Now that most folks are recovering from tax time there may be some individuals that paid an excessive amount of tax to Uncle Sam and are looking for ways to reduce their tax liability for next year. This post will be short and sweet, but hopefully it will drive a few points home.
The best way to explain this is through an example. Let’s say that Mary and her husband Paul both work and file their taxes jointly. Their tax liability for 2013 was $4,000 – meaning that’s the amount of the check they wrote to the IRS. Needless to say, they are both looking for a potential way to reduce that liability – at least in the here and now. In this case, their marginal tax rate is 25%.
The quick trick in this example is to take their tax rate which is 25% and divide it into their tax liability of $4,000. In this case it turns out to be $16,000. This magic number of $16,000 is what Mary or Paul or both of them combined could contribute to their pre-tax retirement plan such as a 401(k), 403(b), 457, etc. All else being equal, this significantly reduces their tax liability for 2014. The reason why is that the money deferred to their retirement accounts is taken from their paychecks before taxes are taken out, thus they have less money to take home that’s subject to taxation. And in this case – they’re paying themselves first!
Granted, they will eventually have to eventually pay tax on the amounts in their retirement plans, but what they are doing now is reducing their tax liability in the present, and paying for it later. This may work out for the both of them as their tax rate in the future may be lower than their current 25%. It could also work against them if their tax liability happens to be higher when they start taking money from their accounts.
This situation may apply to some folks reading this article. If it does and you have question feel free to contact us, or any competent financial professional.