How To Minimize Your Tax Burden In 3 Steps
Taxes are not going away but a portion of your tax bill may well be
Benjamin Frankin wrote in 1789 the timeless phase: “…in this world nothing can be said to be certain, except death and taxes.” Some 200 years later, this is still a very prescient quote. Devoid dropping off the grid and living off the land, taxes are a reality for everyone regardless of nationality and even income. Even the lowest earners of society are subject to priced-in import taxes, VAT’s, sales taxes, and property taxes passed through via rent. For many, this taxation doesn’t happen happily. All of us have heard, or voiced ourselves, complaints about paying taxes. For many though, the thought stops there. It is rare to find someone out of the finance field deeply versed in the tax code and tax minimization strategies. Despite that knowledge having the power to mitigate thousands of dollars of tax liabilities, many know little about it. I’d like to change that in this crash course to the basics of tax minimization. I’ll talk about a few of the most common and widely applicable strategies to get you started doing your taxes smarter and taking advantage of the incentives the tax code harbors.
1. Contribute to tax-advantaged accounts
Contributing to tax advantaged accounts is one of the easiest ways to reduce your tax liability. Specifically, I’m talking about your 401k/403b, IRA, and HSA. After maxing out those, there is also the post-tax 401k and SEP-IRA if you own your own business. Leveraging these accounts, you can potentially reduce your taxable income by tens of thousands of dollars and also invest without having to pay capital gain taxes on the proceeds. I talk more about the power of investing in these tax-advantaged accounts and why everyone max-out their contributions to these accounts before investing anywhere else in one of my past articles:
2. Get smart about itemized deductions
When you file your taxes, you have the option to either itemize or take the standard deduction. I’m not going to explain the difference between the two here but if you are not familiar with the differences, I recommend reading about them here. Now many just hand their current financial situation over to their accountant and let them decide what is best given your situation. This is a fundamentally wrong way to approach taxes as it is reactive, not proactive. It is important to understand taxes and, specifically, deductions so you can take advantage of them during the year. By planning ahead of time — understanding which deductions could apply to your situation and taking action on them — you can drastically reduce your tax burden at the end of the year. I am by no means the first person to preach this idea; this is a major teaching of the book “Rich Dad, Poor Dad” and is often advocated by financial advisors.
Now not all deductions will apply to all people but the most popular deductions are: state and local taxes, charitable contributions and mortgage interest. Making certain decisions in life can allow you to better take advantage of these itemized deductions and pass the standard deduction. For example, buying a house rather than renting, given the same all-in monthly payment, is advantageous. Because a portion of the payment you make — both property taxes and interest — is tax-deductible, you will actually end up paying less for purchased home than rented one. On top of that, you also have an appreciating asset that you’re building equity in. One other way to take advantage of the tax code is using a cash-out refinance rather than other debt instruments. This is a particularly useful tool given the recent drop in interest rates already making refinancing look more appealing. With a cash out re-finance, you can refinance your home with a lower, tax-deductible interest rate and use the cashed out equity to pay off any existing loans such as car or credit card loans. In effect you are consolidating your loans into your home where you can achieve a lower, and fully tax-deductible interest rate.
3. Start a business on the side
Advanced tax minimization strategies almost always come with business ownership. The primary idea is: many of the things you already do could be at least partially written off as business expenses if you also use them for business purposes. Regardless of whether or not you own a business, you will still have cell phone bills, a computer, car payments, insurance payments, a home office, and utilities bills. If you own a business, odds are that these expenses will largely be held constant but you can write off a portion of these expenses as business expenses. In other words, these costs are generally deducted from the business’ revenue and left untaxed. This can add up to thousands of dollars in lesser tax burden with proper records and planning.
This strategy doesn’t, or at least shouldn’t, bring your expenses to zero. The IRS will, quite justifiably, scrutinize your return if you write off your full car payment or phone payment. It quite obvious that weekly call with your mom is not a business call. However, if done honestly and in moderation, you can leverage a business or side hustle to reduce your taxable income.
