Everyone wants to keep more of their hard-earned money, but too often, the focus is only on reducing this year’s taxes. The reality is, the real strategy should be about lowering your lifetime effective tax rate (LETR), which can make a much more significant difference over time.
Your goal should be to minimize your lifetime effective tax rate while maximizing your income.
Here’s what you need to know, along with eight strategies to reduce it:
What Is Lifetime Effective Tax Rate (LETR)?
Your LETR is calculated by dividing the total taxes you pay throughout your life by your total lifetime income. This gives you an overall perspective on your tax burden, helping you understand the true cost taxes have on your wealth-building journey.
Why is this important?
Knowing your LETR allows you to make informed financial decisions, guiding both your planning and tax strategies. Too often, people focus solely on reducing this year’s taxes, but focusing on your lifetime tax strategy is much more effective in the long run.
An Example
Let’s say you earn $5 million over your lifetime and pay $1.5 million in taxes. Your LETR would be 30%, meaning 30% of your income went to taxes—a significant amount.
So, how can you lower it?
Here are eight strategies to help you reduce your lifetime tax rate:
1. Maximize Retirement Contributions
Contributing to tax-advantaged accounts like 401(k)s, IRAs, and Roth IRAs can significantly reduce your taxable income. These accounts either offer tax deferral (reducing your taxable income) or tax-free growth (reducing future taxes).
Choosing between a Roth or traditional account can have a major impact on your lifetime tax strategy. Deferring taxes at higher rates and withdrawing at lower rates is a powerful way to reduce taxes. Alternatively, paying taxes at lower rates now so you never pay again is another great strategy.
2. Do Roth Conversions
Roth conversions align well with maximizing retirement contributions. In early retirement, before required minimum distributions (RMDs) and Social Security kick in, many individuals have a great opportunity to convert funds from pre-tax to post-tax accounts at a lower rate.
For example, if you can defer taxes at 37% and convert them through a 24% bracket with an average rate of 20%, you can significantly lower your lifetime tax rate. However, be sure to plan for those taxes as you will need to pay them in cash or risk incurring a penalty.
3. Optimize Your Investment Strategy
Investing in tax-efficient assets like ETFs and municipal bonds can reduce your lifetime tax bill. Tax-loss harvesting—offsetting gains with losses—is another useful strategy. Direct indexing can also be beneficial in this area.
Additionally, focus on proper asset location by placing the right investments in the right accounts for optimal tax efficiency. For example, bonds in pre-tax accounts, high-growth assets in Roth accounts, and tax-efficient assets in taxable accounts.
4. Leverage Tax-Deferred Accounts
Health Savings Accounts (HSAs) and 529 college savings plans offer excellent tax advantages. Contributions to these accounts are often tax-deductible, and withdrawals for qualified expenses are tax-free. The best part? No capital gains taxes.
For high-income earners, paying capital gains taxes on a large investment can be costly. By using HSAs or 529 plans, you avoid these taxes while saving for medical expenses or college education.
5. Charitable Contributions
Donating to charity is not only a great way to give back but can also provide significant tax deductions. However, many people don’t donate in the most tax-efficient manner.
One strategy is donating appreciated assets through a donor-advised fund, which allows you to avoid capital gains taxes while receiving a deduction for the full value of the donation. Another idea is to concentrate charitable contributions into one year to exceed the standard deduction, maximizing your tax benefits.
6. Real Estate Planning
Using strategies such as gifting, setting up trusts, and charitable donations can help reduce estate taxes. Proper estate planning ensures that more of your wealth is passed on to your heirs, rather than going to taxes. After all, no one wants to pay the 40% estate tax if they don’t have to.
7. Own Real Estate
Real estate comes with a variety of tax benefits, such as depreciation, cost segregation studies, and 1031 exchanges. These strategies help reduce taxes over time, especially when it comes to offsetting active income or benefiting from capital gains exclusion on your primary residence.
Owning real estate can be an effective way to lower your lifetime tax liability.
8. Own a Business
Owning a business provides numerous tax advantages compared to being a W-2 employee. Through strategies like Qualified Small Business Stock (QSBS), the Qualified Business Income Deduction (QBID), and self-employment taxes, business owners have more opportunities for tax planning.
By taking advantage of these options, you can save significantly more on taxes compared to employees who don’t have these benefits.
Remember:
Every dollar saved in taxes is a dollar that can be reinvested, spent, or saved for the future. Start planning today to optimize your lifetime tax strategy and think long-term.
