Everyone is always looking for a get rich quick scheme, and in all honesty, it’s hard to even get rich slowly. Though I’ve found that there are a lot of ways you can better your financial situation without earning an extra penny or sticking to some ridiculous budget. The average household pays WAY too much in taxes, often times they are paying a lot more than necessary. You don’t need an expensive accountant or tax planner, most of the information you need is quick and easy to learn. Lowering your tax bill may not increase your cash flow but it will drastically increase your net worth, which is the most important financial indicator you should pay attention to.
I’ve gotten more serious about lowering my tax bill over the past several years, and when I think about all the potential gain in wealth I could’ve obtained had I planned better it sickens me. There are many years when I overpaid my taxes by several thousand dollars that could be included in my net worth right now. The worst year I can think of was 2013, when my blogging income really started picking up and I grossly underestimated my year end tax bill. To be fair I had a lot going on that year, I bought and sold a house, got a raise at my job, etc. If only I had learned what an SEP IRA was that year I not only would’ve saved the $3,000 in taxes that I paid but I probably would’ve gotten a small refund from the gov’t to boot. It wouldn’t hurt to have an extra $3,000 sitting in an investment account during the last two years of the bull market! Talk about opportunity loss.
The Power of a 401k
Retirement accounts are the single most important weapon when fighting the tax man! It doesn’t take a rocket scientist to defer taxes, invest, and let the money grow! First and foremost, most people have a 401k available to them, and most have an employer who provides some sort of matching funds as well. You are probably used to hearing about how you should at least contribute the amount to receive your full employer match, but that advice has been hurting more people than it helps. In reality, you should be maxing out the full allowed amount of $18,000 (2015 tax year) each and every year! I know, I know, some people will say they simply can’t afford to sock away more in their 401k account. I usually disagree with this train of thought. If you are investing somewhere else like an after-tax brokerage account (which I highly recommend) then you should be maximizing your 401k first. Also, people who continuously get raises each year typically don’t raise their retirement contributions. If you could swing 5% of a lower salary, then why can’t you contribute 6% of your new and higher salary now? Plain and simple, my advice is to get as close to maxing out your 401k as possible. You don’t need after-tax money sitting in a bank earning a 0.25% interest. I’d rather cut my tax bill, maybe get a refund, and invest in the market earning 5+% on average.
IRA’s Are Next!
There are so many damn IRA’s out there it isn’t even funny. I actually don’t qualify for a traditional IRA, at least I don’t get any tax benefit from them. However, if you max out your 401k then the next step is maxing out a traditional IRA! You can put as much as $5,500 in one of these accounts and they come with the same tax deferred benefit of a 401k. Because these are deductions from your taxable income you can actually combine a 401k and traditional IRA and lower your taxable income by $23,500 as a single filer. Even more than that if you have a spouse and you both follow this strategy. If you are in the 25% tax bracket that could equate to over $5,000 less you pay in taxes each year, and on top of that you invest the money and watch it grow exponentially for years to come.
A Roth IRA is another great tool. The caveat here is that it doesn’t lower your immediate tax bill. Rather, all of the withdrawals after 59 1/2 years old become tax free. Still a great retirement tool, but since it does nothing to better your tax bill I won’t delve into it much here.
Now my favorite of ALL IRA’s is the SEP IRA. Why you ask? Simple, because I am technically a small business owner who happens to have a day job as well. It is the ONE type of IRA that you can easily invest money in with little to no paperwork, despite having an employer sponsored 401k plan as well. I am able to contribute/invest roughly 20% of net profit each and every year. This has been a lifesaver in avoiding unnecessary taxes the last few years.
403b’s Are Great
Fortunately my wife is a teacher, which means she is sort of a government employee. This opens up a whole other type of retirement account to us called a 403b. They work just like 401k’s but they are for public sector employees. That means people like you and I who work for “The Man” are not privy to such an account. Her maximum allowed contribution is $18,000 a year as well, not too shabby at all. When all is said and done, my wife and I were able to lower our taxable income by just over $50,000 last year. That means we lowered our tax bill by over $12,000, which is no small amount. I am always looking for new ways to keep our taxes down and our investments up, so if you are aware of anything I didn’t list then let me know.
Healthcare Accounts Are Yet Another Vehicle
There are two very basic and very powerful types of healthcare accounts that can lower your tax bill. First, you have the FSA. An FSA account (flexible spending account) has an allowed maximum contribution of $2,550 a year. This is before-tax money that you can spend on medical bills and such. That includes things like deductibles and co-pays! Just about everyone in the world has one or the other, and most are probably spending after-tax money to pay both. This is low hanging fruit because almost every employer in the world offers this sort of account. The only downfall you have with these accounts is that they have a use-it-or-lose-it clause. Meaning, whatever you don’t use for reimbursement by years end goes to Uncle Sam. Chances are, if you have a 4-person family, you are probably spending at least $2,500 in medical expenses each year in one form or another. For a single person this may be different, but I doubt you have ZERO out-of-pocket medical expenses. Basically you just need to make sure you contribute SOME amount to this account, as it lowers your tax bill and comes in handy more often than not.
HSA’s (health saving account) are the other type of healthcare account. These typically come with what’s known as “high deductible” health plans. Meaning, you have to pay a shit ton more money out of your pocket each year before your insurance actually kicks in and starts paying for things. These types of accounts are generally good for people who routinely hit their “maximum” out-of-pocket expenses each year. That is the threshold for when you pay so much money that you no longer have to contribute a dime that year to additional medical expenses. I should know about this because I have hit that ceiling twice myself now. HSA’s are pretty cool because they are healthcare accounts designed to act like a 401k. You can contribute each year, invest the money, and watch it grow into old age just like any other retirement account. I used to have one myself, and the only reason I don’t now is because I have much lower maximum out-of-pocket plans than the average person. I am very fortunate for this, but not everyone is as lucky.
Some Other Benefits
It’s not only about the money you invest, it’s also about the money your employer invests on your behalf. Employers often contribute a percentage of your salary into a 401k or 401k Roth plan on your behalf. Sometimes it may take a couple years to vest, so pay attention to the small print in your employment contract. The last few employers I worked for even contributed money towards an HSA for you as well. That can add up to some serious cash and often times is the make-or-break factor on whether or not to invest in one.
I have told you time and again that you need to invest your cash rather than letting it sit in a stodgy bank account that gets blown up by inflation every year. However, tax-deferred accounts are the first place I would invest before you start looking at after-tax type of accounts. Many brokerages, including my own, offer IRA’s as well, so I would still recommend opening one up and investing there if possible. If you have read my previous articles then you know I am huge on dividend paying stocks. The best part about retirement accounts is that you can reinvest your dividends and defer taxes on all of those gains as well. I do invest in many dividend stocks after-tax, but rest assured, I have maxed out every single retirement account available to me at the moment.
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