The Quiet Millionaire: Part 6 - Are You Paying Too Much Tax?

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The Quiet Millionaire author and Certified Financial Planner Brett Wilder states that “Most ‘normal’ people think that the subject of taxes is an absolute bore and would much rather spend their free time thinking about more interesting, stimulating, and happier aspects of life.” Thankfully, I would be considered normal by this measure. Thinking about avoiding taxes, the focus of Chapter 6, however, is mildly exciting. I've selected some of Mr. Wilder's ideas and insight that I found particularly useful.

Plan tax reductions rather than just take tax deductions.
There is a difference between 1) gathering your tax information and preparing your taxes or having them prepared by a tax professional and 2) actively planning tax reductions, that is making financial decisions considering the immediate and long-term tax implications of your actions.

For example, if you are ready to capture capital gains on certain investments, then you might also sell shares on stocks that have lost value (and that you are planning on selling soon anyway). As a result, your gains and losses will be recognized in the same tax year and your overall taxes paid will be less than if you didn’t sell the losing investments.

If you are working with a CPA and/or tax professional, shouldn’t that person advise you on tax strategy? Mr. Wilder asserts (and I agree, based on my experience) that

“Even the most competent CPAs are too busy to do meaningful tax reduction planning for you during the height of the tax-filing season, so you need to constantly manage your tax situation as part of an ongoing comprehensive financial management program.”

So, consider:

• Finding a financial advisor who keeps up with tax law and can recommend strategies based on your situation;
• Meeting with your CPA during the off-season to discuss tax ideas;
• Doing your own research and, if you are engaging a CPA, asking very specific questions regarding the feasibility, legality, and reasonableness of your tax reduction plans.

Mr. Wilder dispels two tax myths, beginning with

Myth #1 “Deferring taxes is always good”

Adhering to conventional wisdom will have you reduce your tax liability now. Here’s the upside: as a result of lower taxes, you can free up cash to pay off debt, reduce your need for borrowing, and/or invest savings to begin or add to your portfolio. Mark offers ideas on ways that you can reduce your taxes now if you’d like, such as paying your property tax bill before the end of the year.

But there may be reasons not to defer taxes (and as Mark notes may not be applicable to your situation). For example, if you graduated in May of this year and only have a half-year of earnings to report (June to December), you may not want to pay that property tax bill this year; next year those deductions might be more valuable because you may be in a higher tax bracket based on a full year of earnings (January to December).

Another reason not to defer taxes is that you may need to sell investments now to lock in profits. The sale will trigger capital gains tax but a possible decline in the value of the investments next year may be greater than the tax you’ll owe upon the sale this year.

Myth #2 “Taxes paid go down during retirement”
Retirement income and income tax planning may not be a high priority at this moment but it is useful to consider the possibility that you’ll need more money in retirement than you do now. The two big reasons you may need more are: 1) taxes will be higher and maintaining your standard of living will be costlier due to the impact of higher taxes and 2) things will cost more. Therefore, deferring as much income and income taxes as possible to the future may be damaging to your long-term financial well-being.

To address the unknown of taxes and income, Mr. Wilder offers this agrarian-based tax wisdom:

“…you may be better off not taking the tax reduction opportunity on the smaller amount being invested, the seed, instead of looking toward the gain of a bigger tax break on the larger amount coming out, the harvest.”

Funding Roth (retirement) and 529 (education) accounts are two great ways of paying taxes on the seed in order to avoid taxes on the harvest. There are no immediate tax advantages to funding either of these types of accounts. And if you are converting a tax-deferred account to a Roth, you’ll incur taxes now. However, if you’re a positive cash-flow maniac with a long-term view, you’ll love these benefits: 1) you won’t have to pay taxes on capital gains that occur when you trade investments and 2) you won’t have to pay taxes on withdrawals.

How do you know what’s best? Unless you are an income, investment, and tax prophet, you can’t see and know the future. So, Mr. Wilder allows that it is best to have funds in all types of accounts, which is certainly doable at least from a tax perspective. For example, it is possible to fund a 401(k) and a Roth IRA to lower your tax bill this year and future years. (Income restrictions apply).

Just for fun, I’ve got a few tax-savings ideas that may be applicable to your situation. These are inspired by The Quiet Millionaire and the IRS website:

• Charitable contributions: If you are planning on using funds from investments to make a charitable contribution, transfer appreciated stock to the charity rather than sell the investment, pay capital gains tax, and donate the proceeds. This tip may be especially useful for someone who will be taking the standard deduction rather than itemizing deductions. The warning is that if that stock is going to be sold at a loss, you'll be better off claiming the loss on your taxes. 
• Volunteer expenses: Some, not all, expenses associated with volunteering are deductible. For example, you can deduct the cost of transportation to the volunteer site; you can’t deduct the value of your time or services.
• Medical expenses: These expenses may include surgery, prescription medications, insurance premiums, dental work, modifications made to your home or car for medical reasons, eyeglasses, and tutoring for children with learning disabilities. The catch, according to the IRS, is the “you can deduct only the amount of your medical and dental expenses that is more than 7.5% of your adjusted gross income (Form 1040, line 38).”
• Tax credits for child and dependent care, hybrid vehicles, and more: Mr. Wilder emphasizes that tax credits are superior to tax deductions; credits provide a dollar-for-dollar elimination whereas deductions reduce taxable income upon which tax rates are applied.
   

Avoid, don’t evade.

Cheating on taxes is illegal but it is a sin not to take allowable deductions, according to my personal income tax instructor at the community college. Wilder echoes these sentiments, saying that taxes “should be legitimately avoided, but not illegally evaded.”

”Ironically, if you earn a relatively high income and do too good a job of reducing your tax liability, the IRS can force you to pay a higher alternative minimum tax, or AMT.”

Again, Mr. Wilder recommends planning and projecting taxes to see if your tax avoidance strategies will lead you into “AMT territory."

All this careful planning might not be necessary if your income and the cost of living stayed constant throughout your lifetime, tax laws never changed, ordinary income and capital gains were taxed identically, and taxes were calculated on an unchanging, straight percentage of your income. Not only does income vary, tax laws change every year. Research, tax planning, and financial adjustments can reap payback now and later.

Note: I am not a tax professional so please check with your CPA before using these ideas. I received a copy of The Quiet Millionaire in exchange for a review of this book. This post is part of a series; see also:

• What is Important about Money to You
• Major Obstacle to Financial Success
• Money for Now, Money for Later
• Building Your Net Worth