Let us begin with a story:
You start a new business.
You have a plan.
You have your target customer in mind.
You have product ideas.
You have a plan to be profitable.
You get your LLC filed, only to discover that you have a partner, and you are expected to pay your partner —22-45% of your profits! …but it is a little unclear exactly how much you will pay because the agreement with your partner is 2,600 pages long. Huh?!
Your partner has made it clear on numerous occasions that you should not pay more than required by your complex agreement. That’s nice.
In case you missed it, your partner is the IRS/Government and its profit share is your TAXES.
To the title of the article, not doing tax planning is one of the biggest financial mistakes I see most of us make (other than waiting too long to start investing regularly).
Tax planning? But that’s for corporations or wealthy people that have yachts and stuff.
Well, yes, but it’s also for YOU.
…but what is tax planning? …and how do I do it?
Simply defined, tax planning is understanding the tax impact of various life choices, incorporating this understanding in your decisions, and where possible, arranging your life or business to pay less.
Why tax plan?
For one, it can regularly save you $10,000s per year now and even more in the future.
Second, the IRS does not expect you to pay more than you owe. In fact, tax planning is a perfectly acceptable form of financial planning, and has been legitimized in the courts many times.
In a very famous court decision in a case with the IRS, it was ruled, “Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands…”
Here are a few examples of how tax planning could apply in your situation:
Cost of Living Raise?
Let’s say you live in Chicago making $100k per year.
You get a job offer in San Francisco. Your new employer offers you $175k.
You look at a cost of living calculator and note that it’s about 65% higher in San Francisco vs Chicago. “Ahhh, great,” you think, “I’m getting a cost of living raise plus some!”
Maybe, but did you consider taxes?
Additional income is always taxed at the highest bracket you are in (or higher). Additionally, most states have their own income tax (California’s is higher than Illinois).
In this case, you were paying about $31k of tax while living in Chicago (including federal, state, and payroll).
In San Francisco, you will be paying about $61k!
On an after-tax basis, you were making about $70k per year in Chicago and in San Francisco you would make $114k. Once you factor in cost of living, you really aren’t getting a raise because of increased TAXES.
Using this information to make a decision is tax planning.
To Roth or not to Roth?
You have probably heard of an Individual Retirement Account (“IRA”).
Quick review: an IRA is an account you can contribute to for your retirement that provides a tax benefit. The key difference between a Roth IRA and a traditional IRA is the timing of the tax benefit.
In a traditional IRA, with certain assumptions, you get a deduction when you put money in.
For example, you put $6,000 in and get a $6,000 deduction. Your investments grow tax-free. When you take money out, you pay tax on it at current tax rates.
In Roth IRA, you do not get a deduction when you put money in. Your investments also grow tax-free, but then when you take cash out, you don’t pay any tax. That’s right, no tax on all of that compounding growth!
Many hours have been spent modeling which choice is better. Tax planning here is deciding if you are better off paying tax now (Roth) or later (Traditional IRA). This choice could easily mean hundreds of thousands of dollars to you considering many 401(k) plans now have a Roth option as well.
Making the most informed decision here is tax planning.
Digital Nomadism saves Tax?
Many have inspired our generation to consider geo-arbitrage: living in a low-cost country and earning money from a high-cost country.
You’ve probably seen someone on social media that bounces country to country earning money via an internet business or multinational company and constantly showing pictures of exotic food or beaches.
There are certain popular digital nomads that have claimed a way to pay $0 income tax. While the parameters for this are somewhat narrow, I have done the analysis, and depending on a few factors, it is actually very possible!
Can you imagine? Living in cool places, doing interesting work, and having no income tax obligation? THIS! …is tax planning.
Tax planning is for EVERYONE. Get informed and put at least one person on your personal board of directors that understands tax.
About Patrick King
Patrick is a fellow millennial with 15 years of tax experience. He has practiced in both individual and corporate tax. He enjoys teaching others how to save taxes. You can follow Patrick on Twitter.