Not Everyone Should be Trying to Lower Their Tax Bill
It may sound odd when you say it out loud, but after considering all the facts, it’s quite true.
It’s an emotional but understandable reaction to think you always want to lower your tax bill as much as possible. However, except in the case of death, the tax code is basically a case of “tax me now or tax me later.” In many cases, lowering your current tax bill means that income avoided or deductions taken now are going to come back into your life at some later point. One example would be an IRA. You put money in an IRA and lower today’s tax bill, but those dollars will need to be taxed at some point. When you start taking withdrawals from the IRA (usually in retirement), you will pay tax on that income based on the tax rates in effect at that time. So, did you really save anything? Sometimes, yes. If you were in a 22% tax bracket when you funded an IRA, and then in retirement you are in the 12% tax bracket, then you saved in two great ways. One, the un-taxed money earns interest, and interest on interest on all that money will be larger than the interest earned on an after-tax remainder over the same time period. Then, that larger amount is taxed at 10% less in this example.
However, few people really end up with such a simple and clean fact pattern. Working families with kids that earn EIC and other credits are often feeling over-taxed (because with kids every penny is needed), but in reality, they are often only in a 12% tax bracket. Then they put money in a 401(k) and by accident avoid paying 12% tax on those contributions. As they continue to work and advance in their careers and the kids grow up and move out, they are earning the best money of their career and they retire into a 22%, 24% or even a 32% tax bracket. Then eventually they are forced by IRA RMD to take that money out and give the current tax bracket percentage to Uncle Sam. They avoided 12% tax to pay 24% or 32% tax. Very bad deal for them.
What is the moral of the story? Go to a tax planner and do some thoughtful and proper tax planning. Don’t go in with the ideal that they should always lower your current bill using whatever means necessary. Go and ask, “Should I lower my bill?”, then talk through all the possible future fact patterns and use all those facts to decide what to do now.
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