Taxes. It is our duty as patriotic Americans to keep our individual taxes as low as possible. I want to show you just how patriotic I am.
Over the years our income has grown steadily. Not long ago our combined incomes crossed into six figure territory. In 2013, our earnings peaked right around $150,000 from our jobs plus some dividend and interest income from our investment portfolio.
In my overview of my path to early retirement at 33, I briefly discussed our tax strategies and the benefits of a low tax rate. Our tax rate has stayed very low throughout the last few years. Two factors played a big part in allowing us to pay almost no federal income tax:
- Taking advantage of all available tax deferred savings options
- Having a bunch of kids (well, just 3, nothing too crazy)
Almost all wage earners can take advantage of tax deferred savings plans. Having a bunch of kids isn’t necessarily a great way to save a bunch of money, but I will demonstrate how having kids led to big tax breaks in our situation. On a $150,000 income, we pay 0.1% of our income in federal income taxes. Even without kids, our tax rate would have been under 4%.
You won’t find any clever or unique tax dodges here. No shady or questionable tax treatments. No one is committing federal tax fraud. We simply did the research and put a plan in place to maximize our tax savings.
Shrink Your Paycheck
This seems like backward advice, but do everything you can to make your take home pay as small as possible. Employers offer all kinds of opportunities to reduce your taxable income before you even get your paycheck such as:
- Retirement plan contributions (401k, 457 or 403b plans)
- Pension contributions
- Employee Stock Purchase Plans
- Employee Stock Ownership Plans
- Health Insurance
- Dental Insurance
- Flexible Spending Accounts (for health/dental or child care)
- Health Savings Account
Here’s how you make your income look tiny when you get your W-2’s during tax season. Our combined gross salaries (before any deductions) were around $141,000 in 2013. My salary was around $69,000 and Mrs. RootofGood’s salary plus bonus were around $72,000.
We took advantage of all the benefits offered by our employers. I worked for the government where I had access to a 401k and a 457. I found this unbelievable, but you can actually contribute the IRS maximum of $17,500 to EACH of these accounts. I chose to contribute the maximum of $17,500 into the 401k and the 457. I was also required to have 6% of my salary (or $4,200) withheld to fund my pension (which I never intended to take). The cash value of my pension contributions (without any earnings) can be withdrawn and rolled into an IRA when I would like to do so.
Using these tax deferred savings plans, I turned my beefy $69,000 salary into a puny $29,800 per year.
Mrs. RootofGood was lucky to work for an employer that offered really good benefits. She contributed the maximum to her 401k ($17,500) and also contributed $5,000 to her Dependent Care Flexible Spending Account (daycare for the little one), $6,450 to her Health Savings Account, and paid $500 for the year for health insurance (yes, per year!), and $600 per year for dental insurance.
Mrs. RootofGood’s $72,000 salary magically metamorphosized into a scrawny $41,950 W-2 salary.
At tax time, our W-2’s will arrive telling us that our total earnings (for federal income tax purposes) are $71,750. We basically cut our $141,000 gross salary in half for federal income tax purposes.
Even More Deductions
In addition to our earned income, we expect $9,000 in investment income from our taxable investments at Vanguard and Fidelity ($8,000 dividends and $1,000 interest).
We have $15,000 in capital losses from tax loss harvesting our mutual funds over the years (What is “tax loss harvesting”? – sounds delicious!). Each year we take a $3,000 capital loss write off against our other income ($3,000 per year is the maximum deduction).
Adding up our income (including the $3,000 capital loss), our total income for 2013 will be $77,750.
Our deductions include $11,000 in traditional IRA contributions (maxing out $5,500 into each IRA), and $600 in student loan interest payments.
Subtracting the deductions from our total income, we end up with an “Adjusted Gross Income”, or AGI, of $66,150.
But wait, there are more deductions! A $12,200 standard deduction plus $19,500 in personal exemptions ($3,900 x 5 people) further reduce our “taxable income” to $34,450.
The party doesn’t stop here. Out of our $8,000 in dividend income, $5,500 were “qualified dividends” that are tax free if you are in the 15% tax bracket or less (in 2013, that means $72,500 or less taxable income). We are in the 15% tax bracket with our $34,450 taxable income. In effect, we pay tax on $28,950 ($34,450 taxable income minus the $5,500 qualified dividends taxed at 0%).
Our total tax owed on $28,950 works out to be $3,450. Part of the income is taxed at 10%, part at 15%.
That’s not a bad tax bill considering we made $150,000 in 2013. But we still have to take a few tax credits.
We have three kids. In addition to having superhuman powers of massive cereal consumption, they also generate a $1,000 Child Tax Credit per Cap’n Crunch-stuffed mouth. That adds up to a $3,000 tax credit (that reduces our taxes owed dollar-for-dollar).
We somehow managed to pay $300 in foreign income tax through our international mutual fund holdings. Owning tiny slivers of luxury shopping centers and office buildings in Zurich, Shanghai, Singapore, and Dubai sounds totally sweet until you realize the countries you invest in are siphoning off tiny slivers of your income (they have Uncles too, just not named “Sam”). Fortunately, the federal income tax code, in its infinite generosity to the privileged few, allows a tax credit for any foreign income tax paid. Poof – another $300 in income tax liability gone!
Our tax liability went from $3,450 before subtracting tax credits to a bottom line tax bill of only $150. Yes, that is right folks. Through our Houdini-like usage of tax-defying strategies, we managed to earn $150,000 and pay only 0.1% tax.
I am always a little dumbfounded around tax time. The tax code seems strange and convoluted, and I don’t think a family with our level of earnings should have such a small tax bill. But hey, that’s the law!
The tax savings don’t stop with a tiny 2013 tax bill. We also managed to contribute over $74,000 into tax deferred savings plans that won’t be taxed until we withdraw them at some later date (if we ever pay tax on the withdrawals at all!). Tax deferred accounts are the gift that keeps on giving year after year. Note that we had $9,000 in investment income in our taxable accounts, and we had to pay tax on part of it. We have over $10,000 income in our tax deferred accounts that we don’t pay tax on each year (the tax is deferred – that’s why they call the accounts “tax deferred” I think).
Out of curiosity, I re-ran the tax calculations to see what our tax burden would be if we didn’t do any tax planning. Our tax liability would increase to $19,883. Good thing we know our way around the tax code!
I Don’t Have Kids, So I Can’t Pay 0.1% Taxes Like Mr. RootofGood
Unfortunately, if you don’t have any little booger-encrusted tax deductions running around your house, you’re gonna pay more taxes. Sorry to tell you this, but you are subsiding me and my burgeoning empire of miniature RootofGoods. I thank you, and also want to offer my condolences.
The good news is that you could still pay under 4% of your income in federal taxes if you use all of the deductions and tricks that we did.
I re-ran our tax situation assuming we have zero kids. Aside from the utter peace and quiet throughout our house, a few other things change. The $5,000 Childcare Flexible Spending Account deduction goes away (as does the childcare expense itself!). The personal exemption drops by $11,700 to only $7,800. The child tax credit goes to $0.
After losing all of these deductions and credits, we would end up paying $5,655 in federal income tax on our $150,000 income. That works out to a 3.8% average tax rate.
Moral of the story: have 3 kids, save $5,500 in federal income tax. However, kids can be pretty expensive, so don’t have kids for the income tax benefits alone. They are cute though. And they can fetch beers on command.
Readers, did I miss anything? Have you been able to keep your tax burden low while earning a hefty paycheck?
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