Don’t Tax Yourself

By Russell Kroeger, CFP®, EA

Mar 22
(10 Minute Read)

It’s everyone’s favorite time of the year – Tax Season!

I can’t tell you how often people ask me how to pay as little tax as possible. Because we want to act within the legal boundaries of our system, tax evasion strategies are out of the question. However, there are legal strategies to minimize our overall tax burden, which is called tax avoidance. When people hear “legal” and “tax avoidance” their eyes light up.

Sure, we know tax revenue funds important community benefits like public schools, libraries, and clean parks, but everyone hates paying taxes. Even when one of these programs helps us personally, we still hate taxation.

Think about it…. If you were told that doing Strategy X would make you $1,000 but would end up being taxed at 40%, you’d still be $600 richer than if you did nothing. Simply knowing about the tax makes Strategy X much less appealing, even if doing it will increase your odds of achieving the future you want.

Paying taxes is the proverbial “take two steps forward and one step back”, and nobody likes how that feels. While I can’t change the tax law or provide advice without knowing your unique situation, I can help make sure you don’t tax yourself unnecessarily.

Let’s start by reframing how we think about taxation.

The main problem with our current thinking about tax is that it is a backwards-looking, one-time experience. In February and March, we send our information to a tax preparer or upload to TurboTax and find out the impact of our decisions from the prior year. Then we get annoyed when we owe. We withheld taxes from our paycheck and wonder why it wasn’t enough. We then scramble to figure out where the cash is coming from and what that means for our financial situation in the coming year.

This dance of not knowing and then scrambling is stressful and unnecessary. Through the April filing deadline, your tax preparer should help you take advantage of the avoidance strategies available. However, there is little proactive planning since the relationship revolves around this deadline and past decisions cannot be changed.

The better way to think about taxation is as an ongoing event.

Every action has an implicit tax. New shoes? Sales Tax. New house? Property tax. Give someone more than $15,000 this year? Gift tax. Die with a lot of money? Estate tax.

Now I’m not saying that tax impact should be the key driver in big decisions, but we should be aware of the repercussions to set expectations. It is possible to stack up our cumulative decisions to understand the overall tax liability from our choices. We can prepare mentally and financially rather than finding out a month or a week before the liability is due.

By changing how we think about government-imposed tax from a one-time thing to the cumulative impact of our decisions, we set ourselves up for success even if the amount owed doesn’t change. Correctly anticipating the impact of our actions saves us time and mental energy when the tax is due. We are then free to invest that time and energy in things that are more meaningful to us.

So, how do we unnecessarily tax ourselves?

Not only do our actions impact the dollars owed to the Feds and State, our decisions tax us in non-monetary ways. We rarely talk about these non-monetary impacts because they are not as visceral as money leaving our wallets. This is exactly why it is important to discuss them. They are a far sneakier form of taxation.

The easiest way to think about this tax is through a bandwidth analogy. When you were younger, did your parents complain about you using so much of the family data plan that they were going to get charged extra for their use? Did you ever have a roommate that was constantly streaming videos or playing games that it caused everyone else’s internet speed to slow down?

The same thing happens to our minds when we are unprepared for a significant event, emotionally stressed, or when we are juggling too many things. When our minds are spread thin or hyper-focused on one thing, other important cognitive abilities like planning, attention, or self-control usually suffer.

When we are hungry, we obsess about food. If we lack financial means, we focus on getting money. But these feelings built around a lack of resources impact us beyond what we feel physically. Researchers refer to this phenomenon as a scarcity mentality. Feelings of scarcity create a drag, like a tax, on our mental bandwidth. Instead of losing our abilities completely, we cease to function at our optimal state.

There is broad research on the impact of scarcity over our decision-making and the studies all tell a similar story. Scarcity of our time and financial and nutritional resources significantly reduces performance. One study found that people lose the equivalent of 14 IQ points in the presence of financial scarcity compared to their prior performance when they had an abundance of financial resources.  What does a 14-point swing mean? Assuming we have an average IQ of 100, at 14-point drop would nearly put us in the “dullness” classification.

Monetary taxation reduces the financial resources available for the life we want to experience. Similarly, scarcity taxes mental resources and significantly impacts our decision-making abilities in service of the same desired experience.

How can we avoid taxing ourselves?

  1. Create flexibility by building a cushion.

Think about why those who lived through the depression era place such a high priority on having cash even though they could be earning more if the money was invested. They remember the scarcity of cash and want to avoid that experience as much as possible. Now, understand that there is a spectrum here. Too much cash means that your financial resources may not grow enough to support the life you want decades from now. However, having some cash on the sidelines to help with unanticipated events (such as a tax bill in April) can preserve our mental bandwidth for more important things.

Building resilience helps other aspects of your financial life, but also extends beyond your bank account to your human capital. Giving yourself an extra 15 minutes in between meetings or on your commute to work can also lower the feeling of running behind. This additional bandwidth helps you operate as the best version of yourself, better equipped to handle what life throws at you.

  1. Try to avoid multitasking.

We all do it because we were told it is a valuable “skill”. But cognitive research out of Stanford suggests that not only is multitasking impossible, it reduces performance because we’re really switching tasks at a rapid pace. Following the bandwidth analogy, multitasking has the effective of that roommate slowing down all your other functions. The evidence is clear. Those who attempt to multitask are worse at distinguishing relevant and irrelevant information, thus being less effective at what they are doing.

Consider the impacts of this in your daily life. How beneficial would it be to limit the tax on how well you process the information that influences your decision making? Only processing relevant information would be a tremendous advantage in your career and as you explore your best life. To make sure that relevant information drives your decision making, close some of the tabs on your mental browser to free bandwidth for the task at hand.

  1. Design rules for the decisions you make.

There is no telling what will be going on when an important decision needs to be made. Maybe you’re dealing with family drama. Maybe your workload is unusually stressful. Sifting through relevant and irrelevant information without the impact of scarcity is difficult enough. Why not develop a system for choosing the path forward now, so you have the foundation for future decision making in uncertain times?

These rules don’t have to make life boring and rigid. Instead they align your values and principles with your vision for the future. Crafting decision rules for what you will do with your resources means that you don’t have to spend energy deliberating over every choice. You are quickly able to bypass the hurdle of “knowing what to do” and can invest your time and mental bandwidth on “getting it done”.

Shifting our perspective on tax will change our lives.

 The tax you feel is not singular. It is the cumulative impact of choices and experiences that have led to this moment. Because every action has an implicit tax, proactively collaborating with a professional to anticipate your financial tax burden is a huge help. Planning for the future affords the time to prepare for what life brings. Preparedness and avoiding the tendency to multitask reduces the bandwidth tax of daily life. This financial and mental resilience in life reduces the drag of scarcity to operate as your best self and explore the future.

We have two choices: we can wait to experience the outcome of our decisions and risk getting frustrated about how our life trajectory has been taxed; or, we can proactively identify the levers that we have control over and consciously work to avoid unnecessary tax.

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About the Author

Explorer of life, ideas, possibilities, and limitations. Nothing of me is original, I am the combined effort of everyone I've ever known. #UtProsim

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