How to plan for taxes and pay as little as legally possible
Ben Franklin once said, there are only two things certain in life: Death & Taxes. Both you cannot avoid but you can try and defer them as much as possible. I am no medical expert, but I am sure everyone wants to stay healthy and live as long as possible. Taxes are something that not a lot of people try to avoid or defer or do anything about. Especially when it comes to investing, its imperative that you are investing, tax-efficiently. Here are some reasons why taxes matter and why you should focus on reducing them:
Taxes reduce your available income to invest
Even before you begin investing with your hard-earned money, you pay income tax. Depending on your annual salary it can be anything from 0 to 37%. So even before you start investing, you are losing a huge cut of your income! Why should you pay taxes again when investing?
There are ways like investing in employer 401K plans, solo 401K’s, HSA’s that help in reducing your taxable income, hence reducing the taxes that come out of your paycheck. There are other considerations: if you want to pay taxes now, then invest in Roth flavors of retirement accounts. But point is you need to and should reduce your taxable income as much as possible.
Taxes are frictional costs in trading
Warren Buffet always says his favorite holding period is forever. The biggest reason for this is because buying and selling stocks generates lot of tax liability. Every time you sell at a gain, you owe Uncle Sam some capital gains taxes. Every time you sell at a loss, you need to track it and make sure you claim on your tax returns. Not only is it cumbersome, but if you trade stocks very often, you end up loosing a lot of your gains to the IRS as taxes in short run. In the long run then, you would be left with very little wealth to show for it. Mutual funds are very notorious for this. A lot of times the fund manager will try to keep trading in order to improve performance and just pass on the taxes and commission costs to you as fee. This is opposite of investing tax-efficiently.
Inflation already an enemy
Inflation is your biggest enemy. Managing the rate of inflation is often the job of the Federal Reserve. Currently they plan on a 2% rate of inflation every year. What this means is, say this year you buy x amount of groceries with 100$. Next year that same x amount would cost you 102$. Now I am sure you have heard about compound interest and how it can be your best friend long term. But similarly, inflation “compounds” and the effect can be very negative over long term. So, when you already have this big force working against you which you can frankly not do much about, why would you want to further lessen your gains by paying taxes? Lets say you make around 10% on an investment, 2% of that gets eaten up by inflation, now if it was a short term on, you are probably looking at another 1.0 to 3.7% in taxes based on your annual income. If it was a long term gain, then looking at 0-2% off on your gains. But you can easily avoid this. Just do not sell “every year” to realize the gains and buy something else from the proceeds. Invest for the long term. Imagine not giving up on those 1-3.7% gains every year and allowing them to compound. Results will be wonderful by the time you retire.
Incorrect tax decisions can cost you over your lifetime
Filing a tax return is definitely great to make sure you paid least amount of tax previous year and get back if you paid in excess. Similarly when you make investing decisions, you need to also account for taxes in your decision. Things like your income level, timing of transactions in your taxable accounts, special tax treatment on some type of investments etc. need to be considered before buying any investment. If you do not consider such factors, you may as well end up paying a huge tax bill when the tax man cometh. These decisions might seem small, but will impact you over your lifetime in the long run and can be very costly!
While it’s not possible to avoid taxes completely, they should be deferred. Taxes are like speed bumps on your road to financial independence! They slow you down and might even derail you if you are not smart about your investing decisions. However, each person’s tax saving strategy must depend on their own situation. Like your age, income, retirement age, future after retirement etc.
In the days of online brokers like Robinhood and Webull which gamify investing, encourage short-term trading, there is an even bigger need to understand investing, tax-efficiently. There are a lot of ideas like retirement accounts, tax deductions, tax credits on foreign investments etc. Don’t worry! they are all easy to understand and follow & completely legal! I discuss them in my guide below. Sign up below to get a free copy of comprehensive strategies and ways to reduce taxes on your journey to financial independence!