Around tax time, it can be surprising to see how much you pay in taxes each year. It could be because you focused on the after-tax amount deposited in your bank account or its not until you pull all your information together at the end of the year that you see the total amount of taxes due.
This begs the question, are taxes your biggest lifetime expense? The answer is…it depends. For this article we will share some data around how much people pay in taxes, what some of the key determinants are and a high-level strategy to reduce your lifetime tax bill.
First let’s look at some numbers.
A recent study estimated that the average American pays around $480,000 in taxes over their lifetime. For some Americans it is much more than that while for some it is much less. This number includes income taxes, property taxes, sales taxes and vehicle taxes.
However, according to the IRS, in 2020 the top 1% of taxpayers paid $456,000 on average in federal income taxes for the year!
This brings us to the first factor that can influence how much you pay in taxes, which is how much you make.
Lifetime Tax Factor #1: How Much You Make
In America, we have a progressive tax system, meaning higher earners pay higher rates. Thus, those with the highest income pay higher rates on a higher income resulting in a larger tax bill. As you see in the chart below, the top 1% of tax payers pay a 26% tax rate on average while the bottom 50% pay a 3% tax rate on average.
Source: Tax Foundation
While we typically wouldn’t recommend attempting to earn less just so you can pay less in taxes, it certainly will reduce your tax bill.
Lifetime Tax Factor #2: Where You Life
A second factor that can influence how much you pay in taxes is where you live. How much you pay in property taxes, state income tax, local income tax and sales tax are all location specific. State income tax rates range from 0% in Texas to 13.3% in California’s highest bracket, while states sales taxes are 0% in five states and reach 9.55% in Tennessee.
Source: Tax Foundation
According to the study referenced earlier, the most expensive tax states to live in are New Jersey, Connecticut, and New York, while the cheapest tax states to live in are Alabama, Tennessee, and Montana (source: self.com).
While the local tax rates may not be the first thing you consider when looking for a place to live, they may be worth considering as you consider your overall cost of living.
Lifetime Tax Factor #3: How You Earn Your Money
A third factor in how much you pay in taxes is how you earn your income. For starters, ordinary income (such as wages or interest on bonds) is taxed at higher rates than long-term capital gains and qualified dividends (such as the sale of investments held over one year). As you can see from the tax brackets below. The marginal tax rate for someone at $100,000 of taxable income is 22% (for married filing jointly) compared to 15% for long-term capital gains. The difference is especially pronounced at lower income levels (10% vs. 0%) and for the highest earners (37% vs. 20%).
Source: fpPathfinder; It is important to note that higher earners can be subject to a net interest income tax of 3.8% that applies to capital gains along with dividend and interest payments.
Thus, those who are able to generate income through long-term capital gains may pay significantly less taxes than those who generate income through ordinary income.
Now back to the question – are taxes your biggest lifetime expense?
To get a better idea, we can look at Consumer Expenditure Surveys produced by the Bureau of Labor Statistics. According to the data from 2021, it looks like housing is the biggest expense for Americans on average. However, when we break down these numbers by income level, we see that for top 20% of earners, taxes are their largest expense.
Source: Bureau of Labor Statistics, Consumer Expenditure Surveys (2021); Author’s calculations; Taxes category does not include property taxes and sales taxes
One Approach to Reduce Your Lifetime Tax Bill
Over your lifetime, it is likely that you will be paying different tax rates over time. This could be because your income changes. It also could be due to tax rates change. While the future is not knowable, you can take an educated guess about what your tax rate is now and what it will be in the future. Based on this, it can be advantageous to pull forward or delay income along with advancing or deferring deductions.
More specifically, you may look to reduce income or accelerate deductions during high income years. On the other hand, you may look to accelerate income or defer deductions during low income years. Let’s look at a few examples:
The years before you retire may be some of your highest earning years in your career, placing you in a high income tax bracket. Once you retire, your taxable income may drop dramatically. Particularly if you have not yet turned on social security, are not taking required minimum distributions from your retirement accounts, and do not have any pension income. During the years leading up to retirement, it may make sense to maximize contributions to tax-advantaged accounts such as your 401(k) and HSA account, along with making larger charitable contributions. These steps may lower your taxable income during years when you are in a high tax bracket. In the initial years of retirement, you may do Roth conversions or recognize capital gains since you may be in low tax brackets during these years. These strategies may allow this income to be taxed at lower rates.
During a business sale, you may be realizing significant capital gains resulting in a large tax bill. However, there may be some options to lower the overall taxes paid from this transaction. One option may be to utilize an installment method for the sale to spread the capital gains over multiple years. Another potential strategy is to make large charitable contributions during the year of the sale, potentially offsetting some of the capital gains. Additionally, you could also potentially realize any capital losses you have in your portfolio to offset these gains as well.
Stock Option Sabbatical
Let’s consider a scenario where you have stock options at work and are about step away from your job to take a couple years off. During this time you will likely be going from earning high wages at your job to having limited earnings during your time off. As you look to exercise your stock options before they expire, there are some options to consider to lower your tax burden. In terms of the timing of exercising your options, you may look to exercise them in a year when your income is lower. That could mean waiting until January to leave your job and then exercising the options in a year where your income from wages is lower. You may also consider doing a large one-time contribution to a donor-advised fund during the year you exercise your options, front-loading your charitable contributions. This may allow you to offset the income generated from your option exercise with charitable deductions.
In these circumstances, it is important to consider your overall financial picture and seek the guidance of a tax professional.
For high earners, taxes will likely be one of your largest lifetime expenses. Through proactive tax planning, you may be able to significantly lower your lifetime tax bill. One way accomplish this goal could be to shift income to different years depending on your expected tax rate. If you would like to talk with a financial planner about how you may be able to lower your lifetime tax bill, please schedule a call with us here.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.
Advisory services offered through Financial Life Management, LLC – Doing Business As – SummitView Advisors, a Michigan registered investment adviser. The adviser may not transact business in states where it is not appropriately registered, excluded or exempted from registration. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment advisory services. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.