Since most financial laws are made by the rich for the benefit of the rich, it’s no wonder you are left out when it comes to tax benefits, unless you’re rich (i.e., net worth $10+ million).
Even Charles Koch, Republican Billionaire and fossil fuels magnate says the System is 'rigged' in favor of wealthy.
Are there ways for you also to legally pay less tax?
Your Accountant’s True Expertise
You think that your accountant will do everything possible to help you pay less tax. He may in fact do that by taking advantage of every tax rule when filling out your federal tax return and state tax return. In other words, he is an expert at putting the right numbers in the right boxes but this will not generate savings.
Here is an example of your tax preparer’s expertise:
You come to him with a box of papers. He sorts them into piles and organizes them by tax category and enters the total for each category on your tax return. He then can make such expert decisions as:
- should you itemize your deductions or take the standard deduction to pay less?
- given this year’s IRS limits, can he deduct any part of your long-term
care insurance premium?
- given the facts about your children, do any of them qualify as an exemption
on your tax return to pay less taxes?
- are the federal tax rules different from state tax rules regarding any item on your tax return?
Your accountant is an expert in tax return rules but not the IRS tax code. Therefore, he has the ability to report your taxes properly (i.e. fill in your return) but not to prepare a multi-year savings plan to help you reduce taxes in major ways.
Your Accountant’s Limitations to Help You Pay Less Tax
Note that even if he had memorized the IRS code, he would still need to be creative or have the ability to do tax planning. Saving big money requires a lot more than knowing the rules. To report less income on your tax return requires not merely information (what your accountant has) but also insight.
Nowhere in the IRS tax code will you find the 2nd sentence that follows: “If you borrow money against your house to buy tax-free bonds, the interest will not be tax deductible. However, there are a few ways to structure this transaction so that you have your cake and eat it, too!”
The dismal news: your accountant has not memorized the IRS tax code, he is not creative and does not offer insight.
In addition, because you are price sensitive, you seek out the lowest-cost accountant to do your taxes.
It is precisely these low-cost providers who have the least knowledge about helping you pay less tax. Tax advisors are not commodities—those who charge a lot usually deliver far more value in helping to reduce your taxes.
Rather than just place the numbers in the correct boxes on your tax return, the better tax advisors also provide tax planning advice so that you save taxes year after year.
The most powerful methods for reducing taxes are not in actions that your average accountant can take. There are five reasons for this.
- By the time you see your accountant in March, the previous year is long gone. Anything you could have planned and done to reduce your taxes has already been missed. Actions to pay less tax for any calendar year must be taken in that same calendar year.
- Accountants are focused on the past and not the future. Given the importance of taking actions before the end of the calendar year, you would think that your accountant would meet with you every year in the months of November or December when you still have a chance to pay less tax. Has he ever done that?
Interestingly, in doing so, accountants would significantly increase their income.
Say he does taxes for 500 clients during tax season. He tells you to come for a two-hour meeting in the month of December. While he cannot promise to find any action that you can take to cut your taxes, if he does, the savings will likely be in the thousands of dollars. The meeting is a flat $300.
Not only is that okay with you, he would be $150,000 richer. I guess he is already too rich and doesn’t need the money. Or, he lacks creativity and the ability to see ways to increase his own income.
This is the person you rely on to pay less tax.
- Accountants generally have a short-term year-to-year focus. They tend to think tactically rather than strategically.
- Many accountants are unaware of investment or asset allocation strategies that reduce your taxes.
- Many accountants won’t give advice unless you ask. They have a personality disorder – a type of shyness or reticence to speak up if uninvited.
I know some accountants will be disturbed by my assessment. However, I am only reporting my observations from the last four decades of working as an accountant, financial advisor, and entrepreneur. My opinion is also supported by this article, “Revenge of the Nerds.”
This author has had a CPA license (inactive now) for 40 years and is hopefully qualified to speak about ways to cut taxes, ways to create savings and ways that your accountant does not help.
Overlooked Ways to Pay Less Tax
Ordering of Withdrawals to Pay Less Tax
Once you retire, it is vitally important which pot of your money you spend first. If you spend all of your post-tax money (money on which you’ve already paid tax) before you tap your pretax money (money on which you have not paid tax, such as IRAs, annuity interest, unrealized capital gains), you will save many thousands of dollars over your lifetime.
Here’s a hypothetical example of a person with two pots of money: $100,000 in post-tax money and $100,000 in pre-tax money. Spending the money in the wrong order results in an extra $150,000 in tax over their lifetime (see the column labelled “In 20 Years,” below). Unless your accountant is among the small percent who are also financial advisors, I would be surprised if your accountant mentions this strategy. As the table below shows, using your post of money in the right order can generate quite a bit more retirement income through tax savings.
|Spend Regular Money First|
|Today||In 20 Years|
|Spend Regular Money First|
|Spend IRA Money First|
Let me give you another example.
Reduce or Eliminate Tax on Social Security Income
Some people pay tax on their monthly Social Security income and others do not.
For example, by moving your money from growth mutual funds with high turnover to low turnover index funds, your tax bill will drop. Or by moving money from the bank to tax-free bonds, you will also experience a drop in taxes.
|Taxes and Social Security|
|Single||Married Filing Jointly||Taxable Social Security|
|$0 to $25,000||$0 to $32,000||0%|
|$25,001 to $34,000||$32,001 to $44,000||50%|
|Over $34,000||Over $44,000||85%|
Most accountants simply look at the rules in the above table and tell you how much tax you need to pay. Someone who thinks strategically determines how you can reduce or eliminate paying that tax. They guide you to take the best actions to keep money in your pocket.
For a very significant number of retirees, the ownership of tax-deferred annuities would reduce the amount of tax they pay on their monthly Social Security income. Look at the bottom line of the table below and you will see that the third column, which illustrates the use of a tax-deferred annuity for retirement savings, results in lower federal tax than either the purchase of tax-free bonds or certificates of deposit at the bank.
Interestingly, the portfolio that uses annuities rather than tax-free bonds pays less tax.
Interest from CDs
Fixed Annuity Interest
|Social Security Income||$20,000||$20,000||$20,000|
|Social Security Subject to Tax||$6,850||$6,850||$1,500|
|Adjusted Gross Income||$41,850||$31,850||$26,500|
|Total Federal Tax||$2,788||$1,345||$810|
Please don’t ask why that is. The federal tax laws (and state tax laws) make no sense, they just are. Your accountant’s job is to understand them well enough to give you tax advice that will significantly reduce your tax. Unfortunately, that only happens in a small percent of situations.
Your Accountant is Unlikely to be a Financial Advisor
Most accountants do not train as financial advisors, so they’re not familiar with many of the tax reduction strategies. Last time I checked, of 400,000 CPAs in the U.S., just 3,000+ had earned the PFS credential. This is the accountancy industry’s version of the CFP®. As stated on the website of the American Institute of CPAs, “A CPA/PFS is more than a financial planner—he or she is a CPA with the powerful combination of extensive tax expertise and comprehensive knowledge of financial planning.”
A CPA/CFP® combination is also good. These are CPAs who also took the time to study and prepare for the Certified Financial Planner™ exam. This indicates a good combination of tax savings and financial planning knowledge.
The better financial advisors tend to be more familiar with forward-looking ways to cut taxes.
For example, the average accountant can help you make a decision whether it is best to receive your pension as a lump sum or as lifetime monthly payments from your ex-employer. But his analysis is incomplete because he does not know the alternatives of how you can invest that lump sum. In some cases, you can receive more retirement income by taking the lump sum and buying a commercial annuity rather than accepting payments by the month from your ex-employer. Both can provide a payment for lifetime income.
Surprising as it may be, most financial advisors are not permitted to give you tax advice. All of the big firms, such as Merrill Lynch or Wells Fargo Advisors, explicitly prohibit their advisors from providing tax advice.
Of course, this is crazy from your vantage point. How can advisors explain and sell investments that impact your taxes without giving tax advice or guidance? The large firms do not want the liability of their advisors giving bad tax advice, as they already have the liability of their advisors giving bad investment advice.
I never said that the world was a sensible place.
Do You Bequest Your Traditional IRA or Roth IRA to Heirs?
Let’s consider another topic addressed by the editor of Kiplinger’s Retirement Report. The article discusses the advantages of leaving your heirs a Roth IRA versus a regular IRA.
The decision depends on your relative tax rates. If your heirs have a lower tax rate than you, leave them the taxable IRA. If your heirs have a higher tax rate than you, leave them the Roth IRA.
I doubt that most accountants would ever speak up about this or think about it unless you were sharp enough to ask. The analysis in Kiplinger’s is right on.
However, this question of whether to leave heirs a Roth or traditional IRA overlooks a much bigger benefit. If you intend to leave IRA assets to heirs, it is much better to drain the IRA and put the money into a life insurance policy. The heirs will get all of the proceeds tax-free and they will get far more than if you leave them the IRA balance.
Let’s look at a hypothetical scenario.
Mr. Jones, age 60, is in good financial shape. He doubts he will ever use his IRA, which has grown to $1 million from two rollovers from former employer retirement plans.
Because he is a subscriber to this blog, he makes a lot of smart financial decisions. He learned that, rather than leave the IRAs to his son, it’s a better idea to leave his son a life insurance policy. His son will get more money this way.
Not expecting to live more than 20 years, Mr. Jones asks his financial advisor to buy him a life insurance policy with a $40,000 annual premium. The payments will total $800,000 (20 years x $40,000).
However, in order to have $40,000 each year for the life insurance, Mr. Jones must withdraw $60,000 from his IRA. When Mr. Jones takes $60,000 annually from his IRA, he of course needs to pay income tax. On each annual $60,000 IRA withdrawal. He pays $20,000 and has $40,000 remaining for the life insurance premium.
Mr. Jones is quite confident that over 20 years, his IRA worth $1 million will continue to grow. He is therefore comfortable that his IRA can handle the withdrawals ($60,000 x 20 years).
Looking at life insurance prices at www.termland.com, he sees that he can get $7.637 million of life insurance from Cincinnati Life Insurance Company for an annual premium of $40,000.
Now let’s compare what his son gets if Mr. Jones leaves his IRA alone, growing at 5% annually, or if Mr. Jones uses the IRA to buy life insurance.
|Keep IRA||Buy Life Insurance>|
|Value today||$1 million||$7.637 million|
|Value in 20 years (at 5%)||$2.65 million||$7.637 million|
|Tax paid by son (33%)||$875,000||0|
|Net to Son||$1.75 million||$7.637 million|
I have made several simplifications to illustrate the idea. These simplifications are needed to keep this example to one page rather than five pages:
- We have ignored Mr. Jones’ requirement to take mandatory distributions after age 70 under the “keep IRA” scenario;
- We have assumed that Mr. Jones dies within 20 years (a more conservative strategy would be to buy permanent life insurance at a lower face value); and
- The son takes distributions from the IRA over his lifetime at a federal income tax rate of 33% and there is no growth in the inherited IRA.
- I have ignored state income tax
Note that as soon as Mr. Jones makes the first life insurance premium payment, he has the entire coverage of $7.637 million. So if he leaves the financial advisor’s office after making the first premium payment, gets hit by a bus and dies, his son gets the $7.6 million life insurance death benefit tax-free PLUS the balance in the IRA (less income tax).
This post is not about life insurance or tax on Social Security income or how to invest money. It is about paying less tax. And the fact is, you do not get the guidance you need for the tax savings due you.
I believe the concepts I have introduced above are easy to understand. These are neither advanced nor complex strategies. They are “common tax sense” for those who should know these things.
What Actions Can You Take to Pay Less Tax?
Since you likely do not know which questions to ask, the burden should not be on you to solicit advice from your accountant. Rather:
- Ask your rich friends or professionals to recommend a superior accountant. Explain that you seek someone who has a forward-looking mentality and can help you save more tax and thereby increase your net retirement income. Ask how this person has saved them taxes with unexpected advice.
- Look at the directory of accountants that hold the PFS credential.
- Look for a tax specialist that has the term “tax planning” or "tax guide" on their business card.
- Expect to pay two or three times what you have paid in the past to have your tax return prepared. But confirm with the professional you choose that he will provide any and all tax planning advice that he can glean as appropriate from your financial records.
Make sure to ASK
In addition to your income tax bill, there are other taxes to ask about such as can you decrease your property tax bill? Tips to decrease property tax include reductions or deferments for seniors (e.g. age 55 or 62), reductions when you move to specific counties in your state that offer abatements for seniors "trading down" and reductions for market conditions.
Also ask about personal property tax. Although personal property taxes are not common, some states use them. Your new accountant may have ways to reclassify the personal property or title it differently so that you no longer need to pay the tax.
You Pay More Taxes Than NecessaryAnd we guarantee your CPA has never told you The problem with paying taxes is that most people overpay. So if you are concerned about having enough in retirement, you must stop overpaying taxes. I know you think your CPA takes care of this for you. WRONG. I AM a CPA (retired) and I can tell you that 90% of CPAs do nothing more than enter your information into the little boxes on the tax return but NEVER tell you how to pay less next year. Why? Many of them simply do not know what we can show you. In ten minutes.
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