Over the years I have written considerably about how you can use tax-advantaged accounts to manage your tax bill. Today I want to give a hypothetical tax case study of how a couple making $200K in income can pay less than 10% in tax to the federal government a year. I realize tax season just ended but there is no better time than today to start working on this year’s tax strategy.
Typical Disclaimers Apply, This Tax Case Study is to Stimulate Thought Only
Now I will start out by saying, this article is not meant as a recommendation on tax strategy. Each person’s scenario is unique. It is also completely hypothetical and shows no relation to anyone real or imagined. It has been simplified to make a point. This hypothetical is purely an example of what is potentially possible depending on your goals. Perhaps it will get you thinking on your own tax strategies. It also further illustrates my prior point, those that are poor with money subsidize the rest of us. The better you are with your spending the more likely you will be to manage your money in relation to its taxation.
Focus of This Tax Case Study is On Current Tax Period
I would also like to point out, the focus of this hypothetical is on reduction in this years tax bill. Some of these strategies may shift tax bills into future periods. As I have argued in the past, this is not necessarily a bad thing provided you have sufficient plans to manage your money later when they shift out of these accounts. Of course, our normal disclosures apply. Any tax strategy you employ is your’s and your’s alone. This post is for entertainment purposes only… Anyway, let’s get started.
The Big Spenders Tax Bill
Imagine the hypothetical couple that makes $200K a year, with an even split of income. In a simple worse case scenario our family spends all $200K with no eye towards taxation. Their tax bill would be on the amount of $200K minus the 24K standard deduction or $176K. (Note I am ignoring social security, medicare, and any other deductions for simplicity here) The tax rate on that is 30,816 or 15.5%. Add in 2 kids for a fair comparison and after the $2000 per kid child care credit they would pay 26,816 in federal taxes, or 13.4% of income. Not too bad but leaves ample tax optimization opportunity.
Simple Non-shifting Actions to Reduce This Years Tax Bill
Now let’s consider what they can do with tax-advantaged accounts. So first we have the obvious HSA, for $7K. This reduces their income by 7k for tax purposes. They also probably have at least one kid in day care with both parents working, so $5K can go into a dependent care FSA account, further reducing income. (I have ignored the dependent care tax credit for the purposes of this article but if you have a reasonable income and paid more then $5K for childcare you can receive a credit for up to an additional 1K at 20% of your expenses beyond the $5K). Our couple are now below the ROTH IRA phase out. Our family is now in a lower marginal tax bracket and we haven’t even applied a standard deduction.
Time To Defer Some Taxation
Now we have an immediate $12K reduction in IRS considered taxable income with no tax deferral. Let us do some tax deferral with a 401K for each spouse. At $19K apiece another $38K disappears from taxable income for the current year. What was 200K is now 150K, and that’s before the standard deduction.
Other Options for Deferral, Situational Dependent Tax Case
But we are not done yet. Imagine our couple works for a non-profit or government organization? They might be able to defer another $19K via a 457 plan. Too unlikely one person works for a government organization despite it being the largest employer? Well, how about if one person’s source of income source is a self-run business. In that case after removing the solo 401K employee contribution referenced above they can still contribute 20% of profits to the 401K as an employer (up to 54K) and get the QBI deduction on income not in the 401K. Those 2 would mean at least another 10K off the top. Don’t have your own business? Perhaps you are over 50, then you can put an addition 6K into your 401K per person for catch-up contributions. There are many situational dependent options, the point here being to highlight them. But for simplicity, I’ll cut our family as 2 w-2 jobs and no other qualifications.
With No Special Qualifications the Federal Tax Bill Slides Under 10%, Saving $10K
So our family has an income as far as the IRS is concerned of just $150K to the IRS. After the standard deduction of $24K their taxable income is now just $126K, nearly $50K less than if they just spent the money all other things being equal. Their tax bill is just $19500. Reduced by over $10K without qualifying for any special circumstances or itemized deductions. That is a tax bill reduction of 37%. Their tax rate is now just under 10%. Qualify as the small business I previously discussed and the tax bill drops to around $17K and that number is under 9%.
The Point of This Tax Case Study is To Highlight Just How Important Tax Strategy Is
My point? I am admittedly cherry picking by ignoring social security, Medicare, and even small business tax. Then again I also hurt my example by not itemizing, factoring in business expenses, or any other special circumstances. So this is not a step by step tax guide. That being said that was never my goal for this piece.
The point is with proper tax management you can reduce your tax bill by leaps and bounds! The gains here are real even when controlling for my simplification. The key comes back to, as I said at the start, good financial management. If you spend all your funds then you would not be able to contribute to any of these accounts. That means you are doomed to a higher tax bill. Controlling your expenditures gives you the option to adjust your income tax footprint and thus pay less year after year.
What was your tax rate for 2018?