I’ll try to make this one as not boring as possible as for many, taxes can be a bit dry. Trust me on this one, understanding how taxes work, even on a high level over view, can increase your savings and accelerate your path to financial independence.
Today, we are going to go over taxable events. First of all, what does that even mean? Each dollar that you make has essentially 2 main events when it comes to taxation, when you earn it and when you spend it. Optimizing both sides of this story can give you massive financial benefit.
Let’s talk about the front end, when you earn. This is just referring to income tax, social security tax, and Medicare tax. For business owners it gets more complicated but for those of us on W-2 income, this is pretty much the meat of it. Now the first taxable event is when the government decides it is the right time to take those taxes from your earned income. Typically, that is just when you make it. When you receive your pay stub, or look into your paycheck details using whatever service your employer utilizes, you can see that the government has taken money out based on how much you plan on taking home.
Now how do we stop this from happening? Tax deferral. We can actually tell the government, “Hey I actually would rather you not tax this money right now.” This is what happens when you put your money in a traditional 401(k), IRA, or HSA. So by telling the government to not tax that money by putting it into one of those accounts, you can now decide (based on your future income situations) when you want the government to tax you.
For instance, you can put money into a traditional 401(k), wait a few years until you maybe lose a job, or (if your really smart) utilize capital loss harvesting, and convert that money into a Roth IRA. What this does is it tells the government when YOU want them tax you (during that conversion). By doing this you can tell the government to tax you during a year your taxable income is under the standard deduction and not have to pay taxes on it anyway.
Roth accounts don’t give you that flexibility with deciding when you want to pay taxes which is why I don’t personally use them. Although if you are a low-income earner and don’t have the time or interest to get into the weeds about conversions, it’s totally viable option.
Back-end taxation can be more complicated as it is much more diverse. There are ways that you can give yourself an advantage though. For instance, if you want to make charitable contributions, you can write off that money. This means that when you file your taxes, the government is basically retroactively pretending you never made those contributions to begin with, and therefore would return the money that they took from it in taxes.
Taxable events are game-changers in your savings goals. By understanding them and being able to control them through tax deferments, you are able to optimize your savings.
Thanks for reading!