Optimizing Tax Expenses
After you’ve optimized the big expenses in your life such as housing and food, taxes are another big-ticket item that will stand out in your budget. Although it is not possible to completely eliminate a tax bill from your life, there are ways to reduce the burden of this payment each year. With simple optimizations, you can ensure that your tax bill is as affordable as possible.
Taxes can add up
The average American household spent $10,489 in taxes in 2018. An average of $8,367 was paid to the federal government, while the rest covered state and local income taxes. Whatever you spent on taxes last year, it was likely one of the larger expenses in your budget. If you’ve set up automatic tax payments through your paycheck, then you may not even realize exactly how much you’ve been paying in taxes. However, if you are self-employed then you’ve likely experienced the painful moment of writing a big check to the federal government every spring.
Either way, you likely have room for optimization in your tax expenditures.
How to optimize your tax costs
You won’t be able to completely eliminate taxes from your life but choosing to make intentional choices about your money can lead to a lower tax bill.
1) Max out all pre-tax accounts
If you want to lower your taxes, then you’ll need to lower your taxable income. The most effective way to do this is by maxing out all of your pre-tax accounts.
Depending on your work situation, this might include a 401k, 403b, traditional or Roth IRA, or an HSA. Generally, you’ll have a combination of these accounts based on your unique situation. However, the IRS will limit your pre-tax contributions each year. If possible, max out your 401k, IRA, and HSA.
2) Control your income
If you are earning a variable income, then it can be difficult to control your income. However, when you hit your retirement years, you’ll have more flexibility on the amount of money you bring in.
With careful planning, you can limit your realized income each year to remain in the lowest tax bracket that your budget will allow. Take a closer look at the tax income thresholds each year to determine what income could allow you to enjoy your life without overpaying for taxes.
3) Consider tax-loss harvesting
If you have a taxable investment account, then you may have the option to take advantage of tax-loss harvesting. In general terms, you would less security that has experienced a loss in order to offset the gains of another security in your portfolio.
Although it sounds somewhat complicated, it is fairly simple to execute.
4) Choose tax-advantaged investments
If you are building an investment portfolio or additional income streams, then you may want to consider tax-efficient options. One of those tax-advantaged income streams is real estate. With the help of depreciation, you can offset the costs of taxes.
How I’ve optimized my taxes
Because I house hack and have passive real estate income, this allows me to funnel a large portion of the income I get from nonprofit jobs into maxing out a 401(k) plan. In addition, some years we are able to contribute to traditional IRAs which further reduce our tax liability. By choosing to max out my pre-tax retirement account contributions, I’ve been able to reduce my total tax bill. Depreciation in my real estate portfolio has been able to further optimize my tax obligations. In addition, I am working on a cost segmentation for one of the properties that will give me a lot of accelerated deprecation which will allow me to offset other income. Then lastly, I work with a really good CPA that helps me maximize every deduction that I can legally take.
By being proactive in minimizing my tax liability, I was able to have my effective tax rate in 2018 be a low 7% on a six-figure income. But this is nothing compared to what blogger Root of Good was able to accomplish. He only paid $150 in income tax on $150,000 in income.
The bottom line
If optimizing your taxes sounds difficult, then start with the other Big 5 expenses. After you’ve dramatically reduced your annual expenditures in the most expensive areas of your life, tackling your tax bill might not seem so difficult. However, it is never a bad idea to consult a tax professional to ensure that you’ve optimized your taxes as much as possible. Check out our other article in the FI series on how to optimize healthcare expenses: https://fibyrei.com/optimizing-healthcare-expenses/