Minimizing Taxes Isn’t the Goal of Tax Planning

When done properly, the goal of tax planning is not to minimize your taxes. Instead, the goal is to maximize the money that is left after taxes.

That may sound like a trivial distinction — like I’m just playing games with words here. But it makes a real difference in the analysis.

Let’s look at two common examples, starting with the more obvious one.

Mortgage Interest

You have a $300,000 mortgage with a 3% interest rate. You itemize your deductions every year, and you are able to fully deduct the interest you pay on your mortgage. You have a 25% marginal tax rate, when both federal and state income taxes are considered.

You have $50,000 in a checking account, which you don’t really need for “emergency fund” purposes. Let’s imagine that it’s from a CD that just matured.

If you use that $50,000 to pay down your mortgage, you’ll be saving yourself $1,500 of interest per year. You will lose a $1,500 deduction, which means that your taxes will go up by $375, given a 25% tax rate. But your overall financial position is still improved by $1,125 per year.

Your taxes went up, but that’s fine. The goal is not to minimize taxes, but rather to maximize the amount of money left after taxes. Prepaying your mortgage achieves that goal, in this case.

Let’s move to our second, less obvious example.

Roth vs Tax-Deferred

Looking at your budget for this year, you determine that you have sufficient cash flow to make $7,500 of Roth contributions to your 401(k) this year. Alternatively, you could make tax-deferred (“traditional”) contributions. You currently have a 25% marginal tax rate, and you expect to have a 15% marginal tax rate in retirement. You also expect that, given the length of time in question, this money will approximately triple in value between now and the time you take it out of the account.

If you make Roth contributions, there is no effect on your income tax this year (because the contribution is not deductible), and when you take the money out in retirement, it will be completely tax-free.

Alternatively, if you have $7,500 of available cash flow this year, you could contribute $10,000 to a tax-deferred 401(k), given a 25% marginal tax rate. (That is, if you make tax-deferred contributions of $10,000, you’ll have tax savings this year of $2,500, so your cash flow this year will only be affected to the tune of $7,500, which is the amount we have decided you can afford.)

If you make tax-deferred contributions, when you take the money out (by which point the $10,000 will have tripled in value to $30,000), you will have to pay a total tax of $4,500, given your anticipated 15% marginal tax rate in retirement.

So, in our example, with tax-deferred contributions, you end up paying more tax in total. You get $2,500 of savings up-front, but you pay $4,500 of additional tax later. If you do the analysis with the goal of minimizing taxes, you would make Roth contributions.

But which option actually leaves you with more after-tax money?

In the Roth case, you contribute $7,500, and that money triples to $22,500. And $22,500 is already the after-tax value, because it can come out of the account tax-free.

In the tax-deferred case, you contribute $10,000, and that money triples to $30,000. But then you have to pay $4,500 of taxes. Still, your after-tax value is $25,500 (i.e., $3,000 more spendable dollars than you would have if you had made Roth contributions).

Overall point being, when you contribute to Roth accounts rather than tax-deferred accounts, you generally pay a smaller dollar amount of income tax (because you’re paying tax now, on the amount of the contribution, rather than on the larger amount of the distribution after it has grown over time), but that doesn’t necessarily make it better. Because the goal isn’t to minimize taxes. The goal is to maximize the after-tax dollars that you have available to you.

Focus on After-Tax Dollars

This topic comes up with so many of the common tax planning questions. Which account(s) should I spend from this year? Which assets should I hold in which accounts (i.e., asset location)? Should I spend down my traditional IRA in order to delay Social Security? Should I make a donation from my taxable assets, or via a qualified charitable distribution?

In each case, calculating the taxes paid under Option A and calculating the taxes paid under Option B — then comparing those two amounts — is such an obvious, intuitive way to do the analysis. And in each case, that method can lead you to poor decisions.