, this will lower your tax bills in the future. Tax savings are immense. For example, if you invest $5,500 each year in a Roth for the next 30 years and make an annual average return of 6% per year, you will have made about $270,000 – all tax-free! Roth IRAs also give us flexibility. We can withdraw our contributions without penalty in case we decide to use it elsewhere (like house down payment, help pay for your child’s tuition). If you are no longer eligible for a Roth, you can still do it through backdoor Roth contributions. Thank Congress for leaving this loophole open. This can be a key strategy in retirement planning.
Contribute to a Health Savings Account (HSA) Health Savings Accounts or HSAs are perhaps the most underutilized tax-advantaged way to grow our money. It’s even better than a Roth IRA. While earnings are tax-free in both, HSAs are also tax-deductible. You get the most out of a Health Savings Account if you don’t touch your contribution, and just let it grow by investing in stock and bond funds. Your HSA earnings are tax-free if you use it for qualified medical expenses in the future. An HSA may be suitable if you are:
In a position to have a high-deductible health insurance plan (no kids, healthy, have adequate cash savings);
Looking for the most tax-efficient way to grow your money. Not all high-deductible plans are HSA-eligible. It has to have HSA in its name.
You will have to balance contributing to these tax-advantaged accounts with your other life goals. Talk to a credentialed financial advisor who can provide holistic financial planning advice.