Savings & Spending Tips
Reducing Taxes
Regardless of your age or where you are in the financial lifecycle, always look for opportunities to avoid or reduce income taxes. A key part of successful cash management is determining — in advance — the tax implications of all your financial activities.
This might involve:
- Consolidating deductions into one year rather than taking them over two years
- Spreading income over several years rather than taking it all in one year
- Waiting a few months to sell an asset in order to take advantage of lower long-term capital gains rates
- Borrowing against the equity of your home to purchase a car, for example, to generate interest payments that are deductible
Marginal tax brackets
Do you know what marginal tax bracket you're in? Take a look at how you file (Single, Joint, or Head of Household) and determine your taxable income (not your gross income). Then refer to the chart below:
You don't need to be earning a tremendous sum of money before you're in the higher 25% (or more) federal tax bracket. For instance, if you filed taxes as a single person, the first $6,000 of your taxable income was taxed at the rate of 10%. The taxable income between $6,000 and $27,050 is taxed at 15%. Each additional dollar was taxed at the rate of 25% or more, so your federal tax rate almost doubled! (If you were married and filed taxes jointly, the break point for you was $45,200.) And don't forget to add state income tax on top of your federal income tax.
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Tax Planning Tip |
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It's important to be aware of what taxes are doing to your income.
Example: You're in the combined 32% tax bracket (25% federal plus 7% state), and you have a certificate of deposit paying 3.0%. Your after-tax return is only 2.0% (3% less 33% = 2.0%). The other 1.0% is being taken out in the form of taxes.
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Before-Tax Return |
After-Tax Return |
| Certificate of Deposit |
3.0% |
2.0% |
Don't look at what you're getting paid — look at what you're getting to keep! |
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Take the Investment Strategies Course to learn how to maximize your investments and minimize taxes.
Tax-deferred plans
If you're in the 32% combined federal and state tax bracket, each $100 that you contribute to your employer's tax-deferred plan saves you 32% or $32 on your tax bills. This means that you're putting away $100 which will grow tax-deferred for your future, and it's really only costing you $68 after taxes!
If your combined federal and state marginal tax bracket is 32%, a $1,000 contribution reduces taxable income and saves approximately $320 in taxes. Refer to the Investment Strategies Course for more information.
One objection to tax-deferred growth is that distributions are eventually subject to income taxes when withdrawn, and marginal tax rates frequently may be just as high during retirement as during the accumulation phase. However, tax-deferred growth may still accumulate more for retirement.
It's important to be aware of what taxes are doing to your income.
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Example |
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Ms. Gotrocks has $100,000 accumulated in her tax-deferred plan at age 62, when she retires. Ms. Lessing, using the exact investment plan as Ms. Gotrocks but in a taxable account only has about $70,000 at age 62 because her investments have been eroded all along by income taxes. Both retirees invest their lump sums in conservative portfolios that earn 6% each year during retirement. Distributions on both are taxable.
| $100,000 at 6% |
$6,000/year before tax |
$3,960/year after tax* |
| $ 70,000 at 6% |
$4,200/year before tax |
$2,772/year after tax* |
| * Assumes 32% combined federal and state marginal income tax brackets |
In contributing to your employer's tax-qualified plan, you are also practicing one of the most important habits of sound financial planning, which is to Pay Yourself First!
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Take advantage of tax deductions and credits
Many tax advisors will suggest that you may be able to reduce your taxes by itemizing your deductions, rather than taking standard deductions. For example, your joint income may have been $48,000 in 2003, but by itemizing your mortgage interest, property taxes and charitable contributions you may have reduced your taxable income below the $45,200 mark, which would have lowered your marginal federal tax bracket from 25% to 15%.
Finally, take advantage of any deductions and tax credits that may be available to you. Deductions will reduce your taxable income. This, in turn, reduces the amount of taxes you pay depending on your tax bracket. Tax credits are taken after your taxable income is computed, and represent a dollar-for-dollar reduction of taxes you pay.
For more information on these tax savings ideas, please consult your personal tax preparer.
Tax-advantaged investment strategies
Another way to save money in taxes, is to invest using tax-advantaged strategies. To learn more about these strategies please refer to the Investment Strategies Course.
Municipal bonds
- A bond issued by a state, state agency or authority, or a political subdivision (county, city, town).
- Interest is exempt from federal income taxes and from state income taxes within the state of issue
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| Taxable account/investment |
3.0% |
2.0%* |
| Municipal bond |
3.0% |
3.0% |
| * Assumes 32% combined federal and state marginal income tax brackets |
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Don't compare what you're getting paid; compare what you get to keep after taxes!
For more information on municipal bonds, see the Investment Types Course.
Education funding plans
There are several ways to save money for education on a tax-preferred basis, including:
- Custodial accounts
- Coverdell education savings accounts
- 529 plans
How much do you need to save for your child's education? What will be the cost of your child's education in five years? In ten years?
 Find answers to these important questions by creating a personalized Education Funding Report.
For more information about these and other types of investments, see the Investment Strategies Course.
IRAs
Some Individual Retirement Accounts (IRAs) grow tax deferred* or they may provide an initial tax break through deductible contributions. The traditional IRA is the most familiar type, but a Roth IRA may provide an attractive option for you if your income exceeds the limits for opening a traditional, tax-deductible IRA.
* Income taxes are payable upon withdrawal. Federal withdrawal restrictions and tax penalties may apply to early withdrawals.
For more information on IRAs, see the Investment Strategies Course.
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