Most of us assume that we have very little control over the amount of tax we pay. The accountant looks over a bunch of forms, plugs things into a calculator, gives us a number and that’s it. There may be some credits or deductions we overlook from time to time; but beyond that, well… you know.
But you probably have more control over your “tax liability” than you realize, especially over the long term. While it is true your options are pretty limited when it comes to this or even next year’s taxes, the choices you make today can mean big tax savings over the course of decades. There are three tricks in particular that come to mind:
1: Keep an eye on your future tax bracket
Specifically, try to determine if you will be in a higher or lower tax bracket upon retirement than the one you are in now. If you are unsure how to determine such a thing, start with questions such as:
- How much would I like to be making at the peak of my career?
- What tax bracket would that income put me in?
- Would I want to maintain that income level – and the lifestyle that comes with it – in retirement
- Would I want to downsize and simplify in retirement instead?
- Or, conversely, would I like to be able to splurge a little?
- Do I hope to leave money behind for heirs? If so, how much?
Once you have answered those questions, go through and answer them again – this time focusing more on what you expect rather than what you hope for. Now you have a range of possibilities for what retirement may look like for you.
Supposing your hypothetical retirement income lands right in the middle of that range, would it put you in a higher or lower tax bracket than the one you are in currently? Knowing this will help a lot with the second trick.
2: Be sure to save in the right place
In addition to pre- and post-retirement income, you should also keep an eye on the tax effects of your long-term savings. Broadly speaking, the different options for this come in four main flavors:
Each has its pros and cons, but in terms of tax treatment alone, the HSA is clearly superior and the brokerage account clearly inferior. Deciding between traditional and Roth accounts is a bit more tricky… but becomes a lot simpler if you have an idea of how your retirement tax bracket will compare to your current one.
| If you expect your retirement tax bracket to be higher than your current one, your savings options rank like this: | If you expect your retirement tax bracket to be lower than your current one, your savings options rank like this: |
| 1. HSA | 1. HSA |
| 2. Roth | 2. Traditional |
| 3. Traditional | 3. Roth |
| 4. Brokerage | 4. Brokerage |
3: Take advantage of low-income years
Sometimes, for one reason or another, you may find yourself with far less taxable income than normal. Maybe you are between jobs, or taking a year off to sail around the world, or just coasting by on Social Security at the start of your retirement.
Whatever the reason, such periods can present a golden opportunity. Low-income years are a great time for all kinds of financial chores, such as…
- Converting an IRA to a Roth
- Selling highly appreciated assets
- Applying for a property tax exemption
This is especially true of tasks that carry a high price tag from Uncle Sam. The tax on something like a Roth conversion or property sale is intimidating, but may work out in your favor if you time it right. The reason for this, again, is tax brackets.
For example, the sudden influx of cash from a Roth conversion will almost certainly give you a higher tax rate than normal for that year – and that higher rate will apply to any regular income you earned that year as well! But you can mitigate this effect by saving such big-ticket moves for low-income years.
If nothing else, just remember that while taxes are inescapable, they are not inflexible. It can be easy to miss this fact if you are focused on the short-term – if you only think of saving on this or next year’s taxes. But thinking with a wider view can be much more beneficial, and that is yet another reason why good planning makes such a difference.