Tuesday, October 6, 2015

Am I paying too much in taxes?

I could be totally wrong on this but I've never been too worried about how much I pay in taxes and in fact feel a little encouraged in seeing my tax bill rising year over year.  I use it as a rough indicator to know that I am successful in making more money.  I know that this sounds ridiculous and don't intend to ignore tax efficiency forever but to me growing wealth and paying less in taxes seem to work against one another.

For example, tax incentives are very similar to coupons in how they tend to get us to spend money that we normally wouldn't have spent.  If you are holding a 20% off coupon and you go to the store and buy something for $100...sure you'll save $20 but you'll also be spending $80 that you would have never spent in the first place.  If you are serious about trying to grow your wealth you should only be spending money that you absolutely need to spend and resist spending money in order to "save" it.  Take for instance a tax credit to buy energy efficient appliances or automobiles...if you aren't in need of a new one of these you might be convinced to save money that never needed to be saved in the first place.

Another problem is that a lot of people use tax incentives as an excuse for getting into a certain investment or investment strategy and I think that this is a big mistake.  Investments need to stand on their own merits separate from any tax benefit that you may receive because if the investment turns out to be a bad one the tax savings will seem like a drop in the bucket when compared with all of the losses.  For example you might be convinced to buy a home that you cannot afford due to an incentive that allows you to put less money down.  Sure you are saving money by owning your own home but the truth is that you are now involved in an investment that is over your head and likely to cause problems further down the road.  A good investment should be long term, easy to understand, have low entry and exit costs and be highly liquid...these are requirements that I would not sacrifice for the sake of an incentive.

On the other hand, programs such as 401Ks, IRAs and 529s provide great incentives to simultaneously save while being tax efficient.  There are not too many downsides to programs like these and the only minor issue that I would be aware of is the liquidity cost.  These programs can have stiff penalties for early withdrawals so to avoid this issue I keep a portion of my investments in a taxable account at a discount brokerage that has no withdrawal restrictions.  So long as I make sure that my taxable investments are long term oriented I won't be suffering too much from tax disadvantages and I'll enjoy the benefit of having immediate access to my investment gains.  Remember not every great investment opportunity that comes along is going to come with a tax friendly wrapper.

Being smart about taxes is a great way to save money and I would tend to leave it at that.  Paying more taxes is a natural step in becoming wealthier so I wouldn't be overly focused on fighting tax increases as you may find yourself unintentionally fighting wealth increases as well.  Finally, remember to only use incentives that help you to spend less or save more and you'll be giving yourself an increased chance at becoming wealthy at some point in the future.