Winning at Taxes

Back when I was in business school, I remember the term ‘fomo’ coming up a lot. It stands for ‘fear of missing out’ and it definitely describes how I felt from time to time. Taking two years out of your career and writing obscenely large tuition checks creates pressure to wring every last drop of value out of the b-school experience. Plus you don’t want to be the one who missed out on that cool activity, party, class, club, whatever, that everyone else is talking about.

I’ve started to think recently that I may have tax fomo as well. No matter what my tax bill, it always feels like it’s just so much I therefore assume I must be overpaying. Then I’ll hear about these billionaires who are supposedly beating the system and it will bother me that they must know something I don’t. So I’ll start to feel like I’m missing out.

I do appreciate the importance of taxes, and I’m not interested in tax strategies that might fall in an ethical grey area, but I also don’t want to overpay just because I wasn’t in on the big secret like everyone else. I want to feel like I’m winning the game too.

The following is a summary of insights and opinions from my search to figure out if I was indeed missing out. (read: you should not consider this tax advice...if you need advice for your personal situation, talk to a pro...this stuff gets complicated quickly!)

From tactical to strategic

I’ve come to think about tax savings as a spectrum of opportunities that range from tactics to strategies. The tactics are things like deductions and credits that I assume most popular tax software would be able to bring to my attention if relevant. The strategies are the things that I’d have to more proactively pursue and would merit guidance from a professional tax advisor. The following is how that spectrum breaks out from my perspective. Since this is a very broad and nuanced topic, I’m sure there are many more examples that I haven’t included. If you have thoughts or other good examples to share, I would love to hear about them in the comments.

Claim Tax Deductions

Deductions reduce the income you’ll be taxed on, assuming of course that you’re itemizing, because you’re over the standard deduction. Below are a few categories that I thought were interesting. You can check out the IRS’s website if you want to see all the possible deductions out there, or if you want to dig into the details on any of these. Some are only going to apply if you’ve successfully created the right conditions to make yourself eligible. That means adopting an approach to managing your taxes that’s a bit more strategic. 

Federal tax deductions for state taxes you’ve paid: State income, real estate, property and sales taxes can all be deductible, though you cannot deduct both general sales taxes and income taxes. You have to choose one or the other.

Deductions for charitable contributions: You can use contributions to eligible charitable organizations to lower your taxable income. From what I’ve read, as other tax loopholes close, charitable contributions become more popular among the ultra-wealthy as a means of minimizing taxes.

Deducting interest: If you own a home, you may be able to deduct the interest you pay on your mortgage. This might be particularly interesting to you if you live in a place like California where housing prices are out of control and mortgage interest can end up being a considerable amount of money. Student loan interest is another item you may be able to take as a deduction. Depending on your income level, you can deduct up to $2,500 in interest you've paid on a student loan.

Work-related deductions: There’s a range of possibility in this category from business expenses, to a home office, to depreciation and amortization. The catch is that you’re not going to be able to take these deductions unless you’ve created the conditions to make yourself eligible. Skip ahead to the section called ‘Create a Source of Future Deductions’ for more on that.

Investment-related deductions: This category includes things like contributing to an IRA and deducting capital losses. It’s another area where you need to think ahead a bit to actually be able eligible. I've mentioned a related topic, tax loss harvesting, in other posts on this blog. 

Claim Tax Credits

Tax credits reduce the actual amount of tax you pay, so they can have a bigger impact on your tax bill than deductions. In one article I read, a CFP summarized this well by saying: "in the 25% tax bracket, each dollar of a deduction is worth a quarter, but each dollar of a credit is worth a dollar." Here are a few credits that piqued my interest. You can check out the IRS’s website for more details. If you have higher income levels, be prepared for a letdown as many will not apply.

Family oriented credits: The Child Care Credit, which is one of the few credits without income limits, offsets some of the cost of childcare while you work. The Child Tax Credit, which does have income limits, amounts to up to $1K for a qualifying child.

Credits for being energy efficient: The Residential Energy Efficient Property Credit provides up to 30% of the cost of certain alternative energy equipment, while the Plug-In Electric Drive Vehicle Credit allows up to $7,500 for purchase of a vehicle that runs on a rechargable battery. Neither has an income limit. 

Education oriented credits: The Lifetime Learner Credit allows up to $2K/year for post-high school courses that lead to job skills. The American Opportunity Credit allows a maximum annual credit of $2,500 per student for college. Both have income limits. 

Saving/working oriented credits: For low and moderate income households, there's the Savers Credit which allows up to $2K for contributing to a retirement plan and the Earned Income Credit which is a benefit for working.  

Use Pre-Tax Money

Sometimes you can set aside pre-tax money to pay for certain items and as a result avoid paying taxes entirely on the money used for those purchases.

Health Savings Account: An HSA is a tax-favored savings account created for the purpose of paying for current and future medical expenses. With it, you can deposit pre-tax dollars through your employer (or deduct your contributions) and use those funds to pay for qualified medical expenses. It’s not a use-it-or-lose-it account, so what you don’t use in a given year can continue to grow and won’t be taxed as long as you use it at some point for qualified medical expenses. If you take a withdrawal for non-medical costs, it will be taxed as income (plus a 20% penalty if you’re not yet 65). As long as your health plan meets the deductible requirement and permits you to open an HSA, you can open one anywhere. That means you can shop around for better investment options and lower management fees. 2016 contributions are capped at $3,350 for individuals or $6,750 for families.

Flexible Spending Account: An FSA is also a tax-advantaged savings account. It allows you to set aside pre-tax dollars through your employer for eligible expenses. These accounts are use-it-or-lose-it, so you have to carefully consider what you set aside each year because you’ll generally forfeit any unused balance. There are a few different types of FSAs. Two common ones are:

  • Medical Expense Account. Like an HSA, you can use this account to pay for qualified medical expenses on a pre-tax basis. Unlike an HSA, however, there are no eligibility requirements tied to the amount of your insurance plan’s deductible. Another key difference is that an HSA will allow you to invest anything you don’t use, whereas you’ll lose the funds you have set aside in your Medical Expense FSA. 2016 contributions are capped at $2,550.
  • Dependent Care Account: With this FSA, you set aside pre-tax money to pay for dependent care expenses, like daycare. Your expense must be for the purpose of allowing you and, if married, your spouse to work. Generally, you (and your spouse if filing jointly) must have earned income during the year.  2016 contributions are capped at $5,000.

Defer Taxes

Earnings in some types of investment accounts come with tax advantages. Here’s a quick summary of several of those opportunities, though many have restrictions attached, so it bears digging in to learn a bit more if you’re interested. I did a more thorough rundown in a couple of prior posts: Retirement Planning 201 and 529 What?! Here are some highlights:

  • Traditional 401(k): you contribute to a 401(k) account through your employer before taxes are taken out. You don’t pay taxes on your contributions or earnings until you withdraw. So if you're in a lower tax bracket then, you may come out ahead.
  • Roth 401(k): You contribute to a Roth 401(k) with money you've already paid taxes on, but when you withdraw that money, you don’t pay taxes on what your investments have earned as long as you meet a few requirements.
  • Traditional IRA: Depending on your income and whether you have access to a 401(k), you can deduct contributions you make to your IRA. Your earnings are tax deferred, so you’ll pay taxes when you withdraw. 
  • Roth IRA: You contribute to a Roth IRA with money you've already paid taxes on, but when you withdraw that money, you don’t pay taxes on what your investments have earned as long as you meet a few requirements.
  • 529 account: When you invest (after tax) dollars through a 529 college savings account, you won't pay taxes on what you earn if you use those earnings for qualified educational expenses.

Create a Source of Future Deductions

Many of the deductions highlighted earlier don't apply if you haven't planned ahead to make yourself eligible in the first place. Here are a couple of examples of how you could create the conditions that would give you access to potentially more impactful deduction opportunities. 

Starting your own company: There are many deductions you can take if you are running a business, though apparently you can expect additional IRS scrutiny if you haven't turned a profit in the last 3 out of 5 years. One creative example of how to benefit from having your own business that I read about here is to hire your kids. Some of the income they'll earn will be tax-free and if you pay them a reasonable wage and have them use those wages to pay for college, you will have essentially made college tuition deductible. That’s because you can deduct their wages as a business expense. Kids can also earn some income tax-free, so you can minimize taxes there as well.

Investing in real estate: There’s a nice high level overview of the tax benefits of investing in real estate in this article. Some of the highlights are that you can recover the cost of income-producing property through depreciation, use 1031 exchanges to defer profits from real estate investments, and shield profits on the sale of a personal residence from capital gains taxes.

Change the Circumstances that Define your Taxes

There are bigger life changes that you could also make to potentially save on taxes. I’ve listed a few of the possible changes that stood out to me below. Among them are some more extreme choices and all merit the input of a professional.  

Change how you earn: Earnings from investments held over a year are generally taxed at capital gains rates. Capital gains rates (for now) are 0%, 15% or 20% depending on your overall income level — lower than corresponding ordinary income tax rates. For those who recall the controversy around Mitt Romney’s infamous 13% effective tax rate, investment earnings taxed at capital gains rates were one of the driving forces in bringing down his overall average tax rate. So if you were to, say, become a big hedge fund manager or real estate tycoon, you too might end up in this bucket.

Change your filing status: Your filing status, specifically whether you are single or married, impacts your taxes. As this great interactive article from the NYTimes explains, “The marriage penalty is the additional taxes that couples pay when filing jointly, compared to what they would pay if each person were allowed to file individually. The penalty stems mostly from the fact that tax rates rise as income rises — and the brackets for married people and single people are different.” The penalty (or bonus for some) depends on how much a couple makes in total and how evenly their income is divided. If you’re likely to be in the penalty category, you could theoretically avoid getting married and save on taxes. Or you could consider getting married in January versus December, since the IRS considers you married for the entire year no matter when the wedding happened. Obviously this is a very personal life decision that should probably be predicated on a lot more than taxes.

Change the game: There are other, more extreme, strategies that I’d lump in this category as well, like creating a shell company to offshore money. I’ve included a few links in the resources section to some articles I found in this vein. It’s interesting reading but much of it seems ethically dubious to me and it’s unclear where tax minimization ends and tax evasion begins. Personally I do not see this path in my future.

Looking forwards, not backwards

At the end of the day, you have to pay taxes and it’s probably always going to seem like you’re handing over a ton of money. That’s kind of the deal we have with the Federal government to live in the US. Personally, this research has shown me that I have probably been missing out on some opportunities, but that I haven’t missed anything that was going to be life changing. The conclusion I’ve come to is that it’s time to start looking ahead instead of just looking backwards when it comes to taxes. It’s time to build a relationship with a CPA who can help me think more strategically about how to manage taxes over a longer time horizon, instead of just relying on tax prep software to identify the tactical tax breaks that already apply.