Taxes Explained - Part 1

Tax Time Bomb

Taxes Explained - Part 1

Today's Newsletter:

  • Quote from Albert Einstein

  • Tax Time Bomb

  • A Money Question

Quote

“The hardest thing in the world to understand is income taxes.” - Albert Einstein

Albert Einstein needs no introduction, he was one of the sharpest minds this world has ever seen. Yet, here he is talking about how confusing the tax code is. Well I have bad news, it has not gotten any less confusing.

Who, What, and Why of Taxes

The most common issue that families come to me with is taxes. “What can we do to reduce our taxes?” I get it, taxes stink but they are an inevitable part of life. The good news is with proper planning we can reduce them.

This is part one of a multi-part series I am going to be doing on tax planning. To start let’s differentiate between tax filing and tax planning. Tax filing is what you do during tax season. You are reporting on what you have done over the previous year. Tax planning is what you do throughout the course of the year to reduce your tax bill. One is reactive and the other is proactive.

Our goal with the families we work with is to pay every dollar we owe but not leave the government a tip.

Step one in understanding tax planning is realizing this is not a one-year game. This is a lifetime game. The quickest way to get an advantage on your tax bill is to understand this concept. This means that some years you will pay more in taxes (on purpose). It also means those levers are being pulled to reduce your lifetime tax bill.

Let’s dive in.

Tax Time Bomb

The first piece of tax advice we are taught is to contribute to retirement accounts. When we do this we are receiving a current-year tax benefit and “deferring" taxes until some point down the road.

Example: If you are under the age of 50 you can contribute $22,500 to your 401(k) “pre-tax”. This means that $22,500 will come from your earned income. If you made $150,000 your tax bill will now show you made $127,500.

All traditional retirement accounts such as 401(k)s, 403(b)s, and IRAs are tax deferral accounts. You get a tax benefit in the year you contribute to that account. This is great if you are in a high tax bracket.

What they don’t tell you is that at some point, the government is going to get its share. Without proper planning traditional retirement accounts can turn into a tax time bomb.

When you reach 59.5 years old you can start taking money out of your traditional retirement accounts. Every dollar that comes out of those accounts is taxed at ordinary income rates. As in some of the highest rates we have in the tax code. In theory, you might be in a lower tax bracket at retirement than in your working years. This is sometimes the case but for many of our clients, it is often not. They are either still earning money, collecting social security, or seeing income from their other investments. This scenario creates a ticking tax time bomb.

You truly only “own” 60-80% of your traditional retirement accounts. The other 20-40% is owned by future taxes that are waiting to be paid. Here is an interesting thought, every dollar you have earned investing in your 401(k) has increased your future tax bill by 20-40 cents. While you have been growing your nest egg you have also been growing your tax bill. On one hand, the more money you have in an account the greater the compounding but on the other hand the bigger the future tax bill. It is an odd conundrum.

The second thing most don’t realize about traditional retirement accounts is at some point, the music stops. This is when you hit RMD age (currently 72). RMD stands for required minimum distribution and is the age at which the government starts making you take money out of your traditional retirement accounts. This means each year the government says you have to take a certain percentage out of those accounts. The killer here is you effectively lose all control over your tax bill. I see this time and time again with families that fail to plan around their retirement assets.

Look, traditional retirement accounts are not bad. For many families they are great but for others, they are a ticking time bomb. Truly, the only way to know what you should do is with long-term tax planning. Taxes, while uniform in this country are uniquely personal to everyone. There is a multitude of factors in play and even once you determine what they are, you must take them and apply them to your life.

One simple thing you can do today:

1) Write down what your effective tax rate was this year.

2) Write down what you think your effective tax rate will be in retirement.

If number 1 is higher than number 2, traditional retirement accounts might make a lot of sense. If number 2 is close to, the same, or higher than number 1, you might need to rethink blindly contributing to them. Either way, one thing is certain, make sure you are getting proper tax planning every year.

Oh and one more thing, taxes are at historical lows compared to other times in history. No one can accurately predict where taxes will be in the future but if history is our guide, they just might be higher.

Over the next several weeks we are going to be talking about different tax topics. If you have one that you would like to have discussed you can respond to this newsletter with the title “Tax Topics” and a description of what you would like to have answered.

A Money Question

What does your ideal day look like?

To me, this is the ultimate money question. Money is a tool for our lives. Yet, most people have never mapped out what their ideal day would look like. Start from the time you wake up to the time you go to sleep. What would you do and where would you spend your time? Find the answer to that and start directing your money towards achieving more ideal days.

Work with Jacob

I help athletes, entrepreneurs, and executives pay less in taxes, simplify their financial lives, and invest for the long run.

Until Next Time, My Friends

Moment Private Wealth, LLC is a Registered Investment Advisor, located in the State of Missouri. Moment Private Wealth provides investment advisory and related services for clients nationally. Moment Private Wealth will maintain all applicable registrations and licenses as required by the various states in which JL Strategic Wealth conducts business, as applicable. Moment Private Wealth renders individualized responses to persons in a particular state only after complying with all regulatory requirements, or pursuant to an applicable state exemption or exclusion. Nothing in this content is intended to be, and you should not consider anything in this content to be, investment, accounting, tax, or legal advice.