Basing our practice in a large metro area, once in a while we get inquiries from young people who are considering financial planning for the first time because they feel like they are paying too much tax. They are usually a married couple living in a rental apartment, both employed with relatively high income, and have no children. Together they can be paying 30-40% of their income to different governments and agencies – federal, state, local, social security and Medicare.
This is why it’s exciting for me to hear another financial professional addressing this issue on his podcast this week, coming from an angle similar to mine. He explained how tax planning eventually is about lifestyle planning. You need to know what your mission and purpose is in this world so you can plan your life and career around them. The rest is just tactics.
I will take one step further and say that the overall goal of tax planning is really making sure you can live the life you want, now (from your expenses) and in the future (from your savings), with your “after tax” income.
We often think of tax as a bad thing. The less we have to pay, the better. Even the self-proclaimed socialists will try to reduce their own tax liabilities, while supporting a tax code that expends more government revenue for social services. It’s a totally prudent thing to do for your self-interest.
Nevertheless, we must recognize that tax in itself is not bad, as far as your personal finance is concerned. It is simply a given, whether you agree with it or not. Utilized properly, the taxes that you paid come back as benefits- military, roads, parks, schools, social safety net, etc., and all these benefits create the society that you live in. You may have a different idea of what type of society you want to be part of, and it’s up to you to change it through legal and democratic means. Before that happens, you are bound by your citizen’s duty to pay taxes. Whatever is left is yours.
So eventually, “how do I reduce my taxes?” is not the right question to ask. The real question is “how do I structure my life and career in a way that fulfills my purpose and also maximize my after-tax income?”
Let’s say you, a couple, make $500,000 in salary a year and have to pay 50% in taxes, you still have $250,000 left. If you think $250,000 is not enough to support your lifestyle, you either change your lifestyle, change the way you make money, or try to make more money in the same job. There is no magic trick to help you suddenly reduce your tax liability from $250,000 to $100,000 after the fact. Going forward, however, you may want to consider other scenarios:
Scenario 1: You both love your jobs and want to stay in them. Your lives are going exactly the way you envisioned, and you don’t want to become self-employed. In this case the tax comes with your high salary and not taking entrepreneurial risk. The only way to change the tax is through a change of tax code, or to lower your “salary” in the form of negotiating employer fringe benefits in lieu of taxable income. (Joshua discussed this extensively in the episode.)
Scenario 2: One of you hates his/her job and always wanted to quit to become a full-time parent. You decided that you really only need $150,000 to support your ideal current and future lifestyle anyway. You may be able to drop one income, lower your effective tax rate to 35%, and still have $162,500 to spend or save.
Scenario 3: Both of you are indifferent toward your current jobs, but have always wanted to live on a farm. One of you is able to negotiate a telecommuting arrangement with 25% reduction in salary. You move to another state with no state income tax and start a farm. Now your income is only $187,500, but with a 25% effective tax rate, you end up with $140,625, meaning the farm only needs to generate $10,000 after-tax income to cover your ideal life style.
Of course, there are many more possible scenarios. The idea is that life planning precedes financial planning, which includes tax planning. Tax planning is really finding ways to maximize the pie for you to live the ideal life, and other financial planning steps tell you how to distribute the pie. Either way, you need to know what is important to you, what kind of life you want to live, and willing to move toward it. If you have planned for it beforehand, even when you get taxed at 85% while you made a million, you still have $150,000 to live the way you want. If being taxed more deters you from making more money, it just means that the energy and time you put in is not worth the extra pay, and maybe you should pursue something else. Many parents made the decision to stay at home with their children because of this. Whether this is good for our society as a whole is up for debate, but you make personal finance decision based on what is of your best interest.
So if you still think it’s not fair that you are paying more taxes than your neighbor, take a political action, or take a look at your life – you may come up with meaningful changes that not only lower your tax liabilities, but result in a happier future.