What Is Your Biggest Expense This Year?
What is your biggest expense this year? If you would have asked us this question at various points in our lives, our answers would have differed. We would have guessed house payments, cars, travel or kid related expenses at different points. We would have been wrong, wrong, wrong and wrong. The correct answer for us and most likely you would have been taxes, taxes, taxes and taxes.
This realization first hit me when reading “The Millionaire Next Door”. I realized that we fit the profile of the people described in this book in many ways. In many ways we managed our finances even better than them. That is, except for our lack of a tax strategy. Our income has consistently increased over the years. At the same time, we simply turned and handed much of “our” money back to the government as fast as or even before we ever even had it in our hands. As we began to read personal finance articles and early retirement blogs, our lack of a tax strategy became painfully obvious as we realized how much money we were unnecessarily giving away. We didn’t bother to learn the tax laws and develop a sensible plan to control this expense. In fact we didn’t think of taxes as an expense. We simply assumed that the more money you make the more taxes you pay. We assumed that there wasn’t much we could do about it.
We ignored the fact that you can control a portion of your tax burden by the decisions that you make. We failed to control taxable income through decisions such as not maxing out employer sponsored retirement plans. We ignored the tax implications of our investments. We primarily invested in taxable accounts. We then made matters worse by using managed funds instead of more tax friendly index funds or ETFs, thus giving away a substantial portion of our returns to the IRS in the form of short term capital gain taxes. We were obsessed with paying off our mortgage as quickly as possible, giving up our biggest tax deduction in the process. We purchased our two most recent cars in a neighboring county that levies an additional 1% county sales tax. We tend to give our biggest charitable donations directly to people who we know personally could use our help rather than through charitable organizations, losing this write off. The list could go on. Some of these actions (not using employer plans, not paying attention to investments, etc) were flat out dumb, some (paying off mortgage) involved trade-offs of losing tax advantage for perceived freedom from debt, some (charitable donations) while financially not the best decision are things we would do again in a heartbeat. They all had one thing in common. In the past when we did think about taxes our only response would be to moan and complain about them and then continue on in our ignorance.
I have found the writing on the Mad Fientist blog extremely helpful in beginning to develop our tax strategies for early retirement. Even if early retirement is nowhere on your horizon, this blog is a worthwhile read to get you to at least realize some of the many things that you can do to decrease your tax burden and keep more of your money.
We also have learned that the tax code is very favorable to early retirees. Anyone who is able to accumulate the assets quickly enough to retire early would have to be able to earn relatively high wages and have relatively low spending needs. Thus, in retirement they would see a significant decrease in their tax bracket and effective tax rates. Darrow Kirkpatrick recently wrote an interesting post on his Can I Retire Yet? blog that explains this very clearly. Understanding this concept is a key reason that early retirement works. Once you accumulate enough assets to retire, you can reduce your earned income substantially. Earning less money decreases your tax burden in two ways. If you choose to earn smaller amounts of money here and there you will have a lower effective tax rate, allowing you to keep more of what you earn. This can also lower already favorable long term capital gains rate on your investments to as low as 0%.
Taking the time to learn how to use the tax code to our advantage seemed about as exciting as watching paint dry until we began to learn how huge of an effect it was having on our wealth building. We now see the negative impact that not planning had on us. Going forward, we will make tax planning one of the cornerstones of our financial planning strategy. This has led to a transformational shift in how we look at our finances. In the future, instead of trying to earn more by working more, we will focus on keeping more allowing us to work less. In the past we spent money, time and took on increased risk trying to find investments that can increase return by 1-2%. In the future, we’ll use the tax code to save us 10-15% or even more guaranteed just by avoiding tax mistakes, planning on where the investments are housed, when they are sold, etc.
Not learning the tax code has been an expensive mistake for us in the past. Simply realizing that taxes are our biggest expense and starting to figure out how to control them will allow us to work smarter and invest more efficiently in the future, accelerating the path to financial independence and early retirement.
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