We’ve all wondered how to pay lower taxes without breaking the law, especially as we start to plan for our retirement. As part of our series in retirement planning, today we’ll explain how to avoid common mistakes, and how to prepare for inevitable roadblocks in the process. This includes handling debt, and learning how to pay lower taxes (legally) across your lifetime.
If you’ve followed along in this Retirement Planning series, you’re on your way to establishing your financial plan. You know your needs will be in retirement. But now you need to identify what roadblocks you need to look out for.
First, let’s talk about debt.
“Can I Retire With Debt?”
Yes! A monthly payment is really no different than other expenses, like a grocery bill or travel expense. It’s just harder to wrap our heads around psychologically
You can be fine in retirement with debt as long as it’s not too expensive, and you should remember that not all debt is the same. Consumer debt like credit cards and auto loans are common, but better to avoid, unless the interest rate is very low.
Investments like real estate debt are a much better kind of debt to have in retirement, so long as you’re taking these on responsibly, and with decent interest rates.
All this said, our approach to debt will depend on our comfort with it, and there’s no single right answer here. In general, if you’re debt averse, you’ll be more comfortable when your debts are handled more proactively, and that may be important to consider for a low-stress retirement
How To Pay Lower Taxes Legally
Another retirement roadblock is not using tax laws to your advantage. Taxes are often considered a boring financial topic, but understanding taxes can help you pay less, without resorting to any illicit methods.
Taxes affect almost every aspect of finance, they should be at the intersection of everything we talk about in financial planning
It’s important to think long term about your taxes. Making decisions on tax events (like annual payments) can actually run counter to what’s best for our lifetime tax payments
First, let’s review a few terms you should get familiar with.
- Standard deduction — this is the standard amount you can use to reduce your taxable income. It depends on your tax filing status (income, single vs. married filing, etc).
- Itemized deduction — a standard deduction contrasts with an itemized deduction, which only really makes sense if you have high medical expenses, high mortgage interest, or certain other high-tax expenses.
- Marginal tax rate — the marginal tax rate is often misunderstood, because the rate people pay is actually quite a bit lower than they think they’re paying.
Let’s say your annual income is $50,000. You see your income puts you at a 22% tax rate, so you might assume you are being taxed 22% of $50,000.
In reality, the marginal tax rate means your first $9,950 will be taxed at 10% ($995 tax).
Your income from $9,951 to $40,525 will be taxed at 12%, or $3,669 of tax
Finally, your dollars from $40,526 to $50,000 will be taxed at 22%, or $2,084.
So in total, your effective (average) tax rate is 13.5% (not 22 percent!)
This dispels the myth some taxpayers believe, where they worry that making that extra dollar to put them into a higher tax bracket would cause them to have less total income after taxes, compared to if they stayed in the lower tax bracket.
Tax Reduction Strategies
Here are a few best practices to lower your overall tax payments.
- Participate in your employer-sponsored retirement plan, such as a 401(k) — especially if they match your contributions.
- Contribute to a Traditional IRA — depending on your income level, this can be a good way to put money away without initial taxes
- Contribute to Flexible Spending and/or Health Savings Accounts — this helps you get tax-deductible money into an account to pay for medical expenses, on a tax-free basis
- Itemize tax deductions — If you donate a lot to charities, this is a great option here. If you aggregate your donations to specific year, this can help put you into a higher tax deduction qualification
- Understand capital gains taxes — not just investments in a retirement account, but things like real estate or other investments outside of a retirement plan. Some investments are taxed differently than others, and some are taxed less than normal income taxes
- Take a long view on tax planning — remember, this is not a one-year event, but a journey. There will be years where you spend more in taxes, but where you’ve planned it out so you’ll pay fewer taxes overall
No matter how effective we are at planning, there are always gonna be roadblocks and unexpected issues. We have to build our plan so they’re resilient, and can get through these obstacles. We’ll never be perfect at planning this, so take that pressure off and build the best plan you can.
If you found this article helpful and you’d like to take advantage of some of our other resources, you might want to learn about our financial bootcamp.