Personal Guide to US Taxpayer -2

Strategies to pay less tax

By strategies, I mean various methods we can reduce the `taxable income’ part, meaning that we’d just pay less taxes. Rich people are good at this, so they keep more and pay less. Most of us commoners may not have room or leverage for tax strategies, but the older you get, you can make different strategies. The most common, and approachable `strategy’ is retirement contributions. I’ll elaborate on those, but for the other strategies, you can look up better books about them.

 

Retirement accounts are encouraged by the government, because it’s bad for a nation to have a bunch of poor old people, to put it bluntly. So they `encourage’ saving up for retirement with these tax cuts. Retirement accounts usually give you some tax benefit, but note that you can’t access the money until you’re 59.5 or older. I mean you can, but there’s a hefty penalty (~10%), and limitations.

 

401k

401k is a retirement account that you have with your employer. Usually it is automatically taken out of your paycheck, and most employers have a `match’ program, where they will give you some money when you contribute to a 401k. For example, my company matches the `first half of the 6% of your contribution’, meaning that they’ll add on 3% to my 401k account if I contribute more than 6% of my salary. Some companies do much more, like matching it completely, thereby doubling your 401k contribution. 

 

401k contributions are limited to $19,500 a year.  To clarify, this would just be the principle, and your total account balance may increase/decrease given what it is (stock, bond, etc.)

 

The good thing about 401k contributions is that it is pretax deduction. So if you make 50,000 and contribute 10,000 to a 401k that year, your income, before deductions, would be 40,000. This 40,000 would then go through the standard deductions and the tax function. But since taxes are, well, taxes, so you get taxed when you pull that out as an old person.

Individual Retirement Account (IRA)

Individual retirement accounts are accounts that are connected to you, not an employer. So even if you’re a student, or unemployed, you can make them. Notably, there are two types of IRAs - traditional and Roth. Regardless of the type, you can contribute up to 6,000 for your IRA account per year. This also changes year by year. The cap is also increased if you are 50 years old or older (`catchup’). The major difference between traditional and roth is when you get taxed (it’s like when the bully gives you an option of getting punched now vs after school). For traditional, you can deduct the contribution on the year you made the contribution (like 401k), but you pay taxes when you pull it out. For Roth, you can’t deduct it from your income, but you don’t pay taxes when you pull it out. 

 

Here’s a way to think about it. You put 1,000 in your traditional IRA. You can deduct the 1,000 from your income this year, but when you pull it out - probably a much bigger number since it gained interest / investment gain - you get taxed on that larger amount. So you’re basically trading the benefit now against your older self. But for ROTH IRAs, your 1,000 doesn’t get deducted, but when you pull it out - when it’s a bigger sum - you don’t get taxed on it. So technically you only paid tax for the 1,000, but much earlier.

 

Retirement accounts are sort of funny to think about, especially when we are so young. I blindly contribute to it because I believe they are important, and I don’t want to be a burden to my kids, if I end up having them. I mean, the worst that can happen is that I die and the money goes to a charity. But if you don’t invest in a retirement account, I don’t judge you for it. I don’t think it’s something people should be shamed for. We tend to associate being mature with having a longer-term plan, like a retirement account. However, some people can’t afford it, or some people just value the present pleasures more than future stability. You do you boo. To be honest, I feel like we may not even make it to 59.5, with the climate change, the viruses, and all the war. So retirement accounts increasingly feel more like a gamble. So do what you feel like doing. But there’s no harm in knowing, right? 

 

There’s also ways to access the money earlier than the age of 59.5, but I think it’d be best if you reference other materials on it (like Quit Like a Millionaire by Lueng and Shen), since I’m not an expert.

 

So all this talk about 401k and IRA got you all rallied up. Now it’s time to figure out what to do with them. To be clear, these accounts are just a label (and category, for tax purposes), what you do with the money (cash) in the account, is up to you. Also, you can just invest your money without these labels, you just wouldn’t get these tax benefits (i.e., you’ll just pay taxes on your gains). You can put it in savings and earn interest, or you can invest it in.. whatever! Let’s explore.