"How do I pay less in taxes": asking the right question
This deceptively simple question comes up quite a lot when I'm talking to clients. I say "deceptively simple" not because the answers are always complicated -- and we'll get to that -- but because there are actually several different questions they might actually be asking!
And asking the right question is critical. I've seen people move directly from "I have a nasty tax bill" to "I've got to do something to lower that bill" to...well, suboptimal solutions.
For example: socking money away into a Traditional IRA. I'm not saying that Traditional IRA's are bad; rather, I'm saying they're not always the right solution. If you've got a cash flow problem masquerading as a tax problem, then putting money into a Traditional IRA can actually make it worse. You're locking up your money where you can't get at it until retirement!
So: here are several different questions at the root of "how do I pay less in taxes", each with their particular answers.
"How do I make the sudden shock of a tax bill less painful?"
You're a tech professional. You make pretty good money as a household -- six figures, maybe multiple six figures, especially if you're married to another professional. You get employer stock benefits, and you make good use of them.
You feel pretty good...and then the tax bill comes.
It's multiple thousands of dollars. You're scrambling to find the money, so your first reaction is, "I pay too much in taxes! I've got to lower my tax bill!" And it's not an unreasonable reaction...but it is misguided. The reality is that you're feeling your taxes more because of that big hit at tax time. The taxes that came quietly out of your paycheck didn't hurt at all...because they've been withheld every month since the beginning.
And if you don't have the money to pay it off...tax liens are no joke. The answer? Use an income allocation system to build up buffers. Sure, saving for retirement, paying off debt, etc. are all important -- but the somewhat-intangible benefit of flexibility is equally important, if not more so!
Want more details? Check it out here.
"How do I not get a sudden shock at tax time?"
Of course, ideally tax time isn't a nasty surprise at all; theoretically, our tax system is "pay-as-you-go", which means you pay in small doses throughout the year, not a big chunk on April 15. So why do you end up with a huge bill sometimes? While everyone's situation is different, with tech professionals I see two major issues come up more than most.
Withholding allowances: It could be as simple as putting too many "allowances" on your W-4 withholding form. The allowance guidelines are based entirely on marital status and dependents, so it would be easy for said guidelines to miss something important.
The solution is relatively simple: if you paid a nasty bill last year, reduce the number of allowances and/or add additional withholding by submitting a W-4 form to your employer. Consider using SmartAsset's Paycheck Calculator or the IRS' withholding calculator for a more precise analysis of your allowances.
Employer stock: While basic withholding issues sometimes happen, I find that most often employer stock is what's throwing a wrench in the works. When RSU's vest, employers almost always withhold for taxes in some form or fashion...but unlike your paycheck, they generally withhold a fixed amount, like 22%. Many tech professionals have a higher tax rate than that, and RSU's are taxed at vest, not at sale. So even if you didn't sell a single share, you could get hit with a nasty tax bill if you don't withhold properly!
ESPP shares can similarly bite you: while they're taxed at sale, not vest, employers don't do any withholding at all! So almost by definition, you'll end up underwithholding if you don't take some sort of proactive action.
In either case, in order to properly estimate taxes, you'll have to run some numbers. The RSU calculation isn't terribly difficult: they're taxed as ordinary income at vest, so if you know what they were worth when they vested, you can estimate how much you owe. ESPP's are a little dicier -- see this article for a rundown on how they're taxed. It's pretty messy, but you can make a conservative estimate by assuming the difference between your purchase price and sale price is taxed as ordinary income. (Yes, under the right circumstances part or all of that can be capital gains. That's why it's a conservative estimate!)
As for how to make the estimated tax payment, I recommend using EFTPS to make the payments electronically. Unless you really, really like printing things out, writing checks, and walking to the mailbox!
"How do I optimize my taxes for maximum long-term net worth growth?"
Note that while this one comes closest to "how do I pay less in taxes", it's still not exactly the same. Sometimes paying more in taxes is actually better!
Let's take municipal bonds as an example. As you may know, the interest on "munis" is tax-free. So if you hold bonds in a taxable account, you should always hold munis, right? Wrong! Muni bonds have a lower yield than their federal, taxable counterparts, precisely because people are willing to pay more for the tax benefits! Therefore, in order to determine whether it makes sense to hold tax-free or taxable bonds, you need to calculate the "tax-equivalent yield": the after-tax yield of a taxable bond...which depends entirely on your tax bracket!
For instance, if taxable intermediate-term bonds are yielding 3%, and you're in the 26% tax bracket, then the tax-equivalent yield is (3%*(100%-26%)=)2.22%. If muni bonds are yielding higher, then it makes sense to buy munis. If not, then it makes sense to buy taxable bonds -- even if it means eating the taxes! As you've likely intuited, the higher your tax bracket, the more likely it is that muni bonds are the optimal choice.
And remember the example of a Traditional IRA back at the beginning of this article? While contributions to one will certainly save you in taxes now, you'll have to pay ordinary income tax on the withdrawals later. Contrast this with a Roth IRA, which has no tax benefit now, but can be withdrawn from tax-free in retirement! So depending on the analysis, one or the other may make sense in your situation.
But even then, the taxes aren't the end of the story! In addition to the difference in tax timing, Roth IRA's have two extra, less-tangible benefits. First: if you've had one for 5 years, you can take the contributions (but not earnings) out tax- and penalty-free, at any time, for any reason. (I'm not saying you'd want to if you didn't have to, but flexibility is paramount!) And second: while you have to take Required Minimum Distributions from your Traditional IRA and 401(k) starting age 70.5, there is no such thing for Roth IRA's, which gives you a lot more flexibility in retirement to effectively set your own tax rate!
And the answer is...
You may have noticed that I didn't exactly answer that last question about optimizing taxes. That's because it's worth a whole article in and of itself -- even if I just focus on the strategies most relevant to tech professionals!
Britton is an engineer-turned-financial-planner in Austin, Texas. As such, he shies away from suits and commissions, and instead tends towards blue jeans, data-driven analysis, and a fee-only approach to financial planning.