The Best Way to Reduce Tax and Increase Your Net Worth
I often get asked by my clients, ‘what’s the best way to save big on taxes?’ Well, for most people, here it is. Saving for retirement saves on tax and improves your net worth immensely. There are a lot of numbers below, and for the most part I’m going to let them speak for themselves. If you have a little extra cash in your business (<$20K in this example), you can reduce your tax $18K and better your net worth by $56K….$56K!! That adds up over the years. Some (but not all) of this relates to a change in the tax code, QBI, which allows S-Corps, which most of our clients operate, to deduct up to 20% of their net profit from taxable income. But this deduction fully phases out once you surpass $415K of taxable income (Married Filing Jointly). So reducing your taxable income by putting it into a qualified retirement program can make you “re-eligible” for this deduction and other credits like the Child Tax Credit. To recap, putting money into a retirement program does triple duty:
- It reduces your tax
- It builds your net worth
- It can unlock tax credits and deductions (like QBI) that phase out if your income is too high.
I also want to address a misconception I’ve heard recently: “I’m going to get taxed the same in retirement as I am now on my retirement contributions.” I can’t predict tax law changes in the future, but unless rates go up drastically, that’s plain wrong. That’s because income tax rates are progressive, meaning higher tranches of income get taxed at higher rates, as you can see in the illustration below. When you defer money into a retirement program, it deducts that income from the top brackets. When you retire and take that money out, that income has to fill up the lower brackets before it gets anywhere near the rate in that top bracket. Let’s take the example below, which, by the way, is only on FEDERAL tax—savings also apply to state income tax as well. Below, two spouses younger than 50 defer $38K ($19K each) in 2019. Before the deferral, they had $415K income. Had they not contributed to a qualified retirement program, $15K of that $38K would have been taxed at 32% and the rest at 24%, so they saved $10,320 tax. Ignoring investment gains over the years (which are another big wealth-building tool), let’s say that couple takes out that $38K in retirement to live. Assuming no other income (they were smart and paid off all their debts!), the total federal tax on that $38K is $1400 is 3.68%. So instead of paying 27.2% effective tax in 2019 ($10,320/$38,000), they paid 3.7% in retirement and saved 23.5% in tax, again ignoring state tax which would only increase the savings. That’s a huge return on investment.
Last piece of advice – in retirement (or even better—now), consider moving to a zero income-tax state (WA, AK, TN, NH, FL, NV, WY, TX, SD) with a low cost of living…your money will go further! Housing costs alone in other states can be 70% less than a state like California for a similar home, leading to living expenses that might be 50% below the coasts. Imagine if someone told you you could get a 50% return on your money every year. That’s effectively what happens if you earn the same income (which dentists do, and often time even more than in saturated states) and have living expenses that are 50% less.