The problem with taxes is not paying them (after all, that’s the cost of civilization) but the huge drag taxes have on your ability to create wealth. The federal tax system is structured to encourage you to act certain ways. Why not take advantage of the opportunities to save on taxes?
Once of the reasons I started this site was to raise lawyer’s awareness on the role of taxes in accumulating wealth. Because understanding taxes is complicated, many lawyers do not have a sufficient grasp on the role of taxes in their lives.
Yet, taxes are likely your single biggest expense by far. By simply becoming aware of the amount of taxes you pay, you will be motivated to take action to reduce those taxes. Of course, we’re not talking about tax avoidance. We’re talking about taking advantage of tax incentives built right into the tax code precisely because the government is encouraging you to take those actions.
(1) Tax-Deferred Retirement Accounts
A surprising number of lawyers do not contribute to their 401(k) account. I know this because for a few years I didn’t contribute and many of my peers did not as well.
A minority of law firms offer 401(k) matching programs, so the incentive to contribute is based solely on the individual’s tax savings. When a young lawyer is aggressively paying down student loan debt, it’s easy to think that forgoing 401(k) contributions is the right decision.
That is not the case. Because lawyers are likely working in a high tax environment (i.e. NYC or SF), they will save their marginal tax rate for each $1 contributed to a 401K while only paying an effective tax rate in retirement. Since retirement is quite likely to be in a lower tax environment (i.e. not NYC or SF), there’s a huge opportunity to take advantage of tax arbitrage.
For example, in NYC your marginal tax rate may be approaching 45%. For every $2 contributed to a retirement account, you save $0.90 when taxes are due. Max out your 401(k) and that’s a significant annual tax savings.
401(k) contribution limits are “use it or lose it” meaning you can only contribute during the calendar year and once the calendar year ends, you can no longer contribute for that year. By delaying contributions to a 401(k) plan, you are giving up that contribution year forever.
It makes sense to both contribute to your 401(k) plan AND aggressively pay off student loans. There’s no reason why you can’t do both.
(2) Backdoor Roth IRA
If your income is below $116,000 ($183,000 if married filing jointly), you can contribute to a Roth IRA without any restrictions.
For higher income individuals, you can achieve the same effect by contributing to a Backdoor Roth IRA. A Backdoor Roth IRA is the same as a Roth IRA, except that you’ve made your contribution through the “backdoor” – a loophole Congress made available in 2010 and has not addressed since then.
The loophole is that anyone, regardless of income, is permitted to convert a Traditional IRA to a Roth IRA by paying income tax on any account balance being converted that has not already been taxed.
Because you can make an non-deductible contribution to a Traditional IRA (i.e. an after-tax contribution) regardless of your income, you can make this contribution and immediately convert it to a Roth IRA. It sounds more complicated than it actually is and can be taken care of with a few clicks. Because you paid income taxes on the original non-deductible Traditional IRA contribution, no additional taxes are due when you convert it to a Roth IRA. From there, the money grows tax free and you won’t have to pay taxes on qualified withdrawals.
One thing worth pointing out is that this process doesn’t leave you with multiple Roth IRA accounts. You only have a single Roth IRA account. Each year you effectively roll the $5,500 in contribution to your non-deductible Traditional IRA to your Roth IRA.
Why a Roth IRA? Because you pay taxes on the money today but it grows forever tax-free and all withdrawals will be tax-free.
(3) Stealth IRA (Health Savings Account)
If you have access to a High-Deductible Health Plan, you likely will also have access to a Health Savings Account. Individuals can contribute up to $3,350 ($6,750 if married filing jointly). HSA’s are triple tax advantaged: you don’t pay taxes on the contributions, growth or withdrawal (if such withdrawal is for a qualified health expense).
HSA money also rolls over from year to year, so there’s no concern with losing your money at the end of the year (like a Flexible Spending Account). Even better, after age 59 1/2 you can withdraw money from the account as if it were a Traditional IRA (you’ll need to pay income taxes on the amount withdrawn, but that’s okay since it will be the first time the account is taxed).
(4) Charitable Deductions
As a group, lawyers donate hours and hours to pro bono projects. If they aren’t giving time, lawyers donate money and other resources to charity. All charitable donations to a tax-exempt organization are tax-deductible (assuming you itemize your deductions, which is true for many lawyers).
TurboTax’s ItsDeductible program can help you keep track of charitable giving. You can deduct expenses associated with driving to and from a charity using the IRS federal mileage reimbursement rate and any other expenses associated with donating your time (although you can’t deduct the value for your time.)
Since charity donations reduce your income dollar for dollar, a highly taxed lawyer could save around $0.45 for each $1 donated to a charity or each 2 miles driven. Charitable donations are even a good way to flush out capital gain taxes.
(5) Tax-Loss Harvesting
It’s never great to lose money investing. What is great is that the government will pitch in to share in your loss. You can deduct up to $3,000 a year of investment losses against your ordinary income.
If you’re investing in a taxable account, you can sell your investments with losses to generate a taxable loss. The IRS won’t allow you buy back the same security for 30 days (known as the wash-sale rule) but you can purchase a correlated asset immediately after you sell for a loss. For example, you might sell the Vanguard Total Stock Market Index Fund and buy the Vanguard 500 Index Fund.
This has the effect of lowering your cost basis, which means you will pay more taxes when you sell the investment in the future. I’ll let you decide whether it makes sense to take a $3,000 deduction against your ordinary income today in exchange for paying capital gains taxes on $3,000 at some future date (hint: it definitely does).
(6) Converting Student Loan Interest to Mortgage Interest
Many lawyers find themselves with large amounts of consumer debt (like mortgages, car loans, student loans, etc.) Generally, I think it makes sense to pay these down as quickly as possible. Or, in the case of car loans, avoid them entirely.
The government does make it friendly to carry a mortgage though, since mortgage interest is deductible from taxes. If you have a mortgage and student loans, it makes sense to refinance the loans into the lowest rate possible and make the interest tax deductible if possible.
How can you make student loan interest tax deductible when you have a high income?
Let’s say you have $100K in student loans at 6.8% and can refinance them in the private market to 4%. You also own a house worth $700K with a $400K mortgage. Refinancing the mortgage into a $500K loan at 4% and paying off the student loans wouldn’t change the rate of your mortgage, but would cut your student loan interest by 2.8% plus make the interest tax deductible, reducing the effective tax rate on the student loan down to 2.2% assuming a marginal tax rate of 45% (4% – (4% x 45%)).
(7) Education Tax Credits
If you earned income, went to law school this year and paid for the tuition yourself (taking out student loans counts as paying for it yourself), don’t forget to take advantage of the education tax credits. You can save plenty money by looking into the lifetime earning credits.
Let’s talk about it. Let us know in the comments if you’re taking advantage of any of these tax-deductions. What did I miss?
Joshua Holt is a practicing private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.