The deadline for taxes in the United States is April 18th
this year. That’s coming up much more quickly than you think and if you haven’t
done your taxes yet this year it’s nearly time. Before getting to collecting
all of your tax forms and filing your paperwork, however, I’d like to introduce
you to a family that’s about to do their taxes. We’ll call them the Savers: Mom
Saver, Dad Saver, and Baby Saver.
Like many Americans the Savers don’t mind doing their share
in paying the portion of taxes they owe. But they also know that good ole’
Uncle Sam offers them lots of incentives and programs with which they can save
on their taxes. For 2015 the Savers decided they were going to make the most of
these opportunities and see just how low they could get their taxable income
and, thus, how little they could pay in federal taxes. Between the two of them
Mom and Dad Saver earned a combined $100,000/year and they file jointly. Let’s
dig in to see how they do on their savings.
The Standard Deduction
Itemizing their taxable income is too much work so the
Savers opt to simply take the standard deduction. They don’t own a home yet, so
they don’t have mortgage interest to deduct from their taxes (people who own
property are much more likely to itemize their United States tax return because
of the mortgage tax deduction). The standard deductions for Americans in 2015 look
like this:
Filing Status
|
Deduction
|
Single
|
$6,300
|
Married filing separately
|
$6,300
|
Married filing jointly
|
$12,600
|
Head of household
|
$9,250
|
Because the Savers file under “Married – Jointly” their
standard deduction is $12,600. That means the government looks at their
$100,000 in income and when considering how much they owe in taxes calculates it
at $87,400. Their upper tax bracket is 25% meaning cutting their income by the
standard deduction saves them 25% of $12,600, or a total savings of $3,150. Not
bad, and we’re just getting started!
The 401k
Through his workplace, Dad Saver receives a 401k option for
investing. His employer offers 3% matching and Dad is no dummy; instead of losing $1,000,000 or more on his 401k he takes advantage of it! In addition
to the 3% matching from the employer Dad maxes out all of his 401k for a total
of $18,000 in tax deductible income. His company match doesn’t count towards
the $18,000 personal limit established by the IRS, so all told the 401k reduces
the family’s $87,400 in taxable income all the way down to $69,400 and bumps
them from the 25% tax bracket to the 15% tax bracket. Their total amount saved
on taxes? $7,650.
The Health Savings Account (HSA)
In addition to being offered a 401k through work Dad Saver
takes advantage of the HSA his employer offers too. As the most powerful retirement account available to average Americans, Dad maxes
it out to the tune of $6,750. That’s the maximum amount he’s allowed to put
into it on the family health insurance plan he takes advantage of (the
individual limit would be $3,350) and it pays off when it comes to taxes. The
HSA reduces the Savers’ total taxable income to $62,650 and brings their tax
savings up to nearly $10,000.
The 403b
While Dad Saver is off making a living in the private sector
Mom Saver does her civic duty as a public servant. That lets her get access to
a type of retirement account for public employees called a 403b. It works
almost exactly like a 401k meaning it counts against your taxable income when
you invest in it and it has a cap of $18,000 in 2015. By maxing it out Mom
manages to drop her family’s taxable income down to $44,650 for a tax savings
of $13,837.50.
The Student Loan Deduction
Mom and Dad Saver took on a bit of student loan debt while
they were finishing their degrees. In 2015 they turbo-charged paying off that
debt after reading a great article about getting their finances in order on the internet
and wound up getting a notice that they had earned a student loan tax deduction
for the interest they paid off. The maximum deduction they can earn in a year
is $2,500 whether they filed independently or jointly but because of all that
debt repayment they did earn the
maximum and get to deduct the full $2,500. That means they’re down to $42,150.00
in taxable income and a savings total on their taxes of $14,462.50.
How did the Savers pay off so much of their student loans
you ask? First they took advantage of the most powerful financial tool in the world (and it was free!). Then they cut some expenses. Finally they decided on turning debt repayment into a game or using the most powerful debt repayment method in the world to turn their debt into
tax savings.
The Traditional IRA Deduction
In addition to maximizing their 401k, 403b, and HSA the
Savers take advantage of yet another tax sheltered retirement account: the traditional
IRA (not to be confused with the Roth IRA). The maximum an individual can contribute to their traditional
IRA in a year is $5,500 but Mom and Dad each count as an individual so they can
each sock away $5,500 giving them a total amount of IRA savings that’s $11,000.
Baby Saver doesn’t get to participate because you have to earn income in order
to qualify, but $11,000 still isn’t too bad. With their IRAs the Savers have
managed to drop their total taxable income to $31,150, less than a third of their actual income! They’ve saved over
$15,000 in taxes by taking advantage of all of these programs Uncle Sam offers
them!
Even if the Savers hadn’t opened up their Traditional IRAs
during 2015 they actually have until April 18th, tax day, to open
the accounts and put money into them. Even though it’s 2016 as they do their
taxes Mom and Dad could put aside $11,000 (or whatever they could afford) and
save themselves tons of tax dollars. They can even file taxes as though they
have their Traditional IRAs opened and the government will give them the tax
break even if they don’t have open
IRAs provided the Savers open the accounts by April 18th. Pretty
crazy! The Bill Stark Blog still recommends the Roth IRA for most folks and you can only put away a combined
total of $5,500 into your Roth/Traditional IRA.
The Dependent Deduction
In addition to marking the year they started taking an
interest in their personal finance wellbeing, 2015 also marked another
momentous occasion for the Savers: the birth of Baby Saver. In the government’s
eyes that’s a dependent meaning a savings of $4,000 in taxable income. That
translates to a savings of $600 in taxes and drops the Savers’ taxable income
down to $27,150.
The impact of deductions
Mom and Dad Saver did pretty well with their use of
deductions on their taxes. They took their $100,000 salary and managed to drop
it all the way down to $27,150 in taxable income saving almost $18,000 in taxes
and even dropping themselves down a full tax bracket. That’s pretty incredible,
and by using programs offered directly by the government to incentivize certain
behaviors (like saving for retirement) the Savers managed to do it all legally.
While the deductions they took are nice, they’re not the only way to save on
your taxes. There’s one more set of things to consider: tax credits.
While a tax deduction reduces your taxable income, a tax
credit straight up reduces the amount of taxes you owe. For example, a $1,000
tax deduction means a savings in taxes of 15% or 25% of that total depending on
your tax bracket ($150 or $250 respectively). A tax credit of $1,000 reduces
your overall amount of taxes owed by $1,000. With taxable income of $27,150 the
Savers owe $922.50 in taxes for the 10% portion of the tax bracket up to $9,225
in income and $2,688.75 for the 15% portion of the tax bracket on the rest of
their income giving them a total of $3,611.25 owed in taxes. Let’s see which
credits the Savers qualified for in 2015 and how that impacts their total tax
burden.
Lifetime Learning Credit
In addition to her full-time job with the government Mom
Saver has gone back to school part-time. To help her pay for these expenses the
government offers her the Lifetime Learning Credit. The Savers just sneak under the income requirements of $100,000
when filing jointly and can get up to $2,000 off their taxes. Mom manages to
qualify for the full amount meaning they knock their $3,611.25 in taxes owed
down to $1,611.25.
Child and Dependent Care Credit
To help people with children go to school and work the
government provides a tax credit for families who have to pay for child care
(or for dependent care for elderly/incapacitated family members). The credit
scales progressively meaning the more you earn, the less you can get from the
credit. At $100,000 Mom and Dad’s adjusted gross income is too high, even with
qualified deductions, to get more than the minimum amount of the credit. Still
that’s $600 in taxes that they get to save which brings their billable total
from $1,611.25 down to $1,011.25. They also note that unlike other credits, the
Child and Dependent Care Credit doesn’t earn you money back from the
government. Instead if it reduces your tax total into the negatives the
government considers your tax burden to be $0 but doesn’t pay you any money for
going negative.
The Child Tax Credit
In addition to getting an exemption from having Baby Saver
in 2015, the Savers get a tax credit for their child of $1,000 every year until
the child turns 16. Of course that credit starts to scale downwards once their
combined income reaches more than $110,000 but because it’s not at that
threshold yet the Savers are doing just fine and get to drop their taxes all
the way down to just $11.25.
The Government Doesn’t Want You to Pay Taxes
Seriously! They offer so many savings, deductions, and
credits that the Savers, a family that earns $100,000 a year managed to drop
their total taxable amount of income from $100,000 down to $27,150 and their
total amount of taxes owed from $16,587.50 all the way down to $11.25. That’s
so freaking insane it makes you want to run out and hire a CPA right this second!
So what’s the moral of the story? If you’re the type of
family that can afford to maximize every single tax advantaged savings vehicle that
comes your way then you can save yourself a lot
of money in taxes you don’t have to pay now. Critics will be quick to point out
that eventually Mom and Dad Saver
will have to pay taxes on most of their retirement accounts but only after
years of tax-free investment growth and probably at a time when their tax
bracket is lower than the 25% their $100,000 in income puts them in. More
critics will point out that it’s unlikely many families can actually afford to live on the salary left over
from $100,000 in income when you account for how much of it is locked into
savings for retirement. But instead of second guessing how our hypothetical
family manages to survive on $30,000ish each year while turbo charging their
savings for later shouldn’t we ask ourselves, “Why are we willing to give up so
much free money in order to spend?”
After all, if you’re not taking advantage of 100% of the tax
advantaged savings vehicles provided to you by the government you’re
essentially paying an extra fee for every dollar you spend. You pay sales tax
on the item you’re purchasing and because you used your income to make that
purchase the government takes its 10, 15, or 25 percent cut at the end of the
year during tax season. You might have to make some of those purchases but in context of how much you COULD be
saving you really have to ask yourself: do I need that thing, whatever it is, instead of maximizing my tax
savings by putting away money for the future?
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