In this eighth episode of the One for the Money podcast, we cover a critical component of building wealth and early retirement: not paying more for taxes than necessary. While everyone has to pay taxes, no one says you have to leave a tip. Listen to learn more about reducing what you pay in taxes to have more of your money to spend in early retirement.
In this episode...
- Gaining a general knowledge of taxes [00:39]
- Income taxes and how they’re calculated [02:56]
- Adjusted gross income [04:50]
- Modified adjusted gross income [06:19]
- Types of deductions [07:49]
- Major expenses in itemized deductions [09:44]
- The Augusta Rule [15:31]
Understanding taxes
Pursuing strategies to reduce what you pay in taxes will help ensure you have more of your money to spend in early retirement. Implementing these tax mitigation strategies requires a general understanding of taxes. While taxes may not be the most exciting topic, it’s essential, and I’ll try to make it as interesting as possible.
Taxes can be incredibly confusing, and the terminology certainly doesn’t help. Terms like gross income and adjusted gross income are confusing enough, and now they’ve added modified adjusted gross income. There are also above-the-line deductions versus below-the-line deductions. The list goes on and on. This confusing terminology makes many people want to ignore taxes altogether. However, if taxes are ignored, more will likely be paid in taxes than necessary. Reducing taxes is about implementing specific strategies based on general knowledge and understanding of taxes over many years.
Standard vs. itemized deductions
There are two ways to determine deductions. One is called the standard deduction, which everyone can take. The other is the itemized deduction which includes additional adjustments for qualifying expenses. If these deductions total higher than the standard, the itemized deduction would be used.
The standard deduction for 2021 is different for single, married, and head of household. The deduction for single is $12,550, married filing jointly is $25,100, and head of household or people caring for a qualifying dependent is $18,800. This option, of course, is if you choose not to itemize your deductions. However, if you’ve had certain expenses in total that were higher than the standard deduction, then you would want to itemize. Four major expenses included in the itemized deduction are medical expenses, state and local taxes paid, interest paid on a mortgage, and charitable contributions. These are considered below-the-line deductions because they may not lower your taxable income if the standard deduction is higher.
The Augusta Rule
This episode’s tips, tricks, and strategies portion is a tip that may sound too good to be true, but true it is. This tax mitigation strategy is commonly referred to as the Augusta rule, named after the famous golf course on which the Masters Tournament is played every year. Section 288 of the IRS tax code allows homeowners to rent out their primary residence for up to 14 days per year without needing to report the rental income on their individual tax return. That’s a lot of tax-free income potential that can be earned every year. This rule was created to protect the residents of Augusta, Georgia who had rented out their homes to attendees of the golf championship.
The rent charged must be reasonable and in line with what the rental market supports. Charging $1000 per night when comparable houses rent for $200 per night is not considered reasonable. Homeowners can rent their homes to individuals looking for vacation opportunities or rent to business owners who intend to use the property for business purposes. Whatever you choose, this could be a great way to generate income tax-free.
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