How We Increased Our Net Worth by $8,750 This Year Without Earning More or Spending Less
Today we will outline the simple change we made to our financial plan that will increase our savings by $8,750 this year. It requires no increase in earnings or decrease in spending. The exact dollar amount for you could be less, or even more, depending on your marital status and tax rate.*
One of the most simple yet most effective ways to increase your net worth is to max out savings in tax deferred retirement accounts. This allows you to keep more of your money every year by paying less taxes. All of this money can go to work for you by compounding for years. This also allows you to pay a much lower tax rate, or even no tax at all, when the tax man does come calling on this money. If you, like us, have used a financial advisor and followed mainstream personal finance advice, you may not fully understand this concept. In fact you may never have even known of this powerful strategy. We never considered it until reading other early retirement blogs, and it has cost us thousands of dollars each year just in increased taxes paid unnecessarily.
Today, we hope to clarify why this is such a powerful strategy to drastically increase your savings rate while reducing the need to take investment risk and to explain why most people don’t know much about it. We’ll do this by answering the questions we wish we would have asked years ago, but simply didn’t know to ask.
(1) How do you defer paying taxes on your income? For wage earning workers, the primary options are work related retirement accounts or individual retirement accounts (IRA). The work related plans offer several huge advantages. They allow for higher amounts to be deferred in a year, and they are not restricted by income limits. The common work sponsored options are 401(k) or 403(b) plans with a 2014 limit of $17,500/person ($35,000/couple) or Simple IRA with a $12,000 limit/person ($24,000/couple) that can be deferred. The other option to defer income is an IRA with a 2014 limit of only $5,500/person ($11,000/couple) that can be deferred. The ability to defer even this much smaller amount is dependent on whether or not you have access to a work sponsored account and on your income.
(2) If we’re just deferring our taxes, won’t we just have to pay them later? Yes and no. The standard argument against maxing out tax deferred accounts that we have read and heard from our advisor is that you are not really keeping more money because you are only deferring the earnings on which you will eventually have to pay taxes anyway. This is technically true. You will eventually have to pay taxes on these earnings. However, the rate at which your money is taxed can be drastically different, as low as 0%, depending on when and how it is realized. This is where a basic understanding of the federal income tax code is vital. For a married couple filing jointly in 2014, because of the standard deduction and each individual’s personal exemption, the first $20,300 of earned income is free of federal income tax unless you earn over $305,000 at which point the personal exemptions begin phasing out. The next $18,150 is taxed at 10%. Therefore if you live on around $40,000/year as we do, and you paid taxes only on the money that you needed to live, you would pay a rate of only about 5%. Our example would look like this:
($20,300*0)+($18,150*.10) = $0+$1,815.00=$1,815 tax.
$1,815 tax/ $38,450 income = 4.72% federal income tax rate.
As your earnings increase, the top tax rate incrementally continues to increase to 15%, then 25% to a maximum rate of 39.6% federal income tax for the highest wage earners. Essentially, the more you earn the more you are penalized by the tax code because your dollars are taxed at different rates depending on where they fall in these tax brackets. When you defer taxes on your income, you effectively lower your income avoiding the taxes on the last (most heavily taxed) dollars. The $35,000 that we were able to defer this year all falls into the 25% tax bracket, giving us the $8,750 figure seen in the title ($35,000 * .25 = $8,750). Therefore, depending on the tax bracket where your top dollars fall and whether you are single or married, you may have a higher or lower figure. Regardless of your exact amount the concept is the same.
(For a full 2014 tax schedule, standard deduction and personal exemption amounts for 2014, you can check this link to gain a better understanding of this concept and figure out how much you can reduce your own taxes. It also includes a link which shows that some of these amounts will increase, as they do periodically, in 2015 to adjust for inflation.)
(3) Who should consider this strategy of maximizing tax deferred accounts? This strategy would work to some extent for anyone who has a savings rate that would allow you to max out your tax deferred accounts. That is because, by definition, you would live below your means. Therefore, you would simply be shifting money from the present, when it is highly taxed but not needed, to the future when it would be needed to live and would fall into the lower tax rates. Using our example above, if you utilized only this strategy we would decrease the taxes paid on this money from 25% to less than 5%, a savings of over 20% in tax rate. The people who would benefit the most from the strategy are those who live a relatively frugal lifestyle but have high earnings because the difference in tax rates would be even larger.
(4) If this strategy is so simple and obvious, why doesn’t everyone know about it and do it? To answer that question, you have to look at the duty and motives of those who provide financial information. You also have to consider the spending patterns of the average American.
First let’s look at the IRS. Their duty is to provide information on the tax laws as passed by congress so that you can pay your taxes. They do this at IRS.gov. They have no duty to help you develop a plan to pay the least amount of taxes. In fact, it would be in the government’s best interest to collect as much tax as possible.
Next let’s consider the mainstream media. Their motive is to reach the largest possible audience so that they can maximize revenue through the sale of advertising. Since the average American has a savings rate near 0, this strategy would be completely useless to them. Therefore, you will read and see the same tired stories about how we should all try to save 10% of our incomes (even though it is very difficult to do so blah, blah, blah) to provide for a secure retirement, pandering to the masses while rarely providing any relevant information to people really trying to improve their financial situation.
Financial advisors should know about this strategy, but would they encourage it? Let’s look back to the accounts available to most people outlined in question #1. The most powerful tools for most workers are work related accounts. Advisors would have a hard time charging fees on these accounts. Most advisors are paid by either commissions on investments they sell or a percentage of assets under their management. This aspect of the tax code creates a strong incentive for advisors to not tell you to implement this strategy because the first $35,000 you invest in a year would be difficult to get under their control and charge fees on. Very few people invest anywhere near this amount in a year. Therefore, it is highly unlikely an advisor, paid in standard ways, would advise you use a tax deferral strategy that eliminates their source of income. Ours didn’t!
(5) Is there anything else we can do to decrease our taxes and keep more of our money? Actually,this post is just the tip of the iceberg. Our example is extremely over simplified focusing only on federal income tax rates to attempt to be as clear as possible about the massive impact of this strategy without muddying the waters. We are completely ignoring the impact of having a child or any other deductions. We are talking only about the deferral options available to most wage earning workers. Business owners and certain other workers would be able to defer even higher amounts annually. There are also other accounts such as health savings accounts (HSA’s) that can be used for the same benefits. We are not trying to present our overall tax plan in this one post. There are several other strategies we are employing to have an even greater effect, essentially eliminating taxes on this deferred money.
We want to present this information in bite size pieces to not make it overwhelming to any average reader with limited understanding of tax planning. If you are still hungry for more information on this topic and can’t wait for future posts, I would refer you to the Mad Fientist blog and recommend starting with this post. We have found him to be masterful in explaining these concepts. Here are two other blogs I have been reading to learn more about tax planning: I love this post from GoCurryCracker, and this is another excellent post from the blog Root of Good. They both present some very interesting case studies in ways to drastically increase your wealth through applying these (and more advanced) tax strategies. Check them out and share any comments, questions or ideas you may have below.
*This post is not meant to serve as a recommendation to choose any particular investment or investment strategy. Nor is it meant to serve as tax advice. We are simply sharing our opinions, experiences and strategies that we employ with our own finances. We recommend strongly that you do your own independent research and develop a plan specific and appropriate to your own needs. We encourage everyone to always question everything, including what you read on this blog.
*Image courtesy of Prakairoj at FreeDigitalPhotos.net