Let's first start off with a disclaimer. I am not a tax professional, and I do not provide tax, legal, or accounting advice. Readers should consult their tax advisors! There...I said it!
However, I thought this would be a fun math experiment. Is it possible for a middle class family of 4 to optimize their federal tax to the point where they won't owe anything at the end of the year? I think there are many ways to do this if you plan correctly! In the past I've used my income from the previous year, plus making adjustments to my W-4 withholding to try and approximate how much tax I will owe at the end of the year, so that I can get my tax bill or perhaps a refund that is as close to ZERO as possible!
BIG TAX REFUNDS & BIG TAX BILLS ARE FOR SUCKERS
First let's discuss why getting a huge refund at the end of the year is not "The Move" at all. When you receive a refund, this means that you've OVER PAID what you OWED in taxes for that year. You're essentially providing the government with an Interest Free Loan! When is the last time someone...anyone, especially an institution given you an interest fee loan? For 99% of us that answer is never! The closest you'll get is a credit card balance transfer, and most charge you a fee upfront, with no interest for a certain time period. Typically 6-12 months. After this time period, if you haven't paid off your card, you will be charged interest for the remaining balance as if you were being charged interest the whole time period. Banks are in the business of making money, so a loan is a means of making money off of your need to access cash.When you pay taxes, you are providing cash for the government to take care of the country or states needs. Now it may not be as efficient as we would like it to be, but that is its purpose.
Let's start with a rough example: You or your family unit provides the government with $1,000 of tax revenue each month, which adds up to $12,000 total at the end of the year. Of that $12,000, let's say you really only owed $9,600. That equals $2,400 at the end of year. Unfortunately that money had no opportunity to compound in order to help your money grow in a savings account or in investments. If instead, you could figure out a formula where you pay the exact amount of taxes you will owe, after taking into account Tax Deductions and Tax Credits, then you could put that money in a savings account or invest it throughout the course of the year. Let's assume you are a tax genius, or know one, and you were able to pay exactly $9,600 throughout the course of the year. What would the $2,400 turn into?
I'll use my SoFi Money Checking/Savings account as the example, since you can currently get a 2% interest rate on your cash with this account. Depositing $200 a month, this money would grow to $2,426.18. At the end of the year, you would have $26.18 more than the government would have refunded you for your overpayment. Only $26??? Not a huge deal for some...but over the course of your working lifetime, or 30 years? $2,400 a year would add up to $72,000 over a 30 year period assuming you went the route of waiting for the government to pay you back at the end of the year, and of course saving the money with no interest. If you put that money into a Savings Account each month at a 2% interest rate, you would gain $26,735.60, bringing the total to $98,735.60! Now THAT is a HUGE difference! Little things add up when you look at a longer time horizon. Now what if we invested it into the Stock Market instead?
Instead of a 2% rate, we will use an 8% rate, which is a realistic average you can gain via the stock market. At an 8% rate in the first year, your $2,400 turns into $2,506.94, a $106.94 gain. Over the course of 30 years however, the $72,000 you invest turns into $301,644.42, which is a gain of $229,644.42!!! That's the power of Compound Interest! Yes, I'm saying just your "little ole" $2,400 a year ($200 per month) when invested in the stock market can turn into over $300K! Now that is assuming you optimize your taxes, save and invest the $2400 instead of spending it, and never sell during that period of time. One of the simplest ways to invest, and gain the average 8% that the Stock Market has given us over the course of its history, is by investing in a Total Stock Market ETF. One of the platforms I use is M1 Finance because it's simple and you can automate your deposits each month or every week if you choose. This way you can just set it and forget it. No need to think about making those deposits each month.
TAX DEDUCTIONS AND TAX CREDITS
Let's get into how we can actually estimate our potential Federal Tax Bill. I'm using Federal as the example, because each State Tax varies, and I live in a tax free state! In this example I am only considering 1 specific Tax Deduction and 1 specific Tax Credit. As I mentioned at the beginning, I will use the average family of 4 (two parents, two children). We'll refer to this family as the Jackson's.
The Jackson's are married and file taxes jointly. As a family the Jackson's make $78,950, which is slightly above the 2017 real median family income of $75,938. This is also at the very top of the 12% Tax Bracket for Married Filing Jointly (MFJ). At this income level, your total Federal Tax Bill would be $9,086, which is very close to the example tax bill we used above. Keep in mind that every dollar made over the $78,950 would then be taxed at 22% instead of the 12% rate for incomes between $19,400 and $78,950.
How can we turn $9,086 of taxes into $0? This is where deductions and credits come into play. A Tax Deduction reduces taxable income. In our example the Jackson's taxable income is equal to $78,950 before any Tax Deductions. A family that is MFJ, is eligible for a Standard Deduction of $24,400. This means that instead of the full $78,950, only $54,550 is considered "taxable". This takes your total tax bill down from $9,086 to $6,158.
Tax on your First $19,400 earned is $1,940 (10% Bracket).
Tax on additional money $54,550 - $19,400 = $35,150 * .12 = $4,218 (12% Bracket)
$1,940 + $4,218 = $6,158 Tax Bill
You don't need any special tax trickery or knowledge in order to get this tax deduction, because any MFJ couple who files a joint tax return is eligible for this deduction. $3K down, $6K more to go!
Now let's talk about Tax Credits. Instead of reducing your taxable income the way a tax deduction does, a Tax Credit is applied directly to your tax bill. So if you had a $1,000 Tax Credit, your remaining Tax Bill after the example above, would be about $5K. These are much better than tax deductions! In order to get a $1,000 reduction in taxes using a Tax Deduction within the 12% Tax Bracket, the Jackson's would need to reduce their taxable income by $8,333.33. This means every $1 worth of Tax Credits, is essentially $8.33 worth of Tax Deductions. Tax Credits for the WIN!!!
Where can we get a Tax Credit? This is where The Jackson 2 step in! Kids are not only lovable and huggable expenses, they are also Tax Credits according to the IRS. The Child Tax Credit provides a $2,000 Credit for each eligible child, and is phased out for MFJ above $200,000 Adjusted Gross Income (AGI). If your tax bill happens to be zero before your Tax Credit for other reasons, up to $1,400 of the $2,000 is refundable. Since the Jackson's have two children, they are eligible for a $4,000 Tax Credit, reducing their now $6,158 Tax Bill to $2,158.
START WITH THE END IN MIND
A simplified formula to try and find out how you can reduce your taxes to $0 is to work backwards. Determine all of the Tax Credits you are eligible for, or could be eligible for after any Tax Deductions are taken. In the Jackson's example, the only Tax Credits we mention are the two Child Tax Credits totaling $4,000. We know based on the tax brackets, that within the first bracket $1,940 is the tax for $19,400 of income, and that the Jackson's are not above the 2nd Tax Bracket (12%) which is anything below $78,950 . The Tax Credit of $4,000 minus $1,940 equals $2,060. $2,060 is the amount of tax due in the 12% bracket. $2,060 divided by .12 equals $17,166.66. $19,400 plus $17,166.66 equals $36,566.66, and this is the amount of TAXABLE income the Jackson's would need to stay under in order to live a tax free life!
Previously I mentioned that due to the Standard Deduction of $24,400 for MFJ, the Jackson's TAXABLE income is reduced from $78,950 to $54,550. Their current taxable income of $54,550 minus their Target Taxable Income (TTI) of $36,566.66 equals $17,983.34, which is the total amount of Tax DEDUCTIONS the Jackson's need in order to reduce their tax bill to zero!
Here are 4 simple Tax Deductions the Jackson's can use to reduce their taxable income without itemizing deductions (Above the Line Deduction), while at the same time building towards their future.
Any combination of the above Tax Deductions that can get you to a total of $17,983.34, will essentially help you with the goal of living a Tax Free lifestyle! Now the biggest thing we have to worry about with all of this, is the TTI of $36,566.66 + $24,400 (Standard Deduction). We'll call this the Pre-Standard Deduction Income (PSDI). Why? Because if you can't afford your lifestyle with only $60,966.66 for a Family of 4, then targeting this goal is useless! Controlling your expenses is key to ensure that you do not incur debt while attempting to avoid taxes. But if you are able to reign in your expenses, and invest the $17,983.34 ($1,498.61 per month) in your 401K, IRA, and/or HSA with an 8% average return, then in 30 years you will have about $2.26 Million in your retirement accounts! $2.26 Million, and only $540K is from the money you deposited in your investment accounts over the 30 year period!
Of course, the less money you make, the less additional Tax Deductions you need to get closer to zero tax liability. Also, if you have additional children or other Tax Credits you are eligible for, then your TTI is higher. For example if the Jackson's had 3 kids instead of 2 ($6K vs $4K Child Tax Credit), their TTI is $53,233.33. See Chart below for how the Child Tax Credit combined with the Standard Deduction can affect how much income you're able to earn tax free. This chart does not take into consideration the Student Loan Interest Deduction, Mortgage Interest Deduction, or any other deductions. This is strictly considering the Child Tax Credit and the Standard Deduction, and is a great starting point for most families. Additional Tax Credits and Tax Deductions, thus taxes owed, may vary for your individual case. But this is a great place to start!
Be sure to leave a comment if you found this useful!
Target Taxable Income Chart
Tax Deduction and Tax Credit Definition
Child Tax Credit - IRS (2019)
Real Median Family Income - Census
Tax Brackets - Fairmark
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