Tax Deductions

One way to maximize wealth is to minimize taxes through tax deductions. There are several techniques to minimizing taxes that are unique to each person. The purpose here is not to get into a political discussion about the good and bad parts of taxes but rather how to study the tax code to take the best advantage.

First, I want you to know that I am not a tax adviser. I have some experience with taxes and taking tax deductions that I have learned while working in the financial industry. Please make sure to consult a tax adviser before using any of these techniques.

Taxes are payments charged by the government to pay for certain programs that have been designed by congress and signed into law by the president or the governor of the state. There are a million different types of taxes and a million different programs that these taxes go to pay.

There are many different types of taxes. Sales tax is one example and is charged on almost every item you purchase. Another type of tax is personal income tax. This is the tax most of us are most familiar with because we all see it come out of our paychecks each month. But some other forms include corporate tax, capital gains tax and property tax.

Most of these taxes are pretty straight forward. The government simply imposes a set tax rate on the amount of money you make or on the value of the property and you pay that amount.

But income taxes are a little different. Income tax is a graduated system in which the more you make, the more you pay. So if you make $40,000 per years, you may pay 18% in income taxes (or $7,200) but if you make $140,000 you may pay 30% in taxes (or $42,000). It all depends on the tax bracket you fall into. Tax brackets are a complicated subject and won’t be covered here.

Sometimes, Congress enacts tax law that is designed to encourage or discourage certain behavior. Some might argue this is an attempt by government to control the behavior of the population, but the point is that this is, in effect, what the tax law does.

For example, when Congress enacts a large tax on the purchase of cigarettes, they are, in effect, discouraging people from smoking cigarettes. On the other hand, when Congress implements a tax credit (which is basically a tax rebate) on purchasing a solar energy system for your house, they are encouraging people to buy solar power. There are also a number of instances where the government offers tax deductions.

The difference between a tax credit and a tax deduction is that a tax credit is subtracted from the amount of tax you owe and a tax deduction is subtracted from the amount of taxable income you have. In other words, if you make $100,000 and owe the government $20,000, a $5,000 tax credit would be subtracted from the amount you owe ($20,000) and you would only end up paying $15,000. On the other hand, if you get a $5,000 tax deduction, you subtract $5,000 from the $100,000 in taxable income and you pay tax on only $95,000 which may be around $18,000.

So the way to take advantage of the tax code is to first figure out what is encouraged and what is discouraged by the tax laws and then attempt to do things that are encouraged and that will grow your wealth.

So what types of things are encouraged? Well, there are a number of things that are encouraged that can help you grow wealth. I won’t name them all here but I will try to go over some of the more popular ones.

First, home ownership is encouraged. The government gives people a large tax deduction of all interest paid on your primary residence. In other words, if you take out a mortgage to buy a house, and you pay $1,500 per month for the mortgage, and $1,300 is interest, you will get to deduct all 12 of those monthly interest payments from you taxable income. In this example, your interest for the year would be $15,600 so if you make $50,000 per year in income, you get to subtract $15,600 from that amount and only pay taxes on $34,400. That’s a pretty big tax break. And it’s also nice that a home is an appreciable asset that can grow your wealth.

Along these same lines, there are certain tax benefits to investing in rental properties that you can also take advantage of. These are much more complicated and depend a great deal on you personal situation so I will not go into detail here but if you have the means and are interested, talk to a tax professional about these benefits.

Another behavior the government encourages is starting a business. When you start a business, virtually every expense is deducted from your income for tax purposes.

So, for example, if you start a home business and you pay to advertise that business or you need a computer to run that business or a car to help you get from place to place in that business or you need to go on a trip to Tahiti to study how Tahitians run a similar business, you can deduct all of those expenses from you income for the year.

So if you are able to start a business, that requires you to own the things you want to own and travel to the places you want to travel, you may find that your lifestyle helps you to minimize taxes. (Please understand that the tax code can be complicated and there are limitations to what can be deducted so please consult a tax advisor before taking tax deductions.)

Another behavior that the government encourages is saving. They do this in the form of certain account types and investments that have tax advantages. IRA’s, 401ks, Roth IRA’s, SEP’s, Simples, 457s and 403bs are all retirement account types that have tax benefits. In many cases, money contributed to these plan types allows you to take a tax deduction of that amount.

In addition, you can save for a child’s education through Coverdell Education accounts or 529’s. There are also certain tax benefits to investing in some insurance products although make sure you consider the information on this site about insurance before using this as a technique.

Finally, there are certain investment types that have tax advantages. For example, if you buy a Municipal bond, you generally won’t pay federal tax on it. If you buy that bond from a municipality in your own state, you won’t pay state tax either.

When buying a stock, the capital gains on the sale of that stock may also be tax advantaged. There are also mutual funds that attempt to minimize taxes.

The government also discourages certain behaviors through taxes. For example, every time you buy something, there is a sales tax. This is another reason why the more depreciable assets you buy, the less wealth you will have. Maximizing wealth is done partly by minimizing taxes. Those who buy less items, pay less tax.

Avoiding tax can help to grow wealth. But it’s important to realize that the goal is maximize wealth, not minimize tax. My point is that there are times when it makes sense to pay a little more tax in order to get other benefits like liquidity, a higher rate of return or less risk. If you are paying zero taxes, you probably are not maximizing your wealth. But if you are paying a large percentage of your income in taxes, this is also bad. Return from Tax Deductions to Home Page