As a general rule, the more of your hard-earned income that you keep, the easier it is to save, invest, and build wealth. Tax minimization strategies are typically a great way to enable you to that, as taxes can be a big expense that get in the way of putting your money to work for you.
Despite that reality, there are often very good reasons to make choices that require a larger tax payment today, in exchange for an even more important life benefit elsewhere. With that in mind, here are four reasons I've paid more in taxes over my career so far than I strictly needed to.
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1. What job security?
In my working career so far, there have been three major, economy-wrecking disruptions that have forced many people out of work. They were the bursting of the dot.com bubble , the financial meltdown , and most recently, the economic shutdown put in place to fight the COVID-19 pandemic .
Somewhere along the line while worrying about my job and my family's future, I recognized that while we had saved money, it was nearly all locked away inside a Traditional 401k style retirement account. We were not set up to handle anything more than a brief period of unemployment without facing huge tax and penalty costs. As a result, we made the priority call to slow down our retirement savings and build a more balanced and robust financial plan.
By tapering down those retirement contributions, our immediate tax bill went up. Still, the benefits of having a more robust financial plan in place have certainly been worth it, especially given the absolute mess that 2020 turned out to be.
2. We value our children's educations
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A few years ago, we relocated to a much higher cost of living part of the country for work . We knew going into the move that our costs would go up, and we thought we had a plan to make it work out. We had a plan, that is, until we learned that our house wasn't in the top ranked school system we thought it would be in but rather was in a different, far less solid system in the same town .
Because we value our children's educations, we ended up pulling them from the public school and enrolling them in a private one. That came at a significant cost upper, on top of the expected cost upper that came from moving to that higher cost of living part of the country. Unfortunately, that turned out to be more than we could cash flow from salary.
We made it work thanks to stopping my contributions to my 401k, a scholarship from the school, help from family, and tapping employer dividends from my retirement account. That last move exposed the money to immediate taxation at ordinary income rates, but because the dividends were considered ESOP dividends, we avoided the 10% penalty on early withdrawals .
Were we in the same situation today, it wouldn't be quite so costly from a tax perspective. The Tax Cuts and Jobs Act now allows 529 plan money to be used to cover elementary and secondary school tuitions. As a result, tapping that savings would help us close that gap without quite the same tax bite.
3. Pay now or pay more later
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Once it became available to me, I shifted from contributing to a Traditional 401k to a Roth 401k. By making that shift, I lost the immediate tax deduction on the money I was contributing, which raised our immediate taxes. What we gained, however, was the ability to tap that money tax free in retirement, which can be a huge advantage over Traditional 401k plans when it comes to having money available to spend.
In addition to the income taxes directly linked with Traditional 401k withdrawals, those withdrawals can add other costs and taxes as well. If your income is high enough, up to 85% of your Social Security benefits can be taxed . In addition, if your income is high enough, it will drastically increase your monthly Medicare Part B premiums .
Money you withdraw from your Traditional retirement plans is nearly always considered taxable income that can trigger those increased taxes and charges. Once you reach age 72, you must start withdrawing money from those accounts even if you don't need it to spend. As a result, those mandatory distributions may trigger those additional taxes and charges, regardless of whether you need to spend the money.
Switching to a Roth 401k reduces that risk, since money in a Roth 401k can be rolled directly into a Roth IRA with no immediate tax consequences . Once inside your Roth IRA, it no longer is subject to those mandatory distributions within your lifetime . Plus, once you've "qualified" to take the money tax free, any withdrawals you make from that Roth IRA are tax free .
4. Once bitten, twice shy
Last March, I faced a nasty margin call in the account where I do my options investing. One of the key lessons I learned from that experience was that I should get better at closing my options positions when they get close to their maximum potential profit. After all, at that point, the downside risk is often substantially larger than any remaining possible gain. It's better to actually get almost all your possible profit early than to wait and face the risk of those profits evaporating entirely or turning into losses.
The potential upside of that strategy shift is that it may help make that account more resilient to wild market swings in the future. The downside is that it means more trading, more churn, and faster exposure to taxes. It also could mean more in taxes if more of those positions end in profit instead of converting to losses due to the market's swings. Still, I'd rather be in the position of paying tax on a profit than consoling myself with the potential tax deduction that comes with a loss.
Understand and manage the trade-offs you face with your taxes
In most cases, seeking to legally minimize the taxes you pay is a great way to get and keep more of your money working for you. As these four reasons show, however, there are times when it makes sense to pay a little more in taxes in order to serve a more important financial goal in your life. As you're building your household financial plan for 2021 and beyond, recognize that those trade-offs exist and ask yourself which priorities matter most for you.
In those cases where paying more in tax helps you achieve something that's more important to you, it's OK to bite the bullet and pay the tax. Ultimately, maximizing the value you get from your money depends on both how much of it you keep and how you use it. Find the right balance between the two for yourself, and you'll be in a better spot than if you just focus on keeping your taxes down.
