Pay Less in Taxes—And Get Closer to Financial Independence—With 2 Simple Strategies

The less you spend—whether it’s on discretionary items or paying taxes—the more you have left over to save. Adviser Rachel Podnos O'Leary outlines two basic strategies.
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By Rachel Podnos O’Leary, CFP

The following is adapted from 21st Century Wealth.

Most of the millennial financial planning clients I work with want to build wealth and reach financial independence. If that’s your goal as well, then I’m going to tell you the same thing I tell them: achieving financial independence comes down to saving enough to live the life you want without depending on others for income or credit.

Rachel Podnos O'Leary, CFP

Rachel Podnos O'Leary, CFP

And the less you spend—whether it’s on discretionary items or paying taxes—the more you have left over to save. Most people have some ideas of how they can reduce discretionary spending. But if you’re like many of my clients, lowering your tax bill might seem a bit more challenging.

It doesn’t have to be, though. There are two simple strategies you can use to save and build wealth in a tax-efficient manner. The first strategy is to maximize contributions to tax-preferred retirement accounts. The second strategy is to earn money on investments that are taxed as long-term capital gains.

Let’s go through both of them.

#1: Contribute to a Tax-Preferred Retirement Plan: For high earners, maximizing contributions to a pre-tax retirement plan is likely the easiest way to both save money and pay less taxes. When you make pre-tax contributions to a retirement plan such as a 401(k), every dollar you contribute is taken out of your paycheck before taxes and subtracted from your AGI (adjusted gross income).

Think of it this way: for every dollar you earn in a 35 percent tax bracket, you have to earn $1.35 to save one dollar after-tax. However, to save a dollar into a pre-tax retirement account such as an IRA or a 401(k), you only have to earn a dollar, regardless of what tax bracket you’re in. When you do this, you are making a bet that you are in a lower tax bracket now than you will be in retirement when the government starts forcing you to take taxable withdrawals from your plan.

If you’re in a lower tax bracket, then you might instead bet that you’re in a lower bracket now than you will be down the road and pay taxes on the front end by making after-tax contributions to a retirement plan such as a Roth IRA (or 401(k) if your plan allows it). High earners who are disqualified from directly funding Roth IRAs might consider using extra cash to fund non-taxable back door Roth conversions after maximizing contributions to pre-tax retirement options (however, this is only tax-advantageous if you don’t have existing pre-tax IRA money).

Whether you make pre-tax or after-tax (Roth) retirement plan contributions, the money invested within the account can grow tax-free within the account for decades. If you invest wisely, down the road you will end up with much more than you contributed.

In addition, many employer-sponsored plans offer some sort of free money incentive for employees who contribute, most often in the form of a match or profit sharing. This is free money your employer is putting towards your future! This alone should be incentive to contribute at least enough to get the full match if your employer offers one.

Types of Tax-Preferred Retirement Plans

There are multiple kinds of retirement plans, most of which are employer-provided—and all of which come with some kind of preferential tax treatment. If your employer doesn’t provide a retirement plan such as a 401(k), you may be able to fund an individual retirement account (IRA or Roth IRA).

If you’re self-employed or have 1099 income from a side hustle, you can open a self-employed retirement plan such as a 401(k), SIMPLE IRA, or SEP IRA to shelter income from taxes and save for the future. After all, you are the employer (and employee).

#2: Reduce Your Tax Burden through Long-Term Capital Gains: The other major way to build wealth in a tax-efficient manner is by accumulating money that is favorably taxed as long-term capital gains. In fact, after funding tax-preferred retirement plans, accumulating money that will be taxed as a long-term capital gain (LTCG) is one of the most tax-efficient ways to amass further wealth.

You know that one of the primary benefits of funding retirement accounts is the tax-preferred growth of assets within the account. In a nutshell, you can sell an investment within a retirement account for a massive profit and pay no tax at all until the money is withdrawn, even if this is many years later (or, in the case of Roth accounts, pay no tax on realized profits ever again).

Outside of retirement accounts, however, a profit resulting from selling an asset for more than you initially paid is taxed as a capital gain. Assets sold for a gain after less than one year of ownership are deemed to have a short-term capital gain (STCG) and are taxed as ordinary income.

On the other hand, assets sold for a gain after more than one year of ownership are deemed to have a long-term capital gain. LTCG tax rates, which range between 0 and 23.8% are favorable as compared with ordinary income tax rates. The highest tax bracket for ordinary earned income is currently 37 percent. See why this strategy is so effective?

For most millennials, the simplest way to take advantage of this strategy is through long-term, buy-and-hold stock investing in an individual or joint after-tax investment account (a simple brokerage account, as opposed to a tax-preferred retirement account as described above). If you fully fund all tax-preferred investment accounts available to you and still have extra cash for long-term investing, this is what you should be doing with it.

Beat Taxes with Simple, Straightforward Strategies

Don’t miss your opportunity to save money for the future while saving money on taxes. If you use these two simple tax-efficient wealth building strategies, you’re almost guaranteed to come out ahead.

For more advice on reducing your tax burden, you can find 21st Century Wealth on Amazon.

About the author: Rachel Podnos O’Leary, CFP®

Rachel Podnos O'Leary is a Certified Financial Planner™. While her clients span a variety of ages and backgrounds, Rachel is particularly passionate about working with other millennials to help them achieve financial independence through wealth building. Rachel is also a licensed attorney and member of the Florida Bar. 

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