Slash your tax bill with these exciting strategies (and a few boring ones)
Taxes are like heart disease: a silent killer. You’re chugging along, everything’s fine, and then… WAM! It hits you.
Despite being the second largest expense for most people—and the largest for high-income earners—taxes aren’t easy to see.
Because taxes don’t feel like an expense. Unlike your rent, insurance, or credit cards—which visibly drain your bank account—taxes are quietly withheld from paychecks. You never see the money leave your account because it was never there in the first place.
In other words: You paid the bill, but didn’t write the check. This makes taxes invisible. (Two exceptions are business owners and the self-employed. Both must pay quarterly estimates on their taxes. For them, writing four checks to the tax-man each year make taxes very visible.)
In this section, we’ll talk taxes. Specifically, how you can reduce your taxes now (during the contribution phase) rather than later (during the withdrawal phase, which we’ll cover in a later chapter).
We’ll review some incredibly fun ways to slash your tax bill—and yes, a few boring ones, too.
- Travel abroad (and save big) with the Foreign Earned Income Exclusion
- Move to a tax-friendly state
- Invest in state municipal bonds
- 401(k) accounts or 457 or 403(b)
- Individual Retirement Accounts (IRAs)
- Roth IRA
- Health Savings Account (HSA)
- Other tax-reduction strategies
Travel abroad (and save big) with the Foreign Earned Income Exclusion
As you know, I’m a big fan of working remotely.
In addition to higher pay, the ability to create assets that generate passive income, and the freedom to live wherever you wish, working remotely gives you the greatest, most exciting exemption of all: the Foreign Earned Income Exclusion.
The Foreign Earned Income Exclusion (FEIE) is a legal way to travel the world and reduce your expenses. Here’s how: if you’re a US resident, spend at least 330 out of any 365 days outside the US—and reduce your taxable income by $100k+ per person.
For example, let’s say you and your partner both work online, and make a combined $80,000 a year. Rather than stay at home, you decide to spend a year abroad.
During your travels, you:
- Go scuba diving in Cozumel, Mexico, then spend three months backpacking around Central America, renting monthly apartments in Antigua, Guatemala (where you take classes to brush up your Spanish) and San Juan del Sur, Nicaragua (to go surfing and enjoy the cool expat vibe).
- Fly down to Buenos Aires, and rent an apartment for three months.
- Head home (back in the US) for two weeks.
- Go backpacking in Southeast Asia for three months, enjoying Thai beaches, Cambodian ruins, and Vietnamese street food.
- Head home for another two weeks to catch up with friends and family.
- Spend two months traveling across India and trekking in Nepal.
In the itinerary above, you’ll have spent only 28 days on US soil (the two two-week trips home); congrats, you qualify for the Foreign Earned Income Exclusion!
So how much do you save?
During the time you and your partner are abroad, the FEIE is in effect. If each of you make $40,000 while abroad, or $80,000 combined, that reduces your federal tax to:
If you had stayed in the US you’d likely owe ~$6,000 in federal taxes. In other words, you just saved $500 a month—by exploring the world.
“Wait a minute…” you think. “Sure, I’ll save $500/mo on taxes. But I’ll still need to pay for all this travel! This will get expensive.”
But it’s not. It really, really isn’t. I know, because I’ve lived this exact lifestyle for several years.
To sweeten the deal, consider the following:
- You don’t need to travel so much. Renting a long-term apartment will further cut costs, and prevent burnout. Check out Nomad List for inspiration.
- You can save money just by moving. An apartment in Buenos Aires is cheaper than Boston. Your savings from the FEIE is the cherry on top.
- If you really want to save big, you can eliminate your housing costs with house-sitting, and your travel costs with frequent flyer miles. (This is how my wife and I did it for two years.)
- As you increase your income, you’ll enjoy the tax-breaks even more. In the above example, the couple earned $80,000 a year. Bump that income up to $200,000 a year and this strategy saves $24,000 a year—plenty to subsidize a year of global jet-setting.
Now, there are a few things to note about the Foreign Earned Income Exclusion:
- It only applies if you are outside the US for 330 out of 365 days.
- It doesn’t have to be in the same calendar year. For example, you can start your trip in July and return the following June.
- It only applies to federal tax. Even if you are out of the country all year, you will owe state tax. Unless, of course, you…
Move to a tax-friendly state
Moving to a tax-friendly state can speed up your road to financial freedom. But what states are best?
It depends on several factors: do you own property? How important is sales tax to you? Inheritance? We could go on. But instead, let’s keep things simple, and focus on the biggest tax for most people: income tax.
If you live in one of these states:
- New Jersey
- Washington, D.C
… consider moving to another state. For example, the following states currently have no income state tax:
- New Hampshire
- South Dakota
- Texas (note: Texas has an extremely high property tax)
Here’s a quick example: The average US household income is ~$62,000. A married couple, living in California, will pay ~$1,500 in state income tax per year. If that same couple moved to, say, Washington or Florida, they would save $1,500 a year in taxes.
|Annual income||Tax savings if you move|
And since state income tax is progressive—which means the more money you make, the higher percentage of taxes you’ll pay—you will benefit more as you increase your income.
To see how well this benefits high-income earners, let’s use the previous example, but double the income. So, now, the California couple earns $124,000. While their income doubled, their tax savings goes from $1,500 all the way to just over $8,000—more than a four-fold increase.
The chart below shows how powerful this strategy as you increase your income.
|Annual household income||Tax savings if you move|
The savings add up quickly. If you were to invest that extra $8,000 a year over ten years, and earned a 5% return (adjusted for inflation), you would have $118,685 at the end of ten years. Which, according to the 4% rule, gives you $4,747 a year in passive income for life (118,685*.04=4,747.). All from one move.
|Annual tax savings||Total after 10 years||Annual passive income (based on 4% rule)|
By now, the benefits should be clear. You can save thousands of dollars a year, which, if invested wisely, will provide you with a nice passive income down the road. Does this strategy work? Absolutely. Is it right for you? Maybe.
Before making the move, do the following:
- Estimate your savings. Because states tax you on a graduated scale—the more you earn, the higher a percentage you will pay—this strategy works better as your income increases. (See the chart above for examples.) For example, someone earning $70,000 a year in California will save around $3,000 in state tax; someone earning $140,000 will save closer to $10,000. In other words: your income doubles, but your state tax more than triples.
- Check the fine print. Each state has different rules. (I’ve included links to the most common states further down.)
- Make sure it’s worth it (and not just financially). You’re looking to move to another state, which means moving away from coworkers, friends, and family. Your kids (if you have them) will go to a new school. Don’t make a life change just to save a few bucks; take a gut check, think it over, and then decide.
Once you’ve determined this will work for you, it’s time to change your domicile state. (“Domicile” is a fancy term for “home state.”) This process is pretty straightforward.
You’ll need to:
- Get an address (which could be an apartment; you don’t need to buy a house).
- Update your driver’s license.
- Register to vote in the state.
If you want to go “full nomad”—and need an address for mail and proving residency, rather than a roof over your head—use a mail forwarding service like Escapees.com; they’ll provide you with a physical address (necessary to get a driver’s license). Plus, they open, scan, and email you digital copies of your mail.
Going into a state-by-state comparison is beyond the scope of this guide, so here are links to the top 4 states preferred by nomads (based on taxes and ease of gaining residence):
- Florida: http://www.dmvflorida.org/drivers-license-identification.shtml
- Nevada: http://www.dmvnv.com/realid.htm
- Texas: https://www.dps.texas.gov/DriverLicense/ApplyforLicense.htm
- South Dakota: https://dps.sd.gov/licensing/driver_licensing/obtain_a_license.aspx
Of the four states listed above—all of which have no state income tax—South Dakota is the simplest state to set up your domicile address. As of the time of writing, you only need to spend one night in South Dakota to qualify for a driver’s license, which is good for five years. It’s a nomad’s dream.
In summary, moving to a new state works well if you (i) currently live in a high-tax state (such as California or New York), (ii) are excited to move somewhere new, and (iii) are able to work remotely or find a similar paying job in your new state.
Remember: moving to another state is a big life-change, filled with paperwork, bureaucracy, and emotional baggage. Before taking the plunge, make sure this is right for you—both financially and emotionally. Then, when you’re ready, take the leap.
Don’t want to move to another state? Then consider the following option.
Invest in state municipal bonds
If you live in a high-tax state, invest in state municipal bonds to lower your state income tax burden. You’ll want to check with your financial planner regarding the numbers on this one, though.
For obvious reasons, this approach only applies to people who owe state tax. If you live in a state that doesn’t tax you, municipal bonds lose much of their appeal.
Reduce taxes—with retirement accounts
All retirement accounts share a common goal: reduce taxes. Some accounts—such as Traditional IRAs and 410(k) plans—reduce taxes now, while others—such as Roth IRAs—reduce taxes later.
Below, we’ll look at each type of account, and how each can reduce your taxes. (Please note: the following section summarizes your options at a high-level. We’ll cover how much to invest in each, and in what order, in the section on investment order. If you feel a bit overwhelmed as you go through these: skip it for now, and we’ll circle back to it in the investing section.)
401(k) accounts or 457 or 403(b)
A 401(k) account applies to employees of private, for-profit companies. There are similar plans for people who work in the public sector:
- 403(b) plans for nonprofit institutions
- 457(b) plans for governmental employers
No matter whom you work for, you can reduce your tax bill now by setting aside money from your paycheck into your retirement account.
For example, let’s say you make $60,000 a year. You contribute $20,000 to your 401(k) (or another relevant account). Now your taxable income is only $40,000. Since you don’t pay taxes on that $20,000—not until you withdraw the money, at least—you won’t pay the tax this year. The result? You’ll save about $4,400 (at a 22% federal tax rate) while your investments continue to grow. Not bad.
There is a limit to how you can contribute each year. You can see the current 401(k) maximum contribution here.
Individual Retirement Accounts (IRAs)
An Individual Retirement Account, or IRA, is similar to a 401(k). You put money away this year, and don’t pay taxes until you pull the money out. Pretty simple.
A Roth IRA is the opposite of the Traditional IRA mentioned above. With a Roth, you don’t get any tax savings this year, but all future growth and withdrawals are tax-free. That’s pretty cool.
Health Savings Account (HSA)
A Health Savings Account (HSA) is perhaps your best tax-saving vehicle: you invest with pre-tax money—similar to a 401(k) or IRA)—which grows tax-free, and can be pulled out tax-free. No other investment offers this hat-trick.
To qualify for a Health Savings Account, you must purchase a high-deductible health insurance plan. Then pay all your medical costs out of pocket; this allows you to keep your HSA fully funded at all times, so it continues to grow tax-free. Keep receipts of your medical expenses in case the tax-man comes knocking.
Other tax-reduction strategies
These are tax-deductible. Discuss your business over dinner; write the expenses off when you file your taxes. (Note: check with your financial advisor first.)
Tax-loss harvesting reduces your tax owed—on both gains and income—by claiming losses when you sell a stock. Currently, you can claim $3,000 in losses per year—and any losses in excess of $3,000 can be carried forward to future years.
For example, let’s say you invested $50,000 this year, which then dropped to down to $45,000. You now have $5,000 in unrealized losses. (“Unrealized” means you haven’t sold anything.)
If you decide to sell, you’ll “realize” a $5,000 loss. Since the current limit is ~$3,000 a year, you can reduce your taxable gains or income by $3,000 this year, and $2,000 the next year.
Pretty cool, eh?
One caveat: watch out for wash sales. A wash sale is a sale of a security at a loss and repurchase of the same or substantially identical security shortly before or after. You can read more about wash sales here.
Tax-gain harvesting allows you to increase your cost basis in an investment after one year of holding paper gain without paying federal capital gains tax on it.
It’s a common strategy to use when you’ve stopped working (i.e. stopped making as much money).