Bad Tax Reduction Strategies
Tax season is quickly approaching so I thought it would be a good time to address some of the questions I’ve gotten over the past few months about this complicated issue. I also wanted to share some of the tax mistakes that can be easily made if you’re just trying to reduce your tax bill as much as possible. There is a significant portion of people who believe that there are tips and tricks to paying less in taxes by filing differently, when in reality it is more about living your life differently. So, if you’re looking to reduce your tax bill at the end of the year, these are avenues you should avoid.
Cheating
Cheating or lying on your taxes is a good place to start because it seems to be far more common than most people think or acknowledge. Cheating or lying can come in many different forms from sending out W-2’s to friends/family who have never worked for you to lying about how much you made or lost. I understand that there are gray areas with this as there is some income that the IRS wouldn’t know about, but the best bet is to report everything. I am certainly not advocating paying more than your fair share, but you should pay what you owe. The ramifications for cheating could be fines for minor infractions and jail time for something more outrageous. Aside from those consequences lying and cheating are ethically wrong and taxes are not the place to compromise your ethics.
Not Contributing to Retirement
I have gotten the question about whether contributing to a 401(k) makes sense in terms of reducing your tax bill. In general people are aware that contributing to your 401(k) or other retirement vehicles will reduce your taxable income and therefore lower your taxes. However, there are some people who get bogged down in the details and perhaps miss the forest for the trees. The explanation I’ve gotten is that if you contribute to your 401(k) today you’ll be paying more taxes in retirement because the account will be larger. Because they want to avoid paying larger tax bills in retirement, they would rather skip paying into their retirement accounts today.
This is certainly true, but may not be the important issue. Your contributions today will get you a nice reduction in taxable income and save a decent amount on your taxes now. When that money is withdrawn and taxed you’ll be paying a larger amount in real dollars, but because that money was able to compound and grow tax free you will end up with far more money. So yes, you’ll pay a bit more in real tax dollars but you’ll be in a much better financial situation. The logic here ends up being akin to wanting to be less well off so you don’t have to pay more instead of being comfortable and paying your fair share. So, instead of trying to game the system ineffectively, contribute to your retirement and don’t worry about paying your fair share later in life.
Borrowing Money
Guess what? You don’t pay taxes on money you’ve borrowed, whether that’s from your bank, a payday lender, against your house or car, or against your whole life insurance policy. However, you do pay interest on that post tax loan and you pay it with post tax dollars. Given the predatory nature of many lenders, it is far less of a headache to earn the money, pay the taxes, and move on with your life.
Annuities/Insurance Products Inside Retirement Accounts
There are some people who promote the idea of putting annuities and other insurance products inside your retirement accounts as a way to lower taxes and pay for insurance with pre tax dollars. This is another missing the forest scenario where it is technically true, but ultimately either not helpful or harmful. First of all, annuities and cash value life insurance plans have tax free growth, which is wonderful. However, you know what else has tax free growth? Retirement plans. Putting an annuity inside a retirement plan serves no benefit as they provide the same thing but now you’re paying commissions and fees on the annuity that you wouldn’t normally be paying for a retirement account. Now, one of the benefits of the cash value insurance plan is that the death benefit is tax free to your heirs, but that gets messed up with this strategy because it’s now living inside a retirement plan. That means that when you pass, the amount equal to the cash value of the plan is considered taxable income to your heirs, which makes this idea even worse. So, if you find an insurance salesman that wants to put an annuity into your retirement plan, he’s trying to line his pockets with your money.
Charitable Giving
This probably could be a separate post but I wanted to briefly touch on it here as it does have tax ramifications. Giving to charity is great and can be very helpful to improve the communities we live in, there’s no question about that. However, if you’re just trying to use it as a method to pay less in taxes then find a different way. Say you’re a high earner and your tax rate is 42%, so you decided to give $1,000 to charity in order to reduce your tax bill. Your bill is reduced by $420 which is great, but you’re still $580 poorer. The tax deduction certainly makes it easier to give to charity, but doesn’t improve your personal financial situation. This can also come back to bite you if the donation isn’t tax deductible because of the amount of deductions you’re already taking. If you contribute to a charity and are still under the standard deduction, it won’t reduce your taxable income at all. As I mentioned, charitable giving is wonderful, but it’s a terrible method to reduce taxes.
These are some of the issues I have seen or worked through with people as we get closer to tax time, if there are others that you’ve used or been pitched, reach out to me to let me know. Nobody wants to pay more taxes, but whatever you do don’t use these methods to reduce your tax bill. They won’t actually work and you could end up in trouble with the IRS.