Tax Minimization Strategies

Disclaimer:  I am not an accountant or a tax professional and any advice here should be verified with a professional before acting upon it.

I’m doing my taxes this week.  It’s going to be painful and I’m not going to like the answers it gives me, but I might as well bite the bullet.  If you’re in the same boat you may be looking for strategies to help you minimize your taxes this year.  There are several categories of expenses that we should consider as possible sources of tax deductions:

Business Expenses

Most of the minimization strategies you will see are for people with small businesses.  You open up a world of deductions by starting a business, however this who area of deductions doesn’t apply to most of us.  Consider starting a business if you have one in mind, but we’ll cover individual deductions instead since they are of the broadest interest.

Tax-Deferred Accounts

Make sure you put any money into your IRA, 401(k), HAS or any other tax advantaged accounts you have.  Not having to pay taxes can be a huge savings by itself.  When you throw in the capacity of some of the accounts to grow tax-free, this is a no brainer.

Unemployment

This is very relevant to all of us in this economic climate.  If you lost your job, many of the expenses that you incur in your job search are tax deductable.  Phone calls, agency fees, travel to potential employers as well as costs for printing resumes may all be deductible.  Be sure to take advantage of any opportunities to lessen your tax burden in this climate.
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Investing Step #8: Health Savings Accounts

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This post is step 8 in our Investing Template.

The Health Savings Account is becoming a more popular option recently.  It is a great opportunity to save money on your medical insurance.  Despite that, it is still an under-used option. 

Health Savings Accounts allow you to contribute money to an account whose funds are designated specifically for health uses.  While many people might not immediately see the value in this, it represents an option in which you can almost immediately recoup a large percentage in savings.  If you are in a 33% tax bracket, then every expense you make using this account is essentially at a 50% discount. 
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Investing Step #7: Home Ownership

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This post is step 7 in our Investing Template.

While there are no explicitly tax-deferred savings plans for housing, the Roth IRA can work very much like one.  If you are looking to buy your first home in the future, more than 5 years from now, or if you have a Roth IRA opened already, such an account may be a very reasonable option for your investing dollar.  While you cannot take your contribution out pre-tax, any income you make over those 5 years can be used tax-free to buy a house, up to $10,000 per person.  This can be a considerable savings.

While retirement and college may seem like distant issues, buying a home is much closer on our investment timeline for most of us.  If you already own a home, or have in the past, you can pretty much skip this section as a Roth IRA will not do you much good.  Its exemption for buying a home only applies to first time buyers, but it can be very powerful for those looking to maximize their earnings.

Your Strategy

When you contribute to your Roth IRA, the account must have been opened for 5 years for you to be able to withdraw money to help buy your first house.  Additionally, you can only withdraw a maximum of $10,000 per person.  This means that if you are married you can withdraw $20,000.  If you are slowly saving for a house, putting money into an Roth IRA can be a great option, since all of your investment proceeds can be used without ever paying any tax on them.

Generally your approach here would be to contribute money towards your Roth IRA until it looks like your window is getting close.  At the point where you approach your maximum contribution for your home, you will have to consider whether continuing to contribute to your Roth makes sense.  You may have better options for your other investment goals, but why pay taxes on your home down payment investment when you don’t have to?

An Example

Imagine if you want to buy a house in 10 years.  Each year you put $1000 in your Roth IRA and it earns 11% (a lofty goal, but it helps illustrate the power.)  If you pay 33% in taxes each year, by the time you were ready to buy the house you would have almost $3,500 more dollars in your Roth IRA than you would in a regular investment account.  The Roth would have $18,561 vs $15,097 in the regular account.  You made $3,500 simply by selecting the right account in which to save your money.

This is a fairly narrow option.  It only applies to those who have never owned a home and who can qualify for the specifics of the Roth IRA, bu it should be included in your timeline if it applies to you.  Dedicate some of your investment funds to your Roth and you can get the massive returns that the absence of taxes can provide you.

Investing Step #6: College Saving

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This post is step 6 in our Investing Template.

After retirement, the next farthest investing event is your kids’ college education.  While in some cases a first house may be sooner than college, or in more rare cases retirement might come before your kids go to college, generally money that is invested in College Savings Plans will be tied up the second longest, next to your Retirement Accounts.

Why College Savings Plans?

College Savings Plans, often referred to as 529 plans, allow you to contribute money towards future tuition, have that money grow tax-free, and if it is used for appropriate expenses, used without paying taxes.  Thus, while your contributions are not typically pre-tax, they grow without taxes and can be used without taxes, which can be a huge advantage.

Types of 529 Plans

There are two major variations in 529 plans:

• Prepaid Tuition: In this case you pay for tuition at today’s rates and they are locked in for the future.
• Savings Plans: These allow you to contribute your after tax dollars to grow tax free and offer various investment options.

Overall, 529 plans are implemented at state levels, or sometimes even at the particular institution level.  Thus you see a much wider variety in options and details than in many federal plans. 

Considerations

Due to the wide variety in the plans there can be many key details, but ultimately the primary consideration in these plans is the likelihood that this money will be used for college.   If it is not, then the money will be taxed when withdrawn, as well as a 10% penalty, similar to early withdrawal in a retirement account.  At the same time, college can be a major expense in a family’s life, and the tax benefits of these accounts can be huge.

When deciding if and how to contribute to a college savings plan, I typically recommend caution.  While these plans can offer huge savings if your child goes to an appropriate college, that is not a guarantee.  Many other expenses will definitely happen and are slightly safer options because you can guarantee their use. 

Still, this money should not be viewed as a terrible investment either way.  If you use a typical college savings plan for 15 years and then your child doesn’t go to college, you can withdraw that money with a 10% penalty.  While this may sound harsh, you’ve had 15 years of your gains compounding without taxes, which will generally overcome the 10% penalty.

Investing Step #5: Retirement Accounts

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This post is step 5 in our Investing Template.

Retirement accounts are probably the type of tax-deferred vehicle with which people are the most familiar.  The number of people invested in the stock market has skyrocketed in the past two decades, much of which is owed to tax-deferred retirement accounts.  Some examples of these types of plans are:

401(k) – The most common type of plan.  They are generally offered through for-profit companies and often include matching.

403(b) – 403(b) plans are similar to 401(k) plans, but are offered by public schools and some non-profit organizations.  There are other differences, but that is the most obvious one.

Traditional IRA – IRAs are also tax-deferred accounts, but are not implemented through an employer.  You are able to deduct the amount contributed and it grows tax-free.  You pay taxes on the funds when you withdraw them. 

Roth IRA – A Roth IRA is different from a traditional IRA in that you do not get to deduct your contributions from your income from this year.  However, like an IRA the money grows tax free and you can withdraw it without paying taxes when you withdraw.  Additionally, there are a few exemptions available to withdraw from a Roth IRA before retirement that are not available with other vehicles.

Self Employed IRAs – There are several other types of IRAs, such as a SEP-IRA and SIMPLE IRA,  available to people who are self-employed, which can allow them significant deductions as well.

All of these programs have different income limits and contribution limits, and a wide variety of details.  Make sure to do considerable research and consult with a tax professional before deciding which one is appropriate for you.

Your Strategy

Which of these accounts make the most sense for you can be complicated, but keep these things in mind:

If your company matches your contribution, it is almost always wise to maximize your contribution to the point at which they match.  Even if they only match 33% or 50%, you are still making an amazing return immediately. Many companies match up 100%!  Imagine a guaranteed return of 100% instantly.  It’s an incomparable investment.  This should usually be your number one investment destination after you’ve established your emergency fund. 

With the exception of the Roth IRA, these are funds you should be setting aside for retirement.  That means that this is the longest window in your time horizon.  These are essentially your funds for when you don’t want to work anymore.  Thus, you should only tie money up in these funds that you will not need for a long time.  There can be severe penalties for withdrawing this money before you reach retirement.

By the same token, if you are setting money aside for retirement, there is no reason not to get it into some kind of tax-deferred vehicle.  Once you are comfortable that you can afford to deisgnate this money for retirement, at a bare minimum you want it to be able to grow tax-free.