Author Topic: Case Study: Tax Strategy for moderately high earner  (Read 5177 times)

hgjjgkj

  • Stubble
  • **
  • Posts: 180
Case Study: Tax Strategy for moderately high earner
« on: July 08, 2017, 05:05:19 PM »
Topic Title: Hey everyone. I am pretty decent at limiting costs, drive a $2,200 Prius etc, but I am not so great at understanding Tax strategy and investment savings vehicles. I have been researching but feel I might be someone who at this point earns too much to qualify for deductions and such. Despite my previous cost savings boast, I also did the math via an attached excel on my expenses and even with a 50% savings ratio, the years to retirement figure turned out pretty bad so I am also open to advice there in addition to my tax situation.

Life Situation: Single, W-2 Earner, with very small low 5 figure side income last year, maybe nothing in side income this year. Mid 20s, 2 years out of grad school. Just moved back to the USA and living at home for probably another 18 months. My plan is to then identify a sub $1,000 month apartment for another 24 months, then think about a home buy based on the market/ life situation / cost benefit analysis after that. I live in the South with decent COL but properties are rising fast. In an ideal world I would try something like living in a duplex and renting out a side or buying a HUD home but the opportunity hasn't arisen yet. I am currently looking around to try to land a supplemental job as an English Tutor online. If you have another idea for a 20/hr+ side hustle let me know :)

Gross Salary/Wages: 130k base/ 10k in bonus, 140k total

Individual amounts of each Pre-tax deductions: This is the root of my problem. I have a 401k at work and currently put in 6% so I am at ~6k, but there is no company match. I am switching jobs next month and moving to a company with a 3.3% match on a 20% 5 year vesting schedule (bad I know, but everything else about the job is better).

I have a SEP IRA with 4k. Last year I made 105k gross and only took a 4k deduction from my SEP IRA

Other Ordinary Income: None

Qualified Dividends & Long Term Capital Gains: Not significant at this point

Rental Income, Actual Expenses, and Depreciation: None

Adjusted Gross Income: 140k right now for the coming year I believe last year it was 99k

Taxes: Federal, state/local, and FICA. Taxes last year were 16k, this year with the salary bump they could be much higher in the 23k+ range

Current expenses:

Student Loans: 20k/year My highest expense by far.
Other Expenses 30k/year
Total 50K. 
 - There is a lot of noise in the other expense figure such as one time purchases like a car, paying back a signing bonus, inventory for my business etc, but I think 50k is a decent high end steady state expense estimate for me right now. If I look at my spending since Jan 17 and I back out one time expenses (tax bill, business inventory) I am spending about 2,200 a month in total. This would put me on pace for 26k spend in 2017, but then I would need to kick in another 8k in loan payments.



Assets:

60k in Cash
4k in Sep IRA, 99% SPY and 1% XOM
16k in a brokerage account 96% SPY 1% CMG 3% AAPL
2.2K car
6K 401k
2K frozen in a Citi account i have struggled to get access too.
10K car, have been trying to sell it but I have had to loan it to my parents

Liabilities:

140K in student loans, blended total is roughly 6% interest rate. 15ish year term.

Level payments result in 20K of payments per year, but a shorter term.  I am at month 1 of the start of year 3 of paying them back. I am currently doing graduated payments in order to lower my mandatory monthly payments so I pay now roughly 1k per month. This allows for mandatory payments of 12k per year. This creates more monthly cashflow for myself. I still make an effort to pay ahead and hit the 20k per year level payment target, but this method allows me to put 8k (20k-12k) on credit cards thereby allowing me to get 2% cashback. I do not throw all my cash at the loans because I want to keep money free to explore entrepreneurial and investment opportunities as they arise. My plan for the debt is next year I expect to have enough liquid cash to equal this outstanding liability. I will then solve for a more optimal monthly payment, then likely pay down a large balance and ReFi the remainder (they are all federal currently) with someone like SoFi provided the economy is still strong (as I would give up forbearance protections during the refi).

I carry no other debt.

Life Goals:
1) I would like to be financially independent within 7 years. However my retirement budget makes me think this may not be possible.
2) Get out of the 60 hr work week/ 1 hr daily commute in traffic lifestyle
3) An ideal for me would be working say 3-6 months out of the year as a contract consultant making between 30k-60k, then I have the rest of the year to write or work on my own companies (which don't currently exist), study things I think are cool, visit friends, do whatever.


Specific Question(s): I have a few questions:
1) Given my current situation, what is the optimal retirement account strategy investing strategy? I am not aware of any Pre-Tax deductions I am allowed to do based on my income now.
2) I am an absolute novice at HSA and healthcare savings plans, even after reading on here and elsewhere. How should these figure into my strategy?
3) Given that I am switching jobs in a month, I think I can rollover that 401k into a Roth or Trad IRA. Which should I pick? Since I believe I am ineligible for IRA deductions, I think I should just do the Roth, since I am still (barely) able to contribute to that.
4) Is there anything at all I can do at this point to lower my tax burdens? 130K is a super high salary in my opinion at least, but I am in the typical millennial situation of high loans high salary.
5) I do not think I have an issue with my savings rate now, But my retirement budget in the attached excel seems quite high, and I do not even factor in things like gifts or if I had children. Does this budget seem reasonable? Hopefully I have overlooked something major here. I recognize I can use a library for books, and my travel model assumes being gone for 50 days a year which results in lower daily costs, but my retirement annual budget I feel is still huge.
« Last Edit: August 29, 2017, 11:22:04 PM by sr79 »

seattlecyclone

  • Walrus Stache
  • *******
  • Posts: 7254
  • Age: 39
  • Location: Seattle, WA
    • My blog
Re: Case Study: Tax Strategy for moderately high earner
« Reply #1 on: July 09, 2017, 08:25:00 AM »
Specific Question(s): I have a few questions:
1) Given my current situation, what is the optimal retirement account strategy investing strategy? I am not aware of any Pre-Tax deductions I am allowed to do based on my income now.

Traditional 401(k) is huge. Max that out with the full $18k.

Quote
2) I am an absolute novice at HSA and healthcare savings plans, even after reading on here and elsewhere. How should these figure into my strategy?

If you're relatively healthy and your new job offers a High Deductible Health Plan, the associated HSA can be another way to build up your investments pre-tax. You don't need to take the money out right away to pay for any medical bills you do have; you are allowed to save your receipts indefinitely and "reimburse" yourself from the HSA years later when the money has had a chance to compound.

Quote
3) Given that I am switching jobs in a month, I think I can rollover that 401k into a Roth or Trad IRA. Which should I pick? Since I believe I am ineligible for IRA deductions, I think I should just do the Roth, since I am still (barely) able to contribute to that.

Roll Roth 401(k) funds to a Roth IRA, traditional 401(k) funds to a traditional 401(k). Whether you are eligible to make direct contributions to either type of IRA doesn't make any difference for rollovers. Rolling traditional 401(k) funds into a Roth IRA means you need to pay tax on the full amount this year, which you probably don't want to do. Better to wait until you're retired to pay tax on this money.

Quote
4) Is there anything at all I can do at this point to lower my tax burdens? 130K is a super high salary in my opinion at least, but I am in the typical millennial situation of high loans high salary.

Traditional 401(k) contributions will bring it down by $18k, HSA can knock a few thousand more off. If you have itemizable deductions (charity, state/local taxes, mortgage interest, etc.) higher than the standard deduction, that can also reduce your tax bill. But at some point you just have to pay the tax man.

DavidAnnArbor

  • Handlebar Stache
  • *****
  • Posts: 2266
  • Age: 58
  • Location: Ann Arbor, Michigan
Re: Case Study: Tax Strategy for moderately high earner
« Reply #2 on: July 09, 2017, 06:21:38 PM »
Not to make your head explode but find out also if you can do a megabackdoor Roth. I guess I'm all over that lately. lol.

hgjjgkj

  • Stubble
  • **
  • Posts: 180
Re: Case Study: Tax Strategy for moderately high earner
« Reply #3 on: July 09, 2017, 07:30:07 PM »
Not to make your head explode but find out also if you can do a megabackdoor Roth. I guess I'm all over that lately. lol.

I have read the Mad FIentist post on that, but am still confused on what you gain by doing it. I think phase out for Roth starts at 118 k and ends at 133k so I could not contribute, right? Could I still do a Mega backdoor?
« Last Edit: July 09, 2017, 07:37:11 PM by sr79 »

PapaBear

  • 5 O'Clock Shadow
  • *
  • Posts: 82
Re: Case Study: Tax Strategy for moderately high earner
« Reply #4 on: July 10, 2017, 06:17:35 AM »
I think phase out for Roth starts at 118 k and ends at 133k so I could not contribute, right?

Please note that the baseline for traditional or Roth IRA contribution limits is the modified AGI (see e.g., here https://www.irs.gov/retirement-plans/amount-of-roth-ira-contributions-that-you-can-make-for-2017 and for the detailed worksheet to compute modified AGI see here https://www.irs.gov/publications/p590a/ch02.html#en_US_2016_publink1000230988).

When you max your 401k and other pre-tax contributions up to the limit, you will most likely push your modified AGI below the (upper) threshold for Roth and then some.
With 140k gross, 18k max on the 401k and 3.4k HSA, you would end up with a MAGI of max. 118.6k, potentially even lower if you have other pretax contributions, e.g., healthcare, vision/dental and the like).
--> THat means you would still be able to contribute a slightly reduced amount to your IRA.

I would suggest you build a mock tax return using the spreadsheet linked in this post (https://forum.mrmoneymustache.com/case-studies/how-to-write-a-'case-study'-topic/) to come up with a realistic AGI/modified AGI number when maxing out your 401k and other potential pre-tax contributions.
The basic idea is that you push your AGI to the minimum via all available pre-tax contributions (401k, HSA, ...).

I would also recommend to read the investment order thread (https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153), especially the further links provided for different income situations.
« Last Edit: July 10, 2017, 07:17:43 AM by PapaBear »

PapaBear

  • 5 O'Clock Shadow
  • *
  • Posts: 82
Re: Case Study: Tax Strategy for moderately high earner
« Reply #5 on: July 10, 2017, 07:13:32 AM »
And now regarding Mega Backdoor Roth:
The gain you would have is basically to exceed the annual limit of 5,500 USD of Roth contributions and enjoy the tax-free returns in the Roth wrapper for a larger pot of money. But all the Mega Backdoor Roth contributions would be after-tax, so this is not helping you to reduce your tax burden now. However, the Mega Backdoor Roth is not limited by the same stipulations as the regular Roth IRA contributions (e.g., income limits) as the transfer to your Roth IRA is a rollover.

- Before you think about Mega Backdoor Roth, I would first max out the other available pre-tax contributions to reduce your current tax burden.
- Then you can think of using Mega Backdoor Roth with the 401k with your current employer since you will be leaving him soon. But to be honest, prior to that I would spend a bit more time to understand the underlying tax mechanisms.
- Then the second step would be to contact your (new) 401k custodian to see if they allow in-service withdrawals, to determine if you can continue with Mega Backdoor Roths at your new employer.

However, in my opinion, Mega Backdoor Roth is tax reduction master class - I would start with the tax reduction 101 first (by maxing out and understanding all the tax basics regarding 401k and tIRA/Roth IRA contributions) :)

The forum will be happy to help you on the way, if you keep us updated.
« Last Edit: July 10, 2017, 07:17:00 AM by PapaBear »

hgjjgkj

  • Stubble
  • **
  • Posts: 180
Re: Case Study: Tax Strategy for moderately high earner
« Reply #6 on: July 13, 2017, 08:49:18 PM »
And now regarding Mega Backdoor Roth:
The gain you would have is basically to exceed the annual limit of 5,500 USD of Roth contributions and enjoy the tax-free returns in the Roth wrapper for a larger pot of money. But all the Mega Backdoor Roth contributions would be after-tax, so this is not helping you to reduce your tax burden now. However, the Mega Backdoor Roth is not limited by the same stipulations as the regular Roth IRA contributions (e.g., income limits) as the transfer to your Roth IRA is a rollover.

- Before you think about Mega Backdoor Roth, I would first max out the other available pre-tax contributions to reduce your current tax burden.
- Then you can think of using Mega Backdoor Roth with the 401k with your current employer since you will be leaving him soon. But to be honest, prior to that I would spend a bit more time to understand the underlying tax mechanisms.
- Then the second step would be to contact your (new) 401k custodian to see if they allow in-service withdrawals, to determine if you can continue with Mega Backdoor Roths at your new employer.

However, in my opinion, Mega Backdoor Roth is tax reduction master class - I would start with the tax reduction 101 first (by maxing out and understanding all the tax basics regarding 401k and tIRA/Roth IRA contributions) :)

The forum will be happy to help you on the way, if you keep us updated.

Thanks for the advice, this is super helpful. It looks like I could cram down my AGI enough to gain access to the Roth. How do you feel about my goals, do they seem reasonable or no? Also are there any other techniques you would consider tax reduction master class?

PapaBear

  • 5 O'Clock Shadow
  • *
  • Posts: 82

 

Wow, a phone plan for fifteen bucks!