It’s everybody’s favorite time of year again! That’s right, it’s tax season. Because of that, there’s no better time to bring up today’s topic. Understanding how to calculate your effective tax rate is an essential skill that all business owners should have. With that, let’s get to the topic at hand.
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You know, one of my friends and colleagues, Chris Mahan, has often said that the Internal Revenue Code (IRC) is the greatest wealth-building tool in America. I tend to agree with him. If you look at the IRC, it’s kind of a funny book. I know, some of you are thinking, “Justin, you need to get a life if you think the IRC is funny.” Well, you might be right, but hear me out. I don’t think it’s funny in the comedic sense. Instead, I find it very interesting that only a very small portion of the book tells us how much we have to pay in taxes. The rest of the IRC is jam-packed with information on how to avoid paying those taxes.
As planners, the fourth quarter is the busiest time of year for us. We spend almost the entire month of December just busting it in order to make sure our clients are in the best possible positions for tax season. So, the holiday season is when we begin turning our focus on taxes, and with that, the effective tax rate. But what is it?
Well, according to Investopedia, the effective tax rate is the percent of their income that an individual or a corporation pays in taxes. Knowing what the effective tax rate is is only part of the battle, folks. In addition to knowing what it is, you need to know how to calculate your effective tax rate. To find your effective tax rate, simply divide the taxes you’ve paid by your taxable income.
To better illustrate why the effective tax rate matters so much, let’s assume that I make $100k and paid $20,000 in taxes. That means that I have $80,000 left to live on. Now, you might be saying, “that’s a pretty decent living,” and you’d be right. However, as a financial planner, I know that in order to properly prepare for my retirement, I need to save roughly 20% of my gross income every year.
That means I need to save an additional $20,000, leaving me with $60,000. With a wife and three kids, things just got a little tighter. In addition to taxes and retirement savings, I am a Christian and believe that I should give 10% of my income to the church as a tithe. Now, all of a sudden, I am down to just $50,000 to support my family. This is why the effective tax rate is so important.
By not addressing the 20% that I have given to the government, I am now left with two options. Either I don’t give my tithe to the church, or I decrease or even eliminate my retirement savings. So, the effective tax rate matters, folks.
Using my previous example, let’s say that life happens and I’m no longer able to save 20% for retirement. If I pay my 20% in taxes and save just 10% for retirement, that’s $30,000 that I don’t see, and I’m now living on just 70% of my income. That’s a common scenario, my friends. But what’s worse is that, in that scenario, I would probably come up short when it was time to retire.
But here’s the great news. Through prudent planning, I can actually reduce my 20% effective tax rate down to just 10%. Now I can save the 20% that I need to save for retirement and I still have $70,000 to live on. Better yet, there are many times where we can actually increase our lifestyles, our savings, or even our generosity just by knowing how to reduce our effective tax rates.
Now, I want to be clear that we’re only addressing federal taxes with this discussion. Your effective tax rate isn’t your total tax bill. You still have FICA, state and local taxes, sales taxes, and a variety of others depending on where you live. So, calculate your effective tax rate and meet with your tax and financial planners to see what options are available to you to lower that rate.
This has been a crazy year for many of us, and some of us have really taken a beating, financially. That just makes it all the more important to lower your effective tax rate. Life is hard. But life is good. Paying taxes is frustrating. But knowing how to calculate your effective tax rate can at least be financially simple.
If you need the help of a qualified financial planner to help you prepare for retirement and lower your effective tax rate so that you can build wealth, schedule a meeting. The Financially Simple team has helped hundreds like you!