It’s that time of year… TAXES. I used to be excited about taxes, filing early, and getting a refund. These days I am more on the side of delay, postpone, and groan all the way across the finish line.
Today taxes are our single largest household expense and it is one that I continue to hate with every dollar that goes to it. If you have grown bored of my posts on hobbies, you should be excited, this one is nerdy to the extreme.
Because of how our progressive tax system in the US is built, taxes seem to have very little impact early in your working life and grow their way into one of the most important topics as your income rises or you start to withdraw from assets in retirement. We won’t get off track and talk about how the tax code should change and who is paying their “fair share.” The point for today is that you can make changes to limit taxes today and you should.
First a quick disclaimer, I am not a CPA or a tax expert. I wouldn’t be surprised if I get a fact about taxes wrong, but it’s an important topic. Let’s start by looking at some of the key areas we focus on.
Pretax workplace accounts
These would include 401K, HSA, and FSA. This is the easiest way to reduce your taxes while saving for the future. Simply stated, you are able to save this money before taxes get their piece of it. How does this work? Let’s look at an example:
Let’s say that you are married filing joint and you have a household income of $200K. This would put the last $9250 of your income in the 24% bracket as shown below.
Here is the 2023 Tax bracket
Tax Rate | For Single Filers | For Married Individuals Filing Joint Returns | For Heads of Households |
---|---|---|---|
10% | $0 to $11,000 | $0 to $22,000 | $0 to $15,700 |
12% | $11,000 to $44,725 | $22,000 to $89,450 | $15,700 to $59,850 |
22% | $44,725 to $95,375 | $89,450 to $190,750 | $59,850 to $95,350 |
24% | $95,375 to $182,100 | $190,750 to $364,200 | $95,350 to $182,100 |
32% | $182,100 to $231,250 | $364,200 to $462,500 | $182,100 to $231,250 |
35% | $231,250 to $578,125 | $462,500 to $693,750 | $231,250 to $578,100 |
37% | $578,125 or more | $693,750 or more | $578,100 or more |
If you save that $9250 in a 401K, HSA or FSA it will save you $2220 (24%) in federal taxes. This would eliminate any income in the 24% bracket and keep it all in the 22% bracket and below. If you live in Georgia you would save another $531 in state taxes. Altogether this is a reduction in taxes of $2751.
Where people get stuck, is they look at the above and think; “so I lose $9250 from my paycheck only to save $2751… That seems stupid.” The problem is this logic doesn’t take into account the desire to grow your savings and grow your networth.
In other words, I look at the above situation and flip the conversation. I tell myself “If I save this money pretax in a 401K, HSA, or FSA I can grow my networth by $9250. If I don’t, I am left with $6679.” I don’t know about you, but I would rather keep $9250 than $6679.
Let’s look at the above decision over a 45-year career. If a 20-year-old saves only $9250 a year for a 45-year career and NOTHING else. Based on 9% annual growth at age 65 this super saver would have $6,273,675.
If that same 20-year-old decided to not save in a 401K and paid the tax man and then saved the rest they would be living a little leaner, at age 65 with $4,675,281.
Both would be great retirement nest eggs, but one has you $ 1.6 million richer. That’s the power of using a pretax account and delaying taxes.
Some quick definitions:
401K – This is your Workplace investment account. Sometimes you get an employer match which makes this account even sweeter. As long as you elect traditional and not ROTH this is a pretax deduction. This means a $10K contribution reduces your taxable income by $10K as well.
HSA – Health Savings accounts are another pretax tool that I have written about, this allows you to save money when using a high deductible plan. This money can be invested in the stock market and saved until retirement and spent like a 401K or IRA. Again, this reduces your taxable income.
FSA – Flexible Spending Accounts. These aren’t as good as HSA’s because the money is use it or lose it each year, but it is still a great tool. I’m not sure why they are called flexible because they seem to be restrictive but they can still help lower your taxable income.
In 2024 a married couple can put $8300 in an HSA, $3200 in an FSA, and $23,000 in a 401K. If you are 50 or older you can raise these numbers by $8500 for catch-up contributions. This means that you can save $34,500 for a family with one person working and grow your family’s networth without taxes. If two of you are working, that means two 401K plans that you could contribute $23K each to. I’m sure we don’t all want to save at this high of a level but if taxes are eating your paycheck up, these are easy opportunities to keep more of that money in your pocket and investment account.
Tax loss harvesting – I have written a pretty detailed post about this previously here. This post has an actual example of harvesting a tax loss. You probably don’t have many options to take advantage of this right now since the stock market is at an all-time high. But we all know, things could change quickly. If you have a brokerage account or a taxable investment account this can be a great way to reduce some capital gains tax just by hacking the system.
Donor Advised Funds/Lumping deductions – In April of 2022 I wrote about Donor Advised Funds. This is my favorite recommendation. You can see my old post here, but let me give an overview.
If you are going to give to non-profits or your local church and you are going to do it consistently, why not optimize it? Let’s not forget the true reason for giving…. and it’s not for the tax savings. But that doesn’t stop us from giving efficiently.
It’s 1040 time…
Those are a few ideas that hopefully get the brain stirring. The next best thing you can do is arm yourself with knowledge. Perhaps you do your own taxes on TurboTax, or maybe you have a CPA help you. Either way, look at your taxes, review the 1040, and try to understand what the numbers are and why.
The 1040 is pretty basic when you look at it, It’s divided into a few sections but a lot of them don’t apply to most of us. I thought it would be fun for us to look at an example. Although your definition of fun and mine might be different, hopefully, it’s at least helpful.
We are going to look at a publically shared version of a current famous person as an example. For bonus points leave me a comment and let me know who you think it is. That is for the two nerds left who are still reading this far into a blog post on taxes.
Here is the income section of the 1040 tax document
Box 1a is going to show W2 income from this couple which is $482,335
Boxes 2b-6b are various other types of income. Most of us will have some interest, and perhaps some dividends. You can tell this couple is over 62 as they are getting social security payments, pensions, and some IRA distributions. It’s pretty common to have some of the social security income shielded from taxes which is what you see in 6b.
Box 8 is other income which we can’t see from this form, but is rental real estate.
Box 9 shows household income of $579,514 and right below it in box 12 you see their deduction of itemized of $44,602. This leads us to the bottom number showing that they will have to pay tax on $534,912 of household income.
Below is the schedule A showing the itemized deductions and what all is eligible for itemized. If you don’t have enough of these you simply take the standard deduction of $27,700 for married filing joint couples.
The top section is medical expenses which this couple had none or didn’t bother to include. You can’t deduct any of these unless it exceeds 7.5% of your income so most people don’t bother with this section.
The second section shows taxes paid. This is income and real estate taxes. While this couple paid $56,194 in real estate and state income taxes the current IRS rules only allow for 10,000 in a deduction for taxes which is limiting for this higher networth couple.
Below we see their $14,422 in interest payments on a home mortgage. I don’t know about you, but that is a big mortgage in my mind.
Lastly, we see that they donated $20,180 to charities. All of this together brings them to the itemized deduction total of $44,602.
Are you still with me? One more final screen and we will be done.
Here is the tax owed section
They owe $137,658 of federal income tax on their taxable income of $534,912. This is an effective tax rate of 25% but remember that because of the progressive tax rates they have some of their income in all brackets from 0% to 35%.
Starting on line 25 you see the tax that has already been withheld from their W2s and 1099’s, and estimated tax payments on line 26, totaling $133,026. This leaves them with a deficit or tax owed of $4632.
Ok, did you make it to the end? Hopefully, you have a guess who this could be, if so comment below. In addition, hopefully, this helped explain a little about the mysterious 1040 and how your taxes work. The main thing I want to empower you with is knowledge and hopefully, today helped with that.
In addition, I wanted all of us to realize there are not many opportunities for tax savings. However hopefully after today, you see some of the paths that can be taken. The first step should be to reduce taxable income. Taxable being the key word there, we of course, don’t want to reduce our income, but by playing by the tax rules and sheltering some of our money in savings and from taxes we can pay less while making and saving more. Take some time today to review what money you are putting into a 401K, HSA, or FSA. My advice would be, to increase whatever level you are at. If you have big goals, increase those contributions and work your way to the max. If you want to be comfortable in retirement, try increasing 1% each year or half your raise each year while working your way to the max. Secondly, you would want to review deductions and see if you can do anything better. This would be maximizing giving by being more tax efficient in giving, or just realizing the things that do and don’t make a difference.
Thanks for reading and hopefully today was helpful.