The Top Tax-Saving Strategies to Use Throughout Your Life

No matter what life stage you’re in, taxes are generally your biggest expense. But taxation is also as insidious as a mosquito. A little bit is taken from many places, but sometimes it is insignificant and hard to fight.

There are so many ways an individual could be taxed, including income tax (federal, state, county, township, and residence), Social Security, Medicare, sales tax (federal, state, county, and city), real estate tax, real estate transfer tax (state, county, township), school tax, auto (licenses, tag, title, tolls), unemployment tax (federal and state), tangible and intangible tax, personal property tax, luxury tax, and more!

To attack this whole list would take a lifetime, so maybe start with the biggest bites. For most people, the biggest expense from the list would be federal and state income tax. Remember, it’s not what you make, it’s what you keep.

For those in accumulation mode, a few strategic moves, such as establishing the right accounts, can significantly triple your net worth over your lifetime and enable you to enjoy the benefits of financial freedom (i.e. spending your time how you wish without worrying about money).

Unfortunately, many of us don’t learn about each of the different types of money and how they’re taxed when we go through school. I went to an ivy league university, and it wasn’t even covered there.

The 4 Types of Money

1. Earned Income

Earned income (W2 or 1099) money is the worst because it is taxed at the highest rates. The more you make, the more the government takes, and they take it right away (i.e. they make your employer pay your taxes). This includes Social Security and Medicare tax from you at 7.6% and the same from your employer at 7.6%, plus federal income tax, state income tax, unemployment tax, and local income tax. Collectively, taxes can easily reach 40% of the income you and your employer pay if not more, and it can be a real deterrent and impediment to building and accumulating wealth.

2. Passive Income

Passive income (interest, rent, royalties, etc.) money is much like earned income but without the Social Security/Medicare tax of roughly 15%, thus a savings of 15%.

3. Tax Deferred

With tax deferred accounts (Traditional IRAs and 401Ks), you get a deduction from taxes when you establish the account and when you contribute to it. In addition to those benefits, everything you make in the account is not taxed as you are accumulating and building wealth. However, when you withdraw or distribute the money accumulated, you will pay income tax on every withdrawal at the rates established at the time of the withdrawal. You are also required to take withdrawals once you reach 72 years of age, needed or not.

4. Tax Free

When you contribute to a Roth IRA, Education Savings Account (ESA), or Health Savings Account (HSA), you don’t get a tax deduction starting out, except with the HSAs, however everything earned is not taxed while building or accumulating nor when it is withdrawn. I believe this is akin to “paying taxes on the seeds but not on the crops.” Money accumulated in a tax-free account is by far my favorite type of income. In addition, in the Roth IRA there are no required distributions when I reach 72 years old.

Of course, people may make money in one or all these four ways during their lifetime, starting from childhood.

After a child is born, the parents can open an Education Savings Account (ESA) or a Health Savings Account (HSA), which are both tax-advantaged accounts. The funds in these accounts can help the parent out and be beneficial for the child later in life.

As the child gets older and enters teenage years, he/she might begin working. If working for parents at home, there are no taxes. If working in his/her parents’ business, there may still be some payroll taxes.

However, there isn’t any federal tax until the individual is making over $12-13K in one year. When someone is below that range, it makes sense to utilize a tax-free account, because there is less tax paid on the money to begin with, and it isn’t taxed upon withdrawal.

As they get older, maybe they have student loans from college or they’re just starting out in their career (bringing in earned income), and it may still make sense to use a Roth IRA and HSA, primarily, while still in a lower tax bracket.

As time goes on, life events and other endeavors do offer tax deductions (see below).

7 Tax Avoidance Tools

1. Marital & Kids Deductions

Among other tax benefits, married couples with income disparity often enjoy a lower tax bill, they are permitted to make larger contributions to Health Savings Accounts (HSAs). Plus, and spouses can transfer property to each other without incurring a tax (both before or after death).

For parents, claiming their children as dependents when filing their taxes will enable them to receive a tax credit for each child.

I wouldn’t get married and have kids to save money and become wealthy, because it will end up costing way more, but if you’re going to do it anyway, take the deductions.

2. Mortgage Interest Deduction

The home mortgage interest deduction helps when you buy a home or rental property. However, the government has been chipping away at this deduction for decades and today is limited. Home Ownership and the $250K/$500k deduction when you sell your residence that you lived in for 2 years or more is significant and an excellent way to build wealth and minimize taxes for growing families.

3. Business Expenses Deduction

Owning your own business and paying employees has both advantages and disadvantages. Although you have more control over expenditures, it comes with more regulations. You can pay it forward by establishing tax-advantaged plans for the company and its employees and helping to fund them.

4. Depreciation and Bifurcation

The IRS allows investors to take a tax deduction based on the perceived decrease in the value of a property (i.e. depreciation). As a real estate owner, you can defer taxes through use of depreciation, however it must be paid back at the time of sale. It saves you money when you’re starting out in a deal, but you give it back later.

5. 1031 Exchanges

The 1031 Exchange is a strategy that enables the investor to exchange one investment property for one that is similar (i.e. “like-kind exchange”). 1031 Exchanges are much like depreciation as they save taxes when exchanging investment properties and defer gains taxes until later.

6. Life Insurance

Certain life insurance policies are good for using while you are living because of the tax-free status of borrowing from the policy when you are alive, and the remaining death benefit is tax free to your heirs. My biggest objection to this strategy is that to exit it tax free, you must die.

7. Tax-Advantaged Plans

My favorite is instead the tax-advantaged plans, such as the IRAs, 401ks, ESAs, HSAs, etc. that can be self-directed into asset classes I know and understand. The tax-deferred and tax-free plans provide wealth faster, as you are to use the tax savings to invest, thus growing your net worth. Basically, you are making interest on your taxes and not paying taxes on your interest. This is a reward from the government for saving for your health, education, and retirement. This encouragement is good for the individual, as well as the country.

These are all tax-avoidance tools to consider as you move through life, and one strategy is not the end-all-be-all choice for every individual.

But if you are no longer in accumulation mode and you’re starting to think about estate planning, remember that there are also tax-implications regarding inherited funds. Having the right type of accounts set up can make all the difference and save your beneficiaries money on taxes as well.

Lucy’s Story

Lucy is frugal, but she is on social security and has an old traditional 401K with $750k, which she is required to take mandatory contributions from, as she is 87 years old. She is taxed on each distribution. She has 3 children and 6 grandchildren, and all of them are very successful.

Unfortunately, Lucy then dies in 2019. The accounts were inherited by her 3 children, who were in their highest earning years, as well as the highest tax bracket. Of course, the children are also forced to take distributions based on IRS rules and regulations. These distributions are now taxed at the maximum rate possible.

Lucy could have converted some or all her account to a Roth IRA, at her meager tax rate, and not have had to take Required Minimum Distributions (RMDs). Plus, all the earnings would be tax-free to her while she was alive and then to her children or even to her grandchildren for decades to come after her passing. Making the grandchildren the beneficiaries would have lowered the taxes and prolonged the longevity of the inherited IRA.

As shown in the story above, having the right account type set up for your circumstances (and those of your beneficiaries), can make all the difference.

Regardless of what stage of life you’re in, are you utilizing tax avoidance tools to save money on your biggest expense? Are you building wealth by making money in all four ways?

I’m curious to learn everyone’s favorite tax-saving strategy. Share below!