Every time a new tax law is enacted, we naturally wonder what it means for our own tax bill.
The news covers the long debates and close votes in Congress, followed by the president signing the bill into law. The end result of all this back and forth, will they or won’t they, however, is that some rates may change slightly, and some deductions may be added or removed, but very few of us will notice a real difference in what we pay.
If you want to cut your taxes significantly, you need to understand how and why tax laws are drafted. Once you have a handle on the basics of how taxes work, the political changes to the code every few years will not matter as much.
How much in taxes are you paying?
It always surprises me that we do not put much thought into how much we actually pay in taxes, even though it is one of the most significant expenses in our budget.
Most of us have withholding on our paychecks and then pay whatever the tax software or our preparer tells us, often without even knowing our tax rate. However, the first step to reducing your taxes is to determine your effective tax rate. It’s easy to calculate.
Look at your Form 1040 and divide the total tax, which is the number found on line 24, by the taxable income figure found on line 15. Then, multiply the result by 100. On California Form 540, your total tax is on line 64, and your taxable income is on line 19. Were you surprised by the percentages?
Next, recognize that almost everything you spend money on, if it is not deductible, is paid with after-tax dollars. That means the government takes its share first, and then you spend the remaining amount.
So, if you’re in the 30% (federal and state) income tax bracket, for every $100 you want to spend, you have to earn about $143 before taxes. If your utility bill is $200, you have to earn approximately $286 to cover it. If you buy a refrigerator for $1,200, the real cost to you is closer to $1,700. And that’s just income tax.
When you include payroll taxes, such as Social Security, Medicare, and state disability, you can add another 8-9%, and your pretax costs are even higher.
If you want to achieve a better standard of living in the long run, you need to cut your effective tax rate and the amount you spend with after-tax dollars through tax planning.
Why does the government give tax breaks?
Tax planning is when a taxpayer makes use of the tax law to pay the least amount of taxes possible.
To understand how to do tax planning, you first need to know that income tax isn’t just a way to raise funds to run the government. The tax code has always been part of what economists call fiscal policy, which is the way Congress uses taxes to reward certain behaviors and, to a lesser extent, discourage others while also considering fairness.
For example, one of the first tax rules written over a century ago allowed for a tax deduction for interest and property taxes paid.
Lawmakers sought to encourage homeownership, so mortgage interest and property tax deductions became an untouchable part of the tax code. They wanted to promote charitable giving, so donations were deductible, too.
They later also thought it was fair to give a tax break to families with very high medical bills or casualty losses. Workers could deduct expenses they had to pay out of pocket, such as uniforms and teaching supplies, because it was thought that it was not fair to have them pay for those expenses with after-tax dollars.
How have tax laws changed?
The 2018 tax law brought one of the most significant tax law changes in decades.
It didn’t take away mortgage interest or charitable deductions, but it raised the standard deduction so high that more than 90% of us no longer itemize. Other deductions, notably out-of-pocket work expenses, disappeared.
Now, whether you own a home or rent, whether you give to charity or not, or if you have medical or job expenses, your tax return probably looks the same.
For wage (and salary) earners, this means there is little to no room for tax planning. The best action tax professionals can suggest is to contribute as much as possible to retirement accounts, such as a 401(k) or IRA, as they remain one of the best tax planning vehicles.
You can still cut your taxes
There are still ways to reduce your taxes, but they involve making significant and often difficult changes.
You need to take advantage of the fact that the tax code favors investors and business owners.
Earnings from employment are taxed at the highest rates and are also subject to payroll taxes. Investments are taxed at lower rates, and taxes can be deferred. Business income is minimized with a long list of allowable deductions. Over time, the most effective way to reduce your taxes is to shift your income from employment to investments or business activities.
Let’s look at some simple examples.
You can open an investment account that increases in value without being taxed until you sell. When you do sell, the profit is taxed at capital gains rates, which are much lower than the ordinary rates you pay on wages. Qualified dividend income also pays a lower tax rate than wages. You can also invest in tax-free bonds, which may help you avoid federal and state income tax.
Congress loves to reward business owners and landlords with tax breaks. If you start a business, even if it’s just something on the side, or if you become self-employed, expenses such as mileage, a home office, and business meals and travel can be deducted from your business income. Remember that employees cannot deduct business expenses.
How to get started
The FIRE movement — Financial Independence, Retire Early might be something to consider for more information.
People in FIRE groups live below their means, save aggressively, and invest with the goal of reaching financial independence years before traditional retirement age.
If you are serious about implementing your financial goals, I would also book an appointment with a qualified certified financial planner. Only about 60% of Americans have an investment account. That percentage should be higher.
The bottom line is that the tax code is not neutral. If you follow the basics, such as contributing to retirement accounts, investing or starting a business, you can significantly reduce your taxes, regardless of occasional changes in the tax law.
Michelle C. Herting is a CPA, accredited in business valuations, and an accredited estate planner specializing in succession planning and estate, gift, and trust taxes.