In the previous post, we reviewed several useful tax breaks available to most people. Let’s now look at a few examples, starting with a few things one can do to lower his or her tax burden for last year (2016).
- Individual Retirement Accounts ($5500 per person, $6500 for those over 55). Must be funded by April 18th, 2017 to count towards 2016 taxes.
- HSA contributions ($3350, individual, $6750 MFJ) can still be made until April 18th, 2017.
- Solo 401k contributions can be made until 4/18 provided you have already elected to make them by December 31st of 2016. Weird rule, but that’s the law.
- SEP contributions for small business owners.
- Take any credits for expenses incurred during 2016 that reduce your Adjusted Gross Income (AGI), i.e. student loan interest, tuition credit, moving expenses, etc.
- Evaluate eligibility for the following tax credits/deductions based on AGI:
- Retirement Savings Credit
- Earned Income Credit
- Calculate the amount of itemized deductions (mortgage interest, property tax, charitable contributions, etc.) and compare that with the standard deduction, taking the larger one.
A great way to see what effects the above tax credits and deductions listed above is to use Intuit’s TaxCaster app or website. After optimizing last year’s tax situation, there’s quite a bit that can be done in 2017 to improve the current year’s tax situation.
- Maxing out HSA contributions ($3400, individual, $6750 MFJ)
- Maxing out 401k ($18,000) plus another $6000 for those 50 and over
- Maxing out Traditional or Roth IRA funds ($5500 per person plus another $1000 for people over 50)
- Determining Itemized Deductions for 2017 (mortgage interest, property taxes, charitable contributions, etc.)
- Adjusting FSA ($2550) and Dependent Care contributions if a qualifying life change occurs during the year.
- Planning to pay college expenses if applicable.
To see how some of the tax credits and deductions apply in black and white, there are a few case studies below along with links to the simulated 1040 form. References to line numbers are for the IRS 1040 form that is the standard form for preparing and filing taxes.
Sample 1040 Walk Thru, Case #1
Debbie and Joe Example are a couple who has been starting on the path to saving more and paying less taxes. They each gross $60,000 per year, have two children, one is eighteen and attending college and the other is eleven. They contribute 10% of their paychecks to 401ks, and max out their HSAs, IRAs, and FSAs and have $2000 in additional cafeteria plan spending for healthcare and dental insurance premiums. They receive $5000 per year total in qualified dividends, $250 in capital gains. They have itemized deductions of $15,000, student loan interest of $500 and have spent $2000 toward their college child’s tuition and pay $5000/yr for dependent care while at work.
Total W-2 income (line 7) is $96,700 ($60,000 x 2 – $12,000 -$6750 – $2550 – $2000). From this amount, the capital gain ($250) gets added (line 13), but the qualified dividends do not (line 9b). IRA contributions ($11,000) reduce AGI (line 32) as does student loan interest ($500, in line 33). This results in an AGI of $85,450 even though their actual gross income was $125,250 ($60,000 x 2 + $5000 + $250)–a pretty decent income reduction.
That AGI is further reduced before calculating the tax owed. First, the standard or itemized deduction is applied (line 40). Here, since the itemized deduction is higher, they use the itemized value of $15,000. Next, the $4050 exemption per family member is applied (line 41). This brings down the taxable income to $54,250 (line 43), less than half of gross income. The preliminary tax value is then computed by looking it up in the IRS’s tax tables and a value of $7214 is entered (line 44). The dependent day care credit (line 49) would be $600 ($3000 [max allowable] x 20%). Additional credits would come from the education credit (lines 50 and 68), leaving a total tax bill of $3334. Not too bad considering their gross income and earnings totaled over $125,000 for an actual average tax rate of 2.7%. However, paying even that small amount was more than they wanted, so they decide they can do better.
Example family Case #2:
Let’s rewind the clock and start the same year again (easier for comparative purposes), but this time giving Joe Example a pay bump to $70,000. Debbie is now the owner of a small business whose net income is also $70,000 before any contributions/deductions are made. They first decide to max out their 401ks to $18,000 each, with Debbie able to contribute as both an employer and employee. We’ll keep all other expenses the same, except this time, the Examples elects to do a Dependent Care FSA instead of claiming a credit. Joe’s net income is now $40,700 ($70,000 – $18,000 – $6750 -$2550 – $2000). Debbie’s income will be reduced by 25% for the employer contribution to her solo 401k and she puts in $18,000 as the employee portion for a total of $35,500 (on line 28). Her net income is then $29,500 ($70,000-$17,500-$18,000-$5,000).
Total AGI is $58,950. Taxable income is $27,500. Tax owed in $3,201. Total credits amount to $3000 which includes child tax credit and the education credit. Total tax owed is $201* on an AGI of $58,700 ($145,250 in gross income) or 0.3% average tax rate, which is much lower than the 15% marginal tax rate for the bracket they are in.
All told, even though the Examples pulled an extra $20,000 in income in the second example, their taxes dropped over $3000 or 94% lower than the first example. They did that by taking full advantage of the business retirement plans, a deductible child care deduction (rather than the credit) and maxing out 401ks. They should still have sufficient income for spending with their remaining taxable income ($70,200), $5250 in dividends and capital gains, plus a variety of tax advantaged money that is earmarked for certain expenses: $5000 for dependent care, $6750 from HSA for medical expenses, $2550 from FSA for dental and vision, $2000 in college tuition for a total of $91,750 of potential expenses. Additionally, they saved a whopping $64,500 for their retirement. Not a bad job, especially when keeping their income tax owed to $201.
Case #3 The Earned Income Credit
Changing the Example’s situation to a case where now Joe is laid off from his job and Debbie’s business folds. Debbie is able to find a lower paying job at $50,000 a year, but has no 401k. They only net $3000 in capital gains for the year. They do not plan to use Dependent Care until Joe finds another suitable job. They determine that they will need an average of $3500/month to meet their expenses or a total of $42,000 annually. They expect to fully use the money from their HSA and FSA contributions this year for allowable medical expenses, so they elect to max out those contributions. Even though they saved a lot in the previous year, they know they need to keep saving for retirement.
They would like to fully fund their IRAs at $5500 each, but when looking at tax calculator, they realize that they would only need to contribute about $2750 in a Traditional IRA to get the full tax benefit and that additional contributions do not reduce their taxes. Also, they’re in the 10% tax bracket, so they would be best served to “pay” the tax now and let the money grow completely tax free, so they contribute the remaining $8250 to Roth IRAs. When we say “pay” taxes at 10%, we’ll see that there is actually no tax owed-quite the opposite-they get a tax refund, even if they contributed no money to federal taxes. Their total income** (line 22) is now $38,950 ($50,000 +$250 – $2000 – $6750 – $2250). After discounting the Traditional IRA contribution of $2750 and student loan interest of $500, their AGI is $35,700.
Going through the remaining items on the back of the form, their itemized deductions are still $15,000 and exemptions are $16,200, leaving them with $4500 in taxable income. Looking at the tax tables, the income tax owed is $428, but when they get the results from TaxCaster, they see that in fact, the government owes them $4217! How could that be? They were expecting to get $1000 in child tax credit and were hoping to get almost their $2000 back in tuition credits, but there’s still almost $2000 extra coming back to them that they didn’t pay in. Enter the Earned Income Credit (EIC).
The EIC was designed to help those who are working but have a modest income. In this case, the EIC gave the Example family almost $2000 in supplemental income that allows them to meet their budget needs while still allowing them to save some money for retirement. The EIC has quite a few stipulations and is based on filing status, number of children and income. Those with relatively moderate investment income (above $3400) are also excluded.
Returning to this third case, the Examples had a total income of $53,250, including job and investment income. They had to pay a total of $2983.50 in Social Security and Medicare taxes (7.65% of $39,000). Assuming they use the full HSA and FSA contributions for allowable expenses as part of their $42,000 annual budget, they have sheltered those funds from taxes, but are able to use them when the expenses occur. The only portion of their income that is not available for use during that year is the Traditional IRA contribution of $2750, though they could access it by paying the tax and a 10% penalty if needed. Contributions to a Roth IRA can be withdrawn tax and penalty free, but any earnings would be subject to the 10% early withdrawal tax. Credit card rewards could also be used to add some additional income to provide an additional income buffer.
Along with the EIC, the total income available to cover expenses is $43,484 ($53,250 – 2983.50 -$11,000 +$4217), more than covering the needed expenses of $42,000. Plus, because of the way the IRA contributions are setup, the Examples can file their tax return for the previous year and claim IRA contributions will be made by the mid April deadline and get their refund back before actually having to put the money into their IRA, so in cases where the cash is tight, this is a nice cash flow bonus, but having some time to make the contribution after receiving the refund.
Wrapping it up
Tax planning is neither glamorous nor very exciting, however, spending a couple of hours to understand the basics and not-so-basic tax planning strategies can save people significant sums of taxes, even in situations where income is relatively low. Moreover, since basic tax laws don’t change much year to year, strategies generally only need to be tweaked after they are initially established or as family situations change (new baby, marriage, divorce, children in college, new jobs, new business, etc.) Proper tax planning, once done will streamline future tax filings and allow people to keep more of their money in their pockets, or hopefully, in their investment accounts.
Disclaimer: The above tax examples are the author’s attempt to illustrate some of the tax advantages available in the tax code. The author makes no guarantee that the above examples are compliant to all IRS rules or to anyone’s actual tax situation. Consult a tax adviser or online tax preparation software to get a more detailed estimate of an individual tax situation.
*These calculations do not reflect the self-employment tax for Social Security and Medicare (15.3% total), which is double the employee amount (7.65%), nor the self employment deduction for taking paying them. The goal of this post was to focus on federal income taxes only, assuming Social Security and Medicare taxes were paid quarterly, like they are supposed to. Trying to replicate this on Taxcaster will result in the program computing self-employment taxes, which are significantly more than actual federal taxes, which is where the Taxcaster program differs from these results.
**This is different from tax line 22 total income which excludes cafeteria contributions like HSA and FSA, as well as medical, dental and vision premiums.