Tax Optimization: Keep More of What You Earn
The Hidden Expense That's Killing Your FI Timeline
Taxes might be your largest expense. Think about it: if you're in a 22% federal tax bracket plus state taxes, you might be paying 25-35% of your income in taxes. For someone earning $80,000, that's $20,000-28,000 annually. Check and see if your tax bill is more than your housing cost. You might be surprised.
Yet most people spend more time optimizing their $50/month phone bill than they do minimizing their $25,000/year tax bill. Why? Because most people just treat taxes as an unavoidable expense.
This isn't about complicated tax schemes or questionable strategies. This is about using the legal tools the government provides to reduce your tax burden and accelerate your path to FI.
Important disclaimer: I'm not a tax professional or accountant. This is educational information based on my experience and research. For complex situations, consult a qualified tax professional.
Also, I know this can be confusing. No one likes taxes, but we care about the money we actually end up with. It’s not your pre-tax income that you care about. It’s your post-tax income because that’s what you actually get to keep!
Why Tax Optimization Matters for FI
Every dollar you save in taxes is a dollar you can invest toward FI. But it's actually better than that. Tax savings compound over time.
Example: If you save $3,000 annually in taxes and invest it at 7% returns, that becomes $300,000+ over 30 years.
The FI multiplier effect: Tax optimization helps in multiple ways:
More money to invest (immediate benefit)
Lower taxable income in retirement (long-term benefit)
Tax-free growth in retirement accounts (compound benefit)
Understanding Your Tax Situation
Before optimizing, you need to understand how you're currently taxed.
Marginal vs. Effective Tax Rates
Marginal tax rate: The rate you pay on your last dollar of income
Effective tax rate: Your total taxes divided by total income
Understanding this distinction is crucial because tax deductions save you money at your marginal rate, not your effective rate.
Example: If you're in the 22% marginal bracket and contribute $1,000 to a traditional 401(k), you save $220 in federal taxes.
Types of Income
Ordinary income: Wages, interest, short-term capital gains
Taxed at regular income tax rates (up to 37% federal)
Capital gains: Profits from selling investments held over one year
Taxed at preferential rates (0%, 15%, or 20% federal)
Qualified dividends: Dividends from U.S. corporations and qualified foreign companies
Taxed at capital gains rates
Tax-free income: Municipal bond interest, Roth IRA withdrawals (in retirement)
Not taxed at federal level
Tax-Advantaged Accounts: Your First Line of Defense
These should be your primary tax optimization tools.
401(k) Plans
Traditional 401(k):
Contributions reduce current taxable income
Money grows tax-deferred
Withdrawals in retirement are taxed as ordinary income
2025 limit: $23,500 (plus $7,500 catch-up if 50+)
Roth 401(k):
Contributions made with after-tax dollars
Money grows tax-free
Withdrawals in retirement are tax-free
Same contribution limits as traditional
When to choose which:
Traditional if you expect to be in a lower tax bracket in retirement
Roth if you expect to be in the same or higher tax bracket in retirement
Consider doing both for tax diversification if you’re not sure
Individual Retirement Accounts (IRAs)
Traditional IRA:
Tax deduction for contributions (income limits apply)
Tax-deferred growth
Taxable withdrawals in retirement
2025 limit: $7,000 (plus $1,000 catch-up if 50+)
Roth IRA:
No current tax deduction
Tax-free growth and withdrawals
Income limits for direct contributions
Same contribution limits as traditional
Backdoor Roth IRA:
Strategy for high earners who can't contribute directly to Roth IRA
Contribute to traditional IRA (non-deductible), then convert to Roth
Requires careful execution to avoid tax complications
Health Savings Account (HSA)
The triple tax advantage:
Deductible contributions
Tax-free growth
Tax-free withdrawals for qualified medical expenses
Why it's the best retirement account:
After age 65, can withdraw for any purpose (taxed as ordinary income)
No required minimum distributions
Can be used as inheritance vehicle
2025 limits: $4,300 individual, $8,550 family (plus $1,000 catch-up if 55+)
Potential Strategy: Use HSA as retirement account by paying medical expenses out-of-pocket and letting HSA grow
Advanced Retirement Account Strategies
Mega Backdoor Roth
If your employer's 401(k) plan allows it, this strategy can dramatically increase your retirement savings.
How it works:
Max out regular 401(k) contributions ($23,500)
Make additional after-tax contributions (total limit $70,000 in 2025)
Immediately convert after-tax contributions to Roth
Result: Up to $46,500 additional Roth contributions annually
Requirements:
Employer plan must allow after-tax contributions
Plan must allow in-service distributions or conversions
High income to afford additional contributions
Solo 401(k) for Self-Employed
If you have self-employment income, a Solo 401(k) offers huge contribution limits.
2025 limits: Up to $70,000 annually (or 100% of compensation if less)
Employee contributions: Up to $23,500
Employer contributions: Up to 25% of compensation
Perfect for: Freelancers, consultants, side business owners
Taxable Account Optimization
Once you've maxed tax-advantaged accounts, optimize your taxable investing.
Tax-Loss Harvesting
Strategy: Sell investments at a loss to offset capital gains and up to $3,000 of ordinary income annually.
Example: If you have $5,000 in capital gains and $8,000 in capital losses, you can offset all gains plus $3,000 of ordinary income. Excess losses carry forward to future years.
Important rules:
Wash sale rule: Can't buy the same security 30 days before or after selling for a loss
Use similar (but not identical) funds to maintain market exposure and avoid wash sales
Asset Location
Strategy: Put tax-inefficient investments in tax-advantaged accounts and tax-efficient investments in taxable accounts.
Tax-inefficient (best in tax-advantaged accounts):
Bonds and bond funds (ordinary income)
REITs (mostly ordinary income)
Actively managed funds (high turnover)
Tax-efficient (best in taxable accounts):
Index funds (low turnover)
Individual stocks (control timing of gains)
Tax-managed funds
Tax-Efficient Index Funds
Some funds are designed to minimize taxable distributions:
Low turnover reduces capital gains distributions
Tax-managed funds actively harvest losses
Examples: Vanguard Tax-Managed funds, Fidelity Tax-Free Bond funds
Income Optimization Strategies
Timing Income and Deductions
Strategy: Control when you recognize income and claim deductions to manage tax brackets.
Examples:
Defer year-end bonus to January if expecting lower income next year
Accelerate deductions into high-income years
Roth conversions in low-income years
Business Deductions
If you have self-employment income, maximize legitimate business deductions:
Home office expenses
Business equipment and software
Professional development and training
Business meals (50% deductible)
Travel expenses
Important: Only deduct legitimate business expenses with proper documentation
Health Savings Account Maximization
Advanced HSA strategy:
Contribute maximum to HSA annually (if eligible)
Invest HSA funds for growth (don't leave in cash)
Pay current medical expenses out-of-pocket
Keep receipts for reimbursement decades later
Let HSA grow tax-free for retirement
State Tax Considerations
State taxes can significantly impact your FI strategy.
High-Income-Tax vs. Low-Income-Tax States
High-tax states: California (up to 13.3%), New York (up to 8.82%), New Jersey (up to 10.75%)
Low-tax states: Texas, Florida, Tennessee, Nevada, Wyoming, South Dakota, New Hampshire, Alaska (no state income tax)
FI implications:
Geographic arbitrage can save thousands annually
Consider state taxes when planning retirement location
Some states don't tax retirement income
State-Specific Strategies
529 Plans: Many states offer tax deductions for contributions
Municipal bonds: State-specific munis can be triple tax-free (federal, state, local)
Residency planning: Establish residency in low-tax state before retirement
Tax Planning for Early Retirement
The Tax-Free Ladder
Strategy: Convert traditional retirement accounts to Roth during low-income early retirement years.
How it works:
Retire early with mix of taxable and retirement accounts
Live off taxable accounts initially
Convert traditional IRA/401(k) to Roth annually
Pay taxes at low rates due to minimal other income
Access Roth conversions tax-free after 5-year waiting period
Managing Different Tax Buckets
Three buckets for retirement:
Taxable (immediate access, capital gains rates)
Tax-deferred (traditional 401k/IRA, ordinary income tax)
Tax-free (Roth accounts, no taxes)
Strategy: Draw from different buckets based on tax situation and cash flow needs
Common Tax Mistakes to Avoid
Mistake 1: Ignoring Tax-Advantaged Accounts
Problem: Not maximizing 401(k) match or IRA contributions
Solution: Prioritize these before taxable investing
Mistake 2: All Traditional or All Roth by Default
Problem: Putting all retirement savings in one tax treatment limits flexibility later
Solution: Diversify across traditional and Roth for flexibility (if it makes sense)
Mistake 3: Poor Record Keeping
Problem: Missing deductions or paying taxes on basis already taxed
Solution: Maintain detailed records, especially for taxable investments
This usually isn’t an issue for standard transactions. It can become an issue when you make non-deductible IRA contributions, carry losses forward, make conversions after filing your taxes, and other less common activities. Don’t lose deductions simply because you forgot to keep a record of it!
Mistake 4: Emotional Tax Decisions
Problem: Making investment decisions solely for tax reasons
Solution: Consider taxes, but don't let tail wag the dog. If all of your friends and family live in New York, moving to Florida to save taxes may not make sense.
Mistake 5: DIY Complex Strategies
Problem: Attempting advanced strategies without proper knowledge
Solution: Hire qualified professionals for complex situations
My personal example: I started a Solo 401(k) and the company I purchased plan documents from went out of business! A 401(k) is highly regulated and most people don’t have the knowledge to act as their own administrator.
My Personal Tax Strategy Evolution
Here's how my tax optimization evolved over time:
Early Career (Lower Income):
Maximized Roth 401(k) while in a low tax bracket
Used Roth IRA for additional deductions
Simple taxes
Mid-Career (Higher Income):
Traditional contributions (Roth was income-limited)
Maximized HSA contributions
Implemented tax-loss harvesting in taxable accounts
High Income Phase:
Maxed all available retirement accounts
Used Mega Backdoor Roth strategy
Optimized business deductions for consulting income
Strategic Roth conversions in lower-income years
Current Strategy:
Geographic arbitrage (moved to no-income-tax state)
Managing multiple income streams for tax efficiency
Planning for tax-efficient early retirement withdrawals
Getting Started with Tax Optimization
Phase 1: Foundation (Do These First)
Maximize employer 401(k) match
Contribute to HSA if available
Max out IRA contributions
Phase 2: Intermediate Optimization
Increase 401(k) contributions toward maximum
Implement tax-loss harvesting
Optimize asset location
Consider Roth conversions in low-income years
Phase 3: Advanced Strategies
Mega Backdoor Roth (if available)
Solo 401(k) for self-employment income
Geographic arbitrage considerations
Complex tax planning with professionals
When to Hire a Tax Professional
If you have simple taxes, you don’t need to hire a professional. If you're a W-2 employee who takes the standard deduction, you probably don't need to spend the money on a professional. If you own multiple businesses and itemize rare deductions, it can be worth it to make sure you do it right. For what it's worth, I still do my own taxes and always have. That doesn’t mean you should, but software can cover most situations.
Consider professional help if:
Income over $150,000
Multiple income sources
Self-employment income
Complex investment situations
Considering major financial decisions (home purchase, job change, retirement)
Types of professionals:
CPA: Can provide tax advice and preparation
Tax attorney: For complex legal tax issues
Fee-only financial planner: For comprehensive tax and investment planning
Tools and Resources
Tax Software:
TurboTax (expensive, buggy, but comprehensive)
TaxAct (good value, solid features)
FreeTaxUSA (free federal option)
IRS Free File (free option from the US Government)
Planning Tools:
IRS withholding calculator
Roth conversion calculators
Tax bracket calculators
Record Keeping:
Digital receipt scanning apps
Spreadsheets for tracking basis
Investment account statements
The Bottom Line
Tax optimization is one of the most powerful tools for accelerating FI, but it requires ongoing attention and planning. The key is to start with the basics (maximize tax-advantaged accounts) and gradually implement more advanced strategies as your situation becomes more complex.
Remember: The goal isn't to minimize taxes at all costs. It's to optimize your overall financial situation. Sometimes paying taxes now (Roth contributions) makes sense for long-term benefits.
Every dollar saved in taxes is a dollar that can compound for decades toward your financial independence.
This post means we have finished the basics! We have covered cutting expenses, increasing income, how to invest, and tax considerations. Now we can start exploring deeper dives into these areas and discussing more advanced topics. Next time, we'll dive into more of my personal story. I’ll tell you about what worked and didn’t work for me!
Until then, your homework: Review your current tax situation and identify one optimization strategy to implement this year. Whether it's maximizing your HSA, starting tax-loss harvesting, or increasing retirement contributions.
Here's to keeping more of what you earn,
Max
Remember: Tax laws change frequently, and everyone's situation is different. This information is general guidance. Consult with qualified professionals for specific advice related to your circumstances.