Listen, we talkin about taxes. Not everything that’s going on in the world or the people that we love and would give everything we’ve got for, but taxes. Man, how silly is that.
With all due respect to Allen Iverson (truly, we’re big fans and believe this meme was taken way out of context), talking about taxes feels out of touch right now. But it is more important than ever to talk about taxes. Why?
Because the way society structures our thinking about tax is fundamentally flawed and it hurts us – especially when our worlds are flipped upside down by a pandemic.
How We Talk About Taxes
How we talk about taxes doesn’t address our context - the circumstances and decisions that influence our average tax rate over time. The conversation revolves around the April 15th deadline and ends with whether we owe money or get a refund. Knowing how much tax we owe is necessary to pay the tax bill, but it is only as helpful as knowing when to pay it.
Unfortunately, how we talk about taxes is reinforced by the typical transactional relationship with a tax preparer. Each February, our tax preparer gets tax docs that detail all our decisions from the prior year. The preparer enters that data, runs optimizations to limit tax liability where possible, and then sends the tax return for signature like an accident report summarizing the damage done. To the extent we get proactive tax planning it is inflexible because quarterly estimated tax payment recommendations in April assumes the rest of the year will be like the last.
But what happens when this year is not like the past?
What drives value in the taxpayer experience is context. When we understand the key drivers to the tax drag we’re likely to experience we identify the maneuvers that influence the total tax bill in advance. With enough notice we can set expectations that map more closely to our dynamic reality. A better map provides better context. Better context means more clarity and confidence for the maneuvers we choose based on our options.
Relying on a backward-looking, point-in-time view of tax feeds a cycle of frustration because it ignores context, maneuvers, or expectations. Scrambling to figure out how to pay tax when we feel the weight of crisis is not an experience anyone should have to navigate, and delaying payment deadlines reveals more of our broken system than it solves. We can’t fix the system, but we can avoid unnecessary tax by shifting how we think and talk about taxes.
Every decision touches our finances and every financial outcome has an explicit or implicit tax. Some taxes are applied at a flat rate (sales tax). Others are a progressive schedule where rates increase with inputs (income tax). And many taxes only apply if certain limits or conditions are triggered (alternative minimum tax). But the real complexity arises because decisions in one year impact the tax you pay in another year.
This tangled web of if-then rules creates a black box such that the easiest thing to focus on is the current year tax bill. Even with the utmost confidence allocating our after-tax capital toward what is most important – saving, spending, gifting, investing – we can’t help but think about whether we truly needed to pay 25% in tax. What could we have done with the extra resources if this year’s tax was only 15%?
Questions like this emerge from a lack of context that can drive us toward tax strategies with potentially adverse consequences. Let’s consider an example:
Assume I prioritize reducing my tax bill every year by maxing out my traditional IRA. Because I don’t pay tax on my income when it goes into the account, I must pay tax when the money comes out based on my total income that year. This should work well because I’ll be retired when the money comes out when my income tax rates are lower. But what if this year was not like last year and I need to access that money for an emergency? Taking money out of the IRA creates a vicious cycle due to progressive tax rates. To pay tax on the money I took out I need to take out more money which creates more tax.
But what if I had forgone minimizing taxes for a few years by maxing out my Roth IRA instead of traditional? I would have paid more tax those years but I would have created a maneuver that limits unnecessary tax during my emergency. When I needed extra money, the Roth contributions could have come out tax free because I paid tax on the Roth money that went into the IRA. When at my most vulnerable, tax drag would have been the least painful.
Marcus Aurelius wasn’t talkin about taxes when he wrote, “What we do now echoes in eternity”, but he may as well have been. Rethinking taxes starts with recognizing the purpose of tax strategy is to minimize taxes paid throughout life, not minimize taxes paid in a single year.
Anchoring to long-term thinking about taxes is difficult because we are clearly taking two steps forward and one step back financially. The easiest way to maintain this perspective is to shift from talkin about taxes on our financial capital to talkin about taxes on our human capital.
The Bandwidth Problem
No doubt you have experienced slower than usual internet speeds at home while trying to get important work done. What do you do when a speed test reveals you are experiencing a 25% drag on the speed you expected?
A point-in-time approach might lead to (passive) aggressively disconnecting every device and app using the bandwidth that doesn’t pertain to what you’re focused on now. Context provides space for a more thoughtful approach. Who/what is using the most bandwidth? Based on that answer, sort by priority. What is causing a drag on bandwidth that isn’t relevant or important right now? After eliminating some inefficiency, do you have enough remaining to support what is most important? Would creating extra bandwidth move the needle in a meaningful way?
The internet analogy is a useful steppingstone to rethinking tax drag more holistically. Sometimes the internet is slow because of things outside of our control and other times there are too many competing priorities to drop what is claiming our bandwidth. But just like the financial tax example, knowledge does not mean we stop thinking about what we could do with more. Any experience with scarcity, even feelings of scarcity, create a tax-like drag on our mental bandwidth. When our minds are spread thin or hyper-focused on what is lacking, important cognitive abilities like focus, planning, and self-control are limited.
Research on the impact of scarcity on our decision-making all tells a similar story. Scarcity of resources (time, money, nutrition, etc.) significantly reduces our performance. One study evaluated sugar cane farmers’ results on a Raven’s Matrix test right after their semi-annual harvest (when cash rich) against their score right before their next harvest (when running low on cash). The average score when the farmers were experiencing relative scarcity was the equivalent of 14 IQ points lower than right after the harvest. Assuming an average IQ score of 100, they were nearly operating from the “dullness” classification in an already stressful situation.
Obviously, the farmers didn’t get less intelligent inside that 6-month period. But the drag definitely limits what maneuvers they see and which are worth pursuing. The implications here are important because our ability to sustain the life we want depends on making wise decisions with our human capital and our financial capital so it can compound over time.
Life and Taxes
Fortunately, most of the time life trends upward in spite of tax drag. Our improved skills demand higher pay, we become a better version of ourselves for the people we care about, and shared experiences create and deepen important relationships. These positive experiences facilitate the abundance we rely on to create maneuvers when life doesn’t unfold in line with our expectations.
The beauty of life is that we can be incredibly resourceful with our financial capital as well as our human capital. And the long-term view on minimizing our tax drag means we can tap into abundance in one source of capital to limit the impact of scarcity in another source. Ultimately, it is what we do in times of abundance that creates possibility while experiencing the drag of scarcity.
Space to relax on the weekends might provide the gas to push through chaos at work and earn that promotion. Saying no to requests for your time may allow freedom to explore a curiosity that turns into an enjoyable revenue-producing opportunity. Growth on contributions to an investment account could make it possible to quit a draining job. Paying a personal trainer for exercise accountability could improve health leading to better sleep and overall well-being.
Full context of our resources and an appreciation for maneuvers not only supports more accurate expectations, it’s also easier to adjust expectations when things change. Flexibility reinforces our long-term view because we can set ourselves up for success whether the current tax drag increases, decreases, or stays the same. What matters is that we have a maneuver that avoids unnecessary tax at times when our bandwidth is less than we need. Rethinking taxes is the difference between compounding gains and compounding losses on financial and human capital.
Avoid Unnecessary Tax
Financial abundance doesn’t make us happy as much as it makes us less sad because abundance makes scarcity feel less permanent. Abundance in human capital is no different. Our upward trajectory means we’re more likely struggling with relative scarcity than absolute scarcity. The bad news is that relative scarcity still hurts, especially when we feel trapped in a downward spiral. The good news is that relative scarcity means much of our experience is influenced by our expectations.
If our expectations aren’t rigid we are more open to experiencing a range in tax drag. There is no reason to waste energy wondering if tax could have been 15% instead of 25%. We have context and identified maneuvers so we can get the bandwidth we need without feeling more tax. Even the individual with the utmost confidence to allocate after-tax capital gets a boost in bandwidth as these concerns become less relevant. When we have more bandwidth than necessary, we can increase our reserves (save), enjoy life more fully (spend), support others (gift), or put our excesses to work for future possibilities (invest).
But adapting our expectations in times of scarcity is a challenge. The kids are home, we have to figure out how to get all our work done, we can’t leave the house, and we haven’t seen our family and friends in weeks. With that context do we keep the same expectations for ourselves as when we made our new year's resolutions under completely different circumstances?
Avoid unnecessary tax by finding abundance. We can generate abundance for our financial capital or human capital by being resourceful and identifying maneuvers while the broader context shifts. Give yourself permission to change your expectations by trusting yourself to improve life over the long run and your relationship with tax will change forever.