Your lifetime tax bill is more important than this year’s tax bill

Welcome to the sixth issue of Metrix that Matter, a weekly newsletter from WEALTHMETRIX that helps you focus on what matters most for building and sustaining wealth. Every Saturday, we share an educational essay with actionable takeaways to guide you on your journey to financial independence.

If there’s one thing most of us can agree on in this country, it’s that no one likes taxes. We all feel like we pay too much, no matter what income level we’re at.

I notice this sentiment all the time when people ask for CPA or tax professional recommendations on social media. The request is often asking for someone who will “fight to get every possible deduction” or someone who is “aggressive” with the tax code.

While it’s certainly important for your tax preparer to be thorough and competent, I find that most of the time, it’s not the tax professional’s skill that determines your tax liability. Instead, it’s the tax planning, or lack thereof, that you engaged in throughout the year.

When December 31st rolls around, it’s too late to implement most tax planning strategies. At that point, it becomes the tax preparer’s responsibility to simply report what happened during the past year.

Good tax preparation and good tax planning are both important, but it is critical to understand the difference between the two if you want to make a difference on your tax bill.

Tax Prep vs. Tax Planning

Tax preparation is reactive. It's looking backward at the previous year's financial decisions and documenting them for the IRS. Your tax preparer gathers the income you earned, subtracts the deductions you're eligible for, applies the credits you qualify for, and then calculates what you owe or what refund you're due.

Tax planning is proactive. It's looking forward and making strategic decisions throughout the year that will impact your future tax liability. This includes understanding different types of income and deductions, maximizing contributions to tax-advantaged accounts, optimizing distributions from retirement accounts, considering the tax implications of investment decisions, and structuring your financial life in the most tax-efficient way possible.

While tax preparation is focused on accurate reporting of the most recent tax year, smart tax planning is focused on reducing your lifetime tax bill.

Focus on the big picture

Most people approach taxes with a simple goal: pay as little as possible this year. While understandable, it can actually cost you more money in the long run.

The smarter approach is to think about tax optimization over your entire lifetime. This means understanding your career path and income potential and making decisions accordingly.

Are you in your peak earning years, or are you just getting started in your career? Are you having an unusually high-income year due to a bonus, business sale, or stock options? Or perhaps you're having a low-income year due to a job transition, sabbatical, or reduced hours?

Each of these situations creates different tax planning opportunities. When you're in a high-income year or at the peak of your earning potential, it might make sense to defer taxes by maximizing contributions to traditional retirement accounts. When you're in a lower income year or early in your career, it might be worth paying taxes now through Roth contributions to avoid higher taxes later.

The key insight is that your current tax bracket is temporary. Your income, and therefore your tax rate, will fluctuate throughout your lifetime, some more than others. Smart tax planning takes advantage of these fluctuations rather than simply trying to minimize this year's bill.

By thinking strategically about when to pay taxes and when to defer them, you can potentially save thousands of dollars over your lifetime. This long-term perspective is what good tax planning is all about.

Understanding how federal income taxes work

Now that you understand the importance of lifetime tax planning, the next step is getting a clear picture of where you stand today from a tax perspective. I could write an entire article about all the different types of taxes that exist, but today we’re going to focus on federal income taxes.

One of the biggest misconceptions I hear about taxes is the fear of "moving up a tax bracket." I've had people tell me they considered declining a raise or bonus because it would push them into a higher tax bracket and the taxes owed would be more than the extra income.

This misguided thinking stems from a fundamental misunderstanding of how our tax system works.

The United States uses a progressive tax system, which means that different portions of your income are taxed at different rates. Your tax bracket isn’t the percentage you pay on every dollar you earn. You only pay that percentage on the dollars that fall within that bracket.

Think of it like a staircase where each step is a higher tax rate. As your income climbs, only the income on that step gets taxed at that step's rate. All the income on the lower steps continues to be taxed at lower rates. 

The chart below shows 2025 tax rates for single and married joint filers:

This is why it's important to understand the difference between your marginal tax rate and your effective (average) tax rate. Your marginal rate is the tax bracket your last dollar of income falls into. If you were to earn additional income, this is the rate it would be taxed at. On the other hand, your effective rate is your total tax bill divided by your total income. Because it includes income taxed at lower rates, your effective rate will always be lower than your marginal rate.

Let's say you're married and earned $200,000 of taxable income. That puts you near the top of the 22% marginal tax bracket, which caps out at $206,700 for 2025.

If you receive an additional year-end bonus of $10,000, that will push you into the 24% marginal tax bracket. But you won't suddenly pay 24% on your entire $210,000 income. You'll pay 10% on your first portion of income, 12% on the next portion, 22% on the next portion, and 24% only on the income that exceeds the 22% threshold. In this example, that would be $3,300 ($210,000 - $206,700).

The idea that earning more money could ever result in less take-home pay due to tax brackets is a myth. You will always keep more money by earning more money, even if some of those additional dollars are taxed at a higher rate.

Tax diversification gives you flexibility now and in the future

Once you have a basic understanding of what marginal tax bracket you are in, you now have a solid foundation for making smart tax planning decisions. One of those decisions is figuring out which accounts to utilize.

Just like you should diversify your investments across different asset classes, you should diversify your savings across different types of accounts. Having money in various "tax buckets" gives you incredible flexibility both now and in retirement.

There are three main tax buckets to consider:

Tax-Deferred Accounts (Traditional 401(k), Traditional IRA)

You get a tax deduction when you contribute, you owe no tax while the money is in the account, but you pay taxes when you withdraw in retirement. These accounts are powerful tools when you're in a high tax bracket today but expect to be in a lower bracket in retirement.

Tax-Free Accounts (Roth 401(k), Roth IRA)

You do not get a tax deduction when you contribute, but your money grows tax-free and qualified withdrawals come out tax-free in retirement. These are ideal when you're in a lower tax bracket today or want to hedge against the possibility of higher tax rates in the future.

Taxable Accounts (Brokerage accounts, cash accounts)

You pay taxes on any income or realized gains every year, but you have complete flexibility to access your money anytime without penalties. These accounts can also benefit from lower tax rates on long-term capital gains, qualified dividends, and municipal bond interest.

Ultimate flexibility happens when you have money in all three buckets. During your working years, having taxable accounts provides liquidity for major purchases without derailing your retirement savings. In retirement, having all three account types gives you more control over your tax bill each year.

Tax diversification is about giving yourself options, so you can be prepared for whatever comes next.

Putting it all together

When it comes to taxes, it’s important to be proactive, rather than reactive. Get a clear picture of your current situation. Zoom out to see the big picture. Don’t just focus on this year’s tax bill. Diversify across account types. Repeat every year.

Remember, the goal is to minimize your lifetime tax bill while building the wealth and flexibility you need to make work optional.

What to Focus on this Week

Calculate your Tax Rates, both marginal and effective. Marginal is your highest tax bracket, while effective is the average tax you paid on your total income.

The simplest way to figure out these percentages is by referencing your most recent tax return.

What was your taxable income? What bracket did that fall in?

What was the total tax you paid? Divide your gross income by your total tax to calculate your effective (average) rate.

Unlike the other cash flow metrics (Savings, Burn, Debt), there is no “healthy range” for taxes. There are too many variables to consider.

But you do want to understand your marginal tax rate. It is the starting point for many tax planning decisions. Are you in one of the low brackets (10%, 12%)? Are you on the higher end of the spectrum (32%, 35%, 37%)? Or are you somewhere in between (22%, 24%)?

Are you contributing to appropriate accounts (Traditional or Roth), based on your tax situation?

Elements Invitation

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