Why You Should Aspire to Pay More In Taxes
Have I lost my mind? Is this a political post promoting bigger government? Obviously, the second question is not true, and the first may be debatable, but I do stand by the title.
When it comes to financial planning there are three things we can control—taxes, risk and fees. We will be focusing on taxes here.
Regardless of how much money you currently make or how extensive your investment portfolio is, one thing is generally true—if you earn more money or profit more from your investments, you will probably owe more in taxes.
Isn’t that a good thing—you owe more because you made more? I am confident you wouldn’t want to experience the converse of that last statement. Why would I, as a financial planner, be promoting paying more in taxes? Shouldn’t I be focused on minimizing taxes?
My goal (and yours should be too) is NOT to minimize taxes but to maximize after-tax returns. (That’s a fancy way of saying that at the end of the day, you have more money even after paying Uncle Sam.)
Back to my previous point, our goal (mine and yours) is not to minimize taxes. It is easy to minimize taxes—don’t work and whatever money you do have put in a savings account earning 0.01% or under a mattress. (Unfortunately those are effectively the same thing these days.) I promise you that if you do those two things, you will not owe much in taxes.
With this understanding, you will now need to reconsider your view of paying taxes. It isn’t that your goal should be not to pay any taxes; rather, it should be that you want to make the most that you can while paying as little as you have to each year. That needs to be your new perspective. Sometimes it makes sense to pay taxes today because, over the course of your life, you will do better financially.
So how can you do this?
The first is to take advantage of qualified retirement accounts. You may be familiar with these – they include your 401(k)’s, 403(b)’s, 457(b)’s, IRA’s, etc. Contributions to these accounts are tax-deductible up to certain limits but the IRS makes sure that they will be taxed eventually. Personally, I generally view these accounts as a joint venture with the government because, as these accounts grow over time, the IRS will be reaping benefits from that growth as well.
You may know of Roth retirement accounts that are also used to fund retirement. These are not a joint venture with the government because these accounts are never taxable when used for retirement purposes. This is because the money that has been put in these accounts has already been taxed. A Roth retirement account is generally ideal for people who expect to pay more in taxes when they retire than they do now. Nobody has a crystal ball of what taxes will look like when it is time to retire but, if you expect to have a lot of money saved for retirement, you should strongly consider contributing to Roth accounts even though you will be paying more in taxes today.
At some point, when you’ve contributed all you can contribute, these options are exhausted. If you still want to save and invest, a taxable account will need to be created. Some may suggest an annuity at this point, which is a viable option but, in my opinion, most people would benefit more from a well-constructed taxable account. In this account, the investments will be taxed on their growth and earnings and this is where a thorough understanding of taxation is necessary.
If all of your retirement savings are in retirement plans, the following may not be too critical. If you do have savings in retirement accounts and taxable accounts, this is where it gets fun. This is also where you really start to experience the impact of not minimizing taxes but instead maximizing after tax returns.
It is quite important to choose which investments go in which accounts. For instance, if you have a 401(k), a Roth IRA and a taxable account, you need to plan which investments go into each one. Since the Roth account will never be taxed again, it may make the most sense to choose your investments in this account according to which ones you expect to grow the most. You may want to choose the investments for the other accounts based on how they are taxed.
As you may suspect, different types of investments can be taxed differently.
For example, if you own a corporate bond, the dividend paid by that bond will be taxed at your ordinary income rate and that may be rather high (>33%). It may make sense to own a municipal bond that is federally tax exempt so you wouldn’t pay any tax on the dividends. Recognize, however, that the dividend is going to be less for the municipal bond to account for this difference (assuming that risk is the same). It is important to point out that, for this reason, it is almost never beneficial to invest in municipal bonds inside a retirement account and, therefore, should be used in a taxable account.
Now let’s consider an individual stock as an example. Stocks provide investors with two types of return: dividends and corporate growth in the form of capital gains. Qualified dividends and long-term capital gains receive favorable tax benefits because they aren’t taxed according to your tax bracket. Instead, that dividend or capital gain could be taxed at 0%, 15%, 18.8% or 23.8%. If it isn’t a qualified dividend or is a short-term capital gain, then it would be taxed according to your tax bracket.
Mutual Funds and ETF’s further complicate matters because fund managers make all the decisions on which stocks to hold and when to sell them. It is important to understand how these decisions can impact your personal tax situation and, therefore, determine which account you want to hold these investments.
Every client is different in terms of which accounts their different investments are invested in based on what works best for them and their situation. The purpose of this article is to explain that taxes do matter a great deal when determining your financial plan. You need to be taking them into consideration. You also need to recognize that minimizing them is not the goal - the goal is to maximize your after tax return.
So here’s to you paying more taxes!