Hack Your Tax

Steps To Legally Reduce Your Taxes

"Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands." ~Judge Learned Hand, Helvering v. Gregory

First and foremost I want to reiterate, this is not a guide to tax fraud or tax evasion.  Those are illegal as Wesley Snipes and Al Capone found out.  So here are my four main guidelines I use to maximize my income and (legally) minimize my taxes.

1. Pay tax on the seed, not the harvest

"When you contribute money to a tax-deferred account, it’s a bit like going into a business partnership with the IRS. The problem is, every year the IRS gets to vote on what percentage of your profits they get to keep." ~David McKnight

For a little bit of context, let me give you a hypothetical situation.  I am a bank and you need to take out a loan for $10,000.  For the loan I am going to offer you 2 options:

Option 1:  You take out $10,000.  We agree on the payment terms and interest rate up front and you pay me back based on those terms.

Option 2:  You take out $10,000.  You can do with it whatever you wish for 30 years.  In 30 years, THEN I will let you know what the repayment terms are and the interest rate. 

If you picked option 1, good for you!  If you picked option 2, message me so I can be your private banker

I illustrate this because is if you are deferring taxes into the future, you are gambling with what the tax rates will be.  First, even if they are LOWER, you will NOT save money on taxes!  You will simply be deferring them.  Second, even IF tax brackets stay the same, you will probably be in a higher tax bracket anyway.  This simply due to inflation.  Let’s say you make $50,000 a year and in retirement you also want to make $50,000 a year.  However, you want the same PURCHASING POWER of $50,000.  If you are 27 and plan to retire at age 67 in 40 years, at a simple 2.5% inflation rate you will need $134,253 a year in 2060 to have the same purchasing power.  Congratulations, you just jumped from the 22% federal tax bracket to 24% tax bracket (assuming the brackets are the SAME in 2060). 

So if you can, pay the tax ONCE and then be done with it.  Don’t defer the taxes to a later date and gamble with how much the government will take then. 

Examples of this would be IRAs.  In a traditional IRA you DEFER the taxes to later date.  If your CPA tells you that you SAVE on taxes by contributing to a traditional IRA or traditional 401k, you need to get a new CPA.  If you are deferring the taxes you will pay MORE in taxes, regardless of what tax rates are.  I wrote about this extensively in two articles on Traditional IRAs and Roth IRAs.  With a  traditional qualified retirement plan you get a small tax deduction for the current year and the holdings in the account grow tax free, BUT when you reach retirement the entire balance is subject to tax at your highest marginal rate, whatever that is in the future.

Now Roth accounts are a perfect example of how paying tax on the seed and not the harvest.  You put in contributions after you have paid taxes but then it grows tax free and the disbursements are tax free as well (subject to retirement age).  Back in the 2012 elections, when Mitt Romney disclosed his tax returns it became well known that Presidential candidate Mitt Romney had a 9 figure Roth IRA, completely shielded from taxes, much of it from his private equity business days.  In 2012, Romney was 65 years old and factoring an average lifespan of 78 years, he could withdraw over 7.8 MILLION DOLLARS every year without a penny of it going to Uncle Sam.  Billionaire Peter Thiel used his Roth IRA to invest in PayPal early on  as well as Yelp and Facebook to build up his account to over $95 million.

Read Next: Work to earn, spend, THEN pay taxes

*Full disclosure I am NOT a CPA nor a certified financial advisor (or any other alphabet soup designation) and all of the information in this section is provided solely for educational purposes and does NOT constitute legal or tax advice. EVERYONE should consult their own financial advisors, CPAs and tax strategists to compile their own individualized plans.*

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