How Your Lifetime Effective Tax Rate Shapes Your Wealth
There’s a fundamental tax concept that many people never quite catch on to that could end up costing you millions in your life and (unfortunately) your death.
Lifetime Effective Tax Rate: the total tax you pay in your entire life divided by the total income you ever earn.
To best explain this, let’s look at a scenario.
Someone works most of their life and ends up with a substantial net worth. But it doesn't all happen at once—it takes time:
- Grow up
- Go off to college
- Work their first job
- Go to business school (zero income!)
- Back to work
- Start a family
- Start making good money (start paying tax)
- Make great money (pay lots of tax)
- Retire
- Turn 73
One of the first things you should notice is that this person doesn’t start making the big bucks until step 7. And they don’t pay major taxes (30% + effective tax rate) until step 8.
This shows that their highest earning working income years are concentrated within a narrow ~20 year span of their lifetime.
The great Michael Kitces created a great chart illustrating this process:
You start paying taxes the day you are born, and you pay them until the day you die via the estate tax (if you have a gross estate larger than 13.99MM).
It’s important that long-term tax planning begins ASAP and is important over your entire life and death.
This may sound crazy, but childhood is a planning opportunity for high-earning business owners. Remember, you’re able to hire your kids—and it’s not just a tax write-off opportunity. Working kids can set up a Roth IRA as they have earned income. As a bonus, they can be below the income threshold to pay any tax at all!
In college, this same opportunity is present. Kids over 18 years old who make more than half of their own financial support can become a full-fledged taxpayer. This provides them with all the tuition credits, stimulus benefits, etc.
As a high earner, you were getting no benefit or exemption for your kid. Hiring them allows you to get a deduction at the highest rate for paying them, and they pay very little as a low-earning student.
There is a caveat that applies to this—they need to do actual work to earn their compensation. So, hopefully you get a great employee to help you as well!
When it comes to a young person’s first job, the most valuable life advice you can provide them with is to pay their taxes. In most scenarios, you are in some of your lowest earning years in your 20s. Low earnings = low taxes. This is a prime opportunity to utilize a Roth 401k.
It’s also a great time in life to build a foundation: eliminate student debt, consumer debt, house hack, or buy a multi-family investment, etc.
Think about front loading taxes and making long-term decisions here.
I wouldn't suggest saving in a pre-tax account until you are in the 32% marginal bracket if you are going to spend a substantial time in your life in the top marginal bracket. Folks make a mistake of maxing out the 401k early when they are not really paying taxes!
Once you have finally started making good money, you’ve likely reached midlife and are hopefully dealing with the pain that comes with writing big checks to the IRS. It is at this point in your life that deductions become valuable. Your marginal federal tax rate is in the high 30s, and the state is taking their chunk as well.
4 Strategies to Find Deductions:
- Tax Deferred Savings
This is where I always start. Max your 401k, HSA, thrift plan, etc. It is forced savings, and it will save you in taxes. You’ll most likely realize this income later in life at a lower tax rate.
- Side Hustle
Find a source of income that can support expenses. When I had my W-2 job, I paid for most of my life’s expenses post-tax. Becoming self-employed allowed me to pull a lot of life’s expenses above the tax line. Some of these expenses include cell phones, auto expenses, subscriptions, and education.
- Deferred Charitable Giving
This is especially useful for cash windfalls. You can contribute to Donor Advised Funds to save tax today, while you earmark many years of support for your favorite charity.
- The Crazy Stuff
Conservation easements, historic tax credits, solar credits, etc. These are like the gift cards at Costco, where you pay $1 for > $1 savings. They are a hassle and can carry risk.
If you are a business owner it’s even simpler—start taking ordinary expenses that exist in your life and make sure you are taking every business expense out there.
Finally, you’ve hit retirement. These can be great years for folks to move forward income. If you are 59.5 you can start to pull cash from your IRA or elect Roth conversions to plan your income. This can enable you to set your tax rate more effectively as you retire. It is usually a waste to post a $0 tax year here.
The Big Picture
Throughout life, you don’t know what will happen to your business, the markets, the ever-changing tax regimes, etc. You do your best to make smart business decisions based on what you know today and what you imagine the future may hold.
It’s important to think in decades and save as much as you can to best prepare for your financial well-being. Hire competent CPAs and attorneys. Expect to pay for setup and maintenance. Weigh the lifetime cost vs. benefit and don’t forget to consider your Return on Hassle.
Until next week,
