By Kyle J Christensen, Founder, Principles-Based Planner, Unique Advantage
Unique Advantage Monthly Client Email – April 2024
Leading up to April 15th of every year people all over the country begin asking the question, “How can I reduce my taxes?”
I get it! No one enjoys writing the check to the IRS, especially if it’s large enough to pay for a small condo every year. It’s painful and we as human beings do our best to avoid pain whenever possible. So, the question is a valid and important question.
While it’s valuable to know their options, the answer to the question might not lead to an outcome (long-term) that people really want. My clients have often heard me say, “We shouldn’t let the tax-tail wag the dog.” Avoidance or reduction of taxes really can only occur in one of three ways (three major categories, sub-categories, and probably hundreds of sub-sub-categories below each one). My goal with today’s message is to lay out the three major categories for you to think through and hopefully give you a better idea of what you really want to do and the greater impact of those decisions.
My little disclaimer: I will add up front, I am not a CPA, a tax accountant, or a tax lawyer. So, take what I have to say with a grain of salt and verify whatever you want with a qualified tax professional. As a Principles-Based Planner my focus is on the bigger picture. I’m not simply looking for ways to reduce your taxes temporarily. My primary objective is to help you become and remain Financially Free. Taxes are a small but important part of the picture. Just part of the picture. No becomes Financially Free simply by reducing their tax burden. And many people have unintentionally avoided Financial Freedom as a result of their choices to avoid taxes.
💰Reduce (or Defer) Your Income
One sure-fire way to reduce your taxes is to reduce your income. The easiest way to pay zero taxes is to make zero income. I’ve never heard anyone say, “Man, I hope I make less money this year!” 🤭 I’m not sure that’s a great goal to have. For most people, when they look at that statement, they wonder, “Why would I want to receive less income?” Well, that’s a very good question and the answer might be, you don’t. However, there are myriad ways in which a person can reduce income for income-tax purposes and a surprising large portion of the population uses them to avoid paying taxes (usually, however, just temporary avoidance).
The first way to reduce income is to not receive it. One way of “not receiving it” is to defer it. Deferring it means you don’t receive it now but will at some undetermined time in the future. The IRS provides a number of ways you can defer income. One, which is the most common, would be to put some of what you earn in a given year, into a qualified retirement plan (i.e. a 401(k)). The money contributed to tax-deductible retirement plans is not counted as income in the year you contribute the money to the account (except for the purposes of Social Security and Medicare taxes, which you still pay, even if you defer the income into the retirement account). This is by far the most common method by which people reduce their tax burden in a given year. It’s also the easiest, most convenient, and most-oft promoted by accountants, financial institutions, and traditional financial planners.
Roth accounts (Roth IRAs and Roth 401(k)s) are not tax deductible on the contributions (in other words, you pay the tax on the contribution – it’s not excluded from your income). However, the accounts grow tax-deferred and can be withdrawn tax-free if withdrawn after 59.5 years or five years (whichever comes later). In other words, Roth accounts will not reduce your taxes this year. They may (depending on whether they make money for you and when you pull the money out) reduce future taxes.
Both Roth and Traditional IRAs have limitations that “phase out” (exclude) people who make “too much income” (i.e. For Married Filing Jointly, if either spouse is covered by an employer-based retirement plan, the phaseout on Traditional IRA is $143,000 – if your Adjusted Gross Income is more than $143,000, you are not allowed to deduct contributions to a Traditional IRA). Here’s a link for updated rules for 2024.
For business owners (especially small business owners), the common recommendation by accountants, outside of the more common retirement accounts, is to contribute money to SEP IRAs, SIMPLE IRAs. All retirement accounts have contribution limits. Here’s a link to a comprehensive list of those limitations for 2024.
We won’t go into all of the problems associated with putting money into retirement accounts (because there are a plethora), but most importantly, the long-term impact is that the money is removed from the control, use, and expertise of the contributor for a very long period of time. Additionally, because they are “retirement accounts”, they are purposely designed not produce any income to the account owner until at least age 59.5. Overall, that’s a pretty huge cost that generally outweighs the supposed benefit of avoiding taxes in the year that the money is contributed.
The cost of the decision to contribute is almost never weighed against the cost of losing control and use (in other words, what could you do with the money if you had complete control and use of it?). Yes, there is an opportunity cost to paying taxes, but does that outweigh the opportunity cost of not having access and use of your money for possibly decades? If you are a successful business owner or investor, the answer is almost certainly no! 👈
Health Savings Accounts are also a popular way to reduce taxes in a given year, but once again the money is removed from the full control and use of the contributor. The money in the plan can only be used for certain IRS-sanctioned expenses (qualifying medical expenses). I’m not saying that HSAs are completely not worthwhile. I am saying that it’s important to balance the contributions with the real benefits and the real costs. It is my personal opinion that you should not blindly contribute money to an HSA (continually max out contributions) when you already have sufficient funds in the HSA to cover your annual out-of-pocket maximum on your medical insurance. Again, HSAs are either invested in savings accounts or the stock market (mutual funds), are not designed to produce income, and cannot be used without penalty for non-qualified expenses.
📉Lose Money on Investments
Another way to reduce income is to lose money on investments (investments held outside of retirement plans, because the IRS does not allow deductions for losses on investments inside retirement accounts – one of the “plethora” of problems referred to earlier). It almost never makes sense to me why someone would want to purposely choose investments that lose money. Tons of accountants make these sorts of recommendations to people all the time, “to reduce their taxes”. They instruct their business-owner clients to buy a vehicle, a trailer, and four-wheeler, and a bunch of other things that are bad investments simply to reduce their tax burden for the year. As Robert Kiyosaki says in his books, it doesn’t require a lot of intelligence to find investments that lose money.
When a business owner makes smart investments into his/her business, it’s always into something that is intended to produce more income, not less. So, it’s really not a “tax strategy” to put money into investments. It’s a growth and income strategy (at least, it should be intended for that purpose). And yes, depending on the type of investment, there can be long-term tax benefits related to the income and growth of the value of the investment, but I can’t think of very many good reasons to invest in things that lose money simply to lower my taxes this year. Sometime investments in businesses don’t pan out and therefore create a loss. Investments in businesses (and pretty much anything outside of retirement accounts) that result in losses can be counted against income (subject to certain limitations the IRS sets for passive and active losses), thereby reducing the amount of taxable income in a given year.
🧡Donate to Charities
The last sub-category is to give money to charities. The tax benefits of contributing to charities should be much less important than the other reasons a person contributes to charities. The main reason a person should contribute to charities is because he/she cares about those charities and their causes. It is my opinion that he/she should contribute regardless of the tax benefit or lack thereof. I’m grateful the IRS does not tax charitable contributions (up to 50% of Adjusted Gross Income per year). Charities, in my opinion, are much better equipped to truly help people than the government through forced taxation and use-without-representation. But I digress.
Here’s something interesting to note: What if I told you that people who give more to charities make more money? Those that are more charitably minded create more wealth? Would you believe me? Well, you don’t have to simply believe me. Check out this report. Study after study has actually proven it to be the case. People who give more to charities actually earn more (in that order).
There are a lot of ways a person can donate money to charitable causes. There are over 1.5 million non-profit organizations in the United States alone (as of 2022). Here are a few unique ways people can donate to charities:
- Gift of stocks/investments to charities. Did you know you can donate shares of stock directly to a charity, without selling the stock first? You can reduce your taxes by not realizing the gain of an investment and by simply giving the investment directly to the charity instead. Here’s a link that gives you more details about that.
- Gifts to Charitable Trusts. You can create a Charitable Trust and donate cash and assets into it. You can set up a charitable trust that provides you with a tax deduction today on the amount contributed, and still receive income from those assets for the remainder of your life. Upon your death the charity receives the assets. This is called a Charitable Remainder Trust. Or, you can donate assets to a trust and have the income that is generated from the trust go to the charity, for which you receive a tax deduction, and the remaining assets transfer to your heirs upon your passing. This is called a Charitable Lead Trust.
Irrevocable Life Insurance Trust (ILIT). This can sometimes be a good option for people. Keep in mind that this is done primarily to reduce Estate Taxes only, not income taxes, as the proceeds from life insurance policies are not taxable as income. Putting life insurance in a trust does nothing to reduce income taxes. The beneficiary of an ILIT can be a charity as well, which can create a tax write-off (charitable deduction) related to the premium payments made into the policy. Gifting to charities this way can be a means of turning $1 into $100 to a charity on a guaranteed basis, versus relying on market increases to the value of assets that would otherwise be donated to the charity. Again, this points to the real reason a person should donate to charities, which is because you care about the cause of the charity and want to help them succeed in their mission.
The biggest reason why I say it’s only good to fund an ILIT “sometimes” is because when money is transferred to an ILIT it is essentially and materially transferred out of the control and use of the donor (the person paying the premiums). I’m generally not a fan of my clients giving up control and use of their money for long periods of time in their lives. In the event that a person is older and simply has no use of the cash value (or is extremely unlikely to need or want to use the cash value of the policy before dying), funding the life insurance through an ILIT is a way to remove the life insurance proceeds from the value of the estate, for estate tax purposes, and gives the donor (the person paying the premiums for the life insurance) a tax deduction if the beneficiary of the ILIT is a charity.
What’s to come in Part II?
Category 2 – Recharacterize Your Income
Stay tuned!
