A major goal of my family is tax efficiency. While this post won’t be outlining any fishy tax schemes, it should help you save on your taxes. Paying less taxes has also helped us direct more money to paying down our loans while simultaneously investing.
Taxes are a necessary evil. They pay our salary and provide services. However, the government has proven to be an inefficient user of my tax money, and given the option, I would prefer to redistribute my wealth in my own fashion. Our tax strategy leverages two important principles: saving and paying attention to changes which impact our tax situation.
Part 1: SAVING to reduce taxes
The IRS punishes spenders and rewards savers. By being a consumer, your money is taxed when you earn it and when you spend it, in the form of income and sales tax. States and cities also get a piece.
Retirement Saving Contribution Credit
Perhaps the most powerful incentive to save provided in the IRS code is the Retirement Saver’s Credit.
At each denoted AGI level, the IRS will return to you, in the form of a non-refundable credit, 10%, 20% or 50% of savings contributed to a retirement saving vehicle, like a 401K or IRA. There is a maximum of $2000 individually, $4000 filing jointly.
To take advantage of this massive credit, the average taxpayer, military or civilian, must to some pre-January tax planning. Whether you are a lower earner or a high-percentage saver, you must not exceed the Adjusted Gross Income (AGI) for your filing status. Exceed the tabulated AGI’s and you forfeit the credit. You also should not have your total credits exceed your tax burden, because by doing so you may be contributing to your retirement account in a tax-inefficient manner.
Military Members are Special
The military pay scheme makes the saver’s credit easier to attain compared to the civilian workforce. Consider: servicemembers are compensated at a level commensurate with skill, experience, and tenure to the civilian sector. However, while a civilian making $100,000 a year has an AGI near $100,000, less any personal additions or deductions, because of Basic Allowance for Housing (BAH)and other incentives being tax-free, the same service member seeing an effective salary of $100,000 starts with an AGI around $70,000. This makes it much easier to get down to the Saver’s Credit’s AGI limits.
Examples with round* numbers:
For example, consider the single Petty Officer Second Class Gooblatz. If PO2 Gooblatz does what most folks are told, he saves 5% of his paycheck. Let’s assume he saves it in a non-Roth TSP (401K) option, for now.
- His taxable salary for 2017 is about $33,780, assuming he has no special dividends or student loan deductions, etc. He, therefore, saves $1650 this year. Because non-Roth contributions to the TSP (401K) directly reduce your compensation for taxable purposes, this lowers his AIG to $31,350.
- This saving rate makes him ineligible for the retirement savers credit. Doing a simple rundown of his tax burden, he probably owes ~$2,351 in taxes at the federal level. Ignore state taxes.
- At the end of the year, PO2 Gooblatz’s bank account would have $29,800 more than last year, less any spending.
But what if he had saved more. Would he have had significantly less spending money at the end of the year?
Say PO2 Gooblatz gets a roommate who picks up some of his rent, and so he saves 20% next year. That works out to be $6,700, a significant increase in his investment from last year.
- This reduces his AGI to ~26,500. His tax burden becomes: ~ $1,956.
- However, his lower AGI now makes him eligible for the saver’s credit. Following the chart, he is eligible for: $670 as a credit. His paycheck now looks like:
- 33,780-6,700-1,956+670= 25,794. This year his bank account is shorter $4000. Consider the upside, however. While he sees less in his bank account, his retirement account sees a four-fold contribution increase!
Saving an additional $5050 did not “cost” him $5,050. It cost him only $4000.
(To paint the full picture, PO2 will have to pay taxes on this money, and its earnings when he withdraws it unless he converts it wisely to a Roth option in the future. However, his earning will likely have outgrown earnings made with smaller, after tax dollar contributions, due to the magic of compounding.)
Let’s take as another example, a married couple who both work, with no children: LT and Mrs. McMann. Their combined income hovers around $100,000 before taxes. In December they must plan carefully to take advantage of the saver’s credit for next year. Their primary mission will be to reduce their AGI to below $62,000, in a tax efficient manner.
Again assuming that the McMann’s have no capital gains or refunds above the line to worry about, they need to defer $38,000 to be eligible for the saver’s credit. Because they are thrifty and want to save even more to be eligible for the entire $4,000 credit, they aim for $40,000 into their retirement accounts. Here is one way they could accomplish this:
- Mr. M’s TSP – $18,000
- Mrs. M’s 403b – $18,000
- Mr. M’s Traditional IRA $4,000
|Mr & Mrs McMann||5% Savings||Efficient savings
|Saver’s Credit||No||Yes (up to 4K)|
|End Bank Account
Gain, less investments
|End Bank Account, with Investments||$89,771||$99,000|
Again, we see that even though the McMann’s invested $35,000 more, it only “COST” them $25,000 to increase their retirement savings exponentially. The IRS rewarded them with $10,000, just for appropriately saving in a retirement account.
The “COST” was not to the McMann’s bank account or wallet- it was to their lifestyle. By making a large investment in their future, they kept more of their money. But, while their retirement accounts grew, their ability to spend money month to month on consumption decreased.
If the McMann’s wanted to save more money (say they are FIRE enthusiasts who are seeking to hit a 50% pre-tax savings rate) they might look at whether they should continue to contribute pre-tax, or contribute to a post tax (Roth) plan. This will specifically depend on the rest of their deductions, exemptions, and credits.
While they are eligible for $4000 of savers credit, this credit is non-refundable. This means if the sum of their credits exceeds their tax (in our example $5,000) they would not be able to get a check for the difference, and any excess would be lost. However, if their credits exceed their tax, it also means they owe Zero tax. Contributing extra money to a Roth, instead of a traditional account at 0% is effectively double tax-free. Tax-free in, tax-free growth and tax-free withdrawal.
Consider too, if the McCann’s were eligible for another credit or exemption, perhaps the Homebuyer credit. If the credit were large enough, it might take up some of the credit otherwise earned by saving. In this case, making tax-deferred contributions over the amount needed to reduce AGI below the AGI limits would be tax-inefficient. The McManns might defer $38,000 tax-deferred to get below the required AGI, then contribute any additional savings Roth style. Since they won’t receive the total $4,000 of the saver’s credit, this Roth contribution is more tax efficient.
The McMann’s have the ability to make an additional $7,000 in retirement contributions if they max out their IRA’s! They certainly shouldn’t contribute this to traditional, pretax account.
Part 2: Paying Attention to Tax–Advantages of Changing Circumstances.
Please don’t overpay your taxes.
Many people love getting a refund check at the end of the year. By setting their withholding on their W-4 to be higher than their tax bill, they force themselves to save a little bit each month and enjoy spending the extra money at tax time. Whole businesses enterprises spring up to relieve people of their refund checks- Car sales, furniture, clothes, etc.
People also fear having to pay taxes. This makes sense, given that a number of sources, from CNN to the Atlantic, have reported most American’s can’t afford a $400 unexpected expense, much less a tax bill. What the tax – over – payers are giving up is the compound interest on their over-payments which they could have earned, had they been invested instead of overpaying.
If you have income which is difficult to plan for:
- plan this year’s withholdings to eliminate last year’s refund check. That way you get the largest paycheck month to month, which will allow you to invest the largest amount earlier in the year.
- Update your W-4 throughout the year if you work a considerable amount more (or less) such that your overall income year over year will be impacted. Why give the government an interest free loan to misuse your money?
- If you owe a little bit at the end because you really screwed it up, you should be fine given your emergency fund, or reducing extra debt payments, or even reducing retirement contributions for 1 or 2 months. It’s not like that money is spending itself in the future, right?
Other Life changes have tax consequences:
- Adding to family
- Job loss, reduction, raise
- Income variations
- Property tax – ability to prepay
- Large purchases
- Anticipated deductions
Each year we should be looking forward two or even three years.
- Will I be taking an income hit next year because my wife will stop working due to childbirth? Next year might be a good year to shoot for the Retirement Savers Credit, or roll over some traditional contributions to a Roth IRA if our tax rate will be reduced or eliminated.
- Can I skip a month’s of contributions this December to really juice next year’s 401K contributions and get my AGI down?
- Should I stash as much money away this year because next year I will income phase out of my IRA contributions due to a raise?
- Can I Tax Loss Harvest this year to offset some gains and income in future years?
- Will my tax rate be lower next year such that I should plan on Tax Gain Harvesting?
- Do I not know what these terms mean? This is the year to educate myself on the tax code and its implications to my wealth!
There are a number of deductions and credits you can take, some by shady accounting, some by costing yourself thousands elsewhere (mortgage interest deduction requires buying a house!)
Saving, Pre-planning and paying attention to changes in your tax situation can net you thousands without resorting to such measures. You owe it to yourself and your family to save your money from being wasted… by your hands- or the government’s. Saving doesn’t have to be painful- if you play it right, it might be even less painful than you thought.
*I used a very simplified tax formula of: Gross Earnings minus (contributions to 401k & IRA’s)= AGI minus (Standard deduction and Exemptions) = taxable income = tax per tables, minus credits = tax owed.
Disclaimer: I am not a licensed financial counselor of any sort. The opinions contained here are my own. Investing has implicit risk, past gains are no guarantee of future returns. You may lose money, including the principal. The US Government does not endorse any of my opinions.