Tax planning can be counter-intuitive. Sometimes the way to have more money in the bank in the long haul is to pay more now, rather than later.
We each have a level of personal financial success set in our mind where we think we’ll start paying attention to our money—as soon as we get that raise or move into that new position.
But it’s never too early to start learning about money — and the earlier you start, the longer you’ll benefit.
Tax time may have just passed, but that means you have plenty of time to get on the bandwagon before next year’s deadline. So follow these four tax tips to help your money grow, and years down the road, you’ll be glad you did.
1. Don’t let the IRS become your forced savings plan; get your withholding right from the start.
There’s nothing redeeming about a huge tax refund because it means you’ve lost the opportunity to let that money earn interest. Better you target your withholding to a reasonable number that leaves a bit of wiggle room, take the extra money and save it somewhere else.
The more allowances you claim on Form W-4, the less your employer will withhold. Having kids, or owning a home and having itemized deductions from mortgage interest and property tax, can lead to more allowances (less tax withheld). Being married with two incomes, or also doing freelance work alongside your regular job, often means fewer allowances (more tax withheld).
If you’re able to free up some cash every month by adjusting your withholding, consider automatically depositing that directly from your checking account into an investment account with a mutual fund company or brokerage firm.
2. Maxing out your 401(k) is easy, but may not be best.
Consider that future gains on all those 401(k) deposits will be fully taxable when you retire. They’ll be taxed at “ordinary income” tax rates when you cash out, as opposed to the capital gains rates that apply to gains on investments sold in a taxable account.
The difference between those two rates, under some scenarios, can be big enough to eat away at the 401(k)’s tax advantage. It’s especially possible if you use tax-efficient investments like stock index funds and ETFs — and 2012’s low rates on capital gains and dividends get extended through your investing years.
Put away as much as you can to get your employer match but consider alternatives, like the one below, with the excess.
3. Prepay your taxes—kind of—with a Roth IRA.
Yup, managing your 401k contribution and setting up a Roth IRA means you’ll pay more taxes now. But realistically, you’ll probably be in a lower tax bracket now than when you’re in your 60s and 70s, right? If so, a Roth might be a smart choice.
4. Get a tax break for investment in equipment that is required for you to do your job.
Probably no other generation of workers is as focused on work-life balance, and that invariably leads to more telecommuting. If you’re self-employed, file your receipts and keep tax break in mind when selecting equipment. It might be more advantageous to buy that better laptop or desktop with the knowledge that some of that money will come off your tax return.
Tax planning can be a bit counter-intuitive, but sometimes the way to get more money in the bank is to pay more now, rather than later.
What tax planning questions can we help you with?
Bob is the Founder and President of Barry Capital Management, a fee-only Wealth Management firm located in Hackettstown, New Jersey.