Early Retirees, and aspiring ones, are …… different. We don’t quite fit the mold. This is true in many areas, and it’s particularly true in tax planning. Our tax code is overly complex; ridiculous really. If you play the game right, you can avoid many taxes when you are working (See Root of Good
and Mad Fientist
) and when you aren’t working (See Go Curry Cracker!
This guide should help those looking for an edge, or those simply looking for an explanation. It will also be heavily focused toward the early retiree given that we are on an early retirement forum. Therefore, it will likely contradict many of the common recommendations you’ll find elsewhere like “Young people should put all
their money in Roth accounts since they will have higher taxes later in life”. Strategies recommended here might not apply to your friend/dad/sister/boss if they don’t lean toward a FIRE lifestyle.
All of these items should be considered on a Macro level if you want the maximum benefit in your tax planning strategy. In other words, a larger contribution to your 401K/IRA may increase your student loan interest deduction, therefore it may lower your AGI in two ways, therefore it increases your chances to qualify for the child tax credit and the saver’s credit, etc. It’s a very iterative process, but the more of these deductions/credits you aim for, the more it all snowballs. In addition, this is not something you should be thinking about at/after year end, this is something to keep in mind throughout the year.Form 1040 Savings Measures (The Working Years):
This list sequential, meaning it roughly follows the lines on a 1040.Pre-Tax Deductions:
As you’ll see in the links provided above and below, there are many deductions you can take before income is ever taxed. These deductions can include 401(k)/403(b)/457(b)
, Health/Dental Insurance
, Cafeteria Plan
, and Health Savings Account
, among others. Some of these items reduce the FICA wage base as well, and they are the only available deductions against Social Security and Medicare Tax. All of these deductions reduce the income you are required to input on your tax return. Therefore, they all reduce your AGI, MAGI, taxable income, and tax, and they should be maximized whenever possible in most cases.Tax Loss Harvesting
is a way to sell securities in a regular (taxable) brokerage account in order to reduce taxable income. Any losses will first offset any other Capital Gains in the current year, including capital gain distributions on your Schedule D. The result from Schedule D carries to your 1040 and you can use a $3,000 loss to offset other income reducing your AGI and taxable income accordingly.Traditional and Roth IRAs
are another great tool to consider utilizing, and they are both good. A Traditional IRA contribution reduces your AGI and taxable income, a Roth contribution does not. A lot is said about both of these accounts all over this forum and the interwebs including a great analysis from The Mad Fientist
. What you need to know for tax planning purposes is this: If you believe you will pay a higher tax rate in the future, go with Roth, and if you believe you will pay a lower tax rate in the future, go with Traditional. When you clear out all the other noise, this is really the only thing that matters. Most
early retirees will benefit more from Traditional if they qualify (see the links to the IRS or key facts and figures for qualification), but this must be a case by case analysis.Student Loan Interest
is a Pre-AGI tax deduction unlike mortgage interest, but it has some limitations. The first is you can only deduct up to $2,500 of interest payments; hopefully most of us won’t exceed that anyway. The second is many high income earners have a chance of losing all/part of this deduction. It is gradually phased out as your AGI grows from $130K-$160K (MFJ for 2014). This means if you pay $3,000 in SL interest and your AGI is $145K, your deduction will first be limited to $2,500, then cut in half to $1,250 because you have reached 50% of the phase-out.Deductions/Exemptions: The Standard Deduction
is available to everyone, and can be particularly beneficial to a frugal early retiree. It doesn’t matter how much you spend, what city/state you live in, or what you ate for breakfast, you get $12,600 (MFJ for 2015). Some forum members barely exceed that amount in expenses each year.The Itemized Deduction
is available for the spendypants members. If your deductible expenses from this form exceed the standard amount, use the itemized amount; you can’t use both. For many people this is very easy to reach. If you live in a state with an income tax, real estate tax, and personal property tax (see Cheddar Stacker – my deductible taxes in 2014 were $9,080) you will likely itemize. If you are close to the top of the standard deduction, consider intentionally lumping expenses into one year. In 2015 forego charitable contributions and paying your real estate tax bill. In January 2016, pay your 2015 RE tax bill and make your 2015 charitable contributions. Then in December 2016, pay your 2016 RE tax bill and make your 2016 charitable contributions. The result can be a nice way to squeeze out an extra $1,000-2,000 in deductions.Personal Exemptions
are available for each person claimed on your tax return. Multiply the number claimed in box 6d times the personal exemption rate for any given year ($4,000 for 2015) and reduce your taxable income accordingly.
If I could highlight one thing from this section, it would be for the reader to realize there is an automatic $20,600, tax-free space in 2015 for a married couple. These numbers are adjusted for inflation each year. Given proper tax planning efforts, you should do everything in your power to create enough income each year to fill this space. The Roth Pipeline (conversion ladder), or simply withdrawing funds from a Traditional IRA will help with this.Credits:The Credit for Child and Dependent Care
is a nice benefit for working parents with kids in daycare. If you have a cafeteria plan you should use that instead of this (don’t double dip), but this is a nice option for those who don’t have one. In summary, the IRS will pay for 20-35% of the cost of someone watching your kids, up to $3,000 in expenses for one kid, or $6,000 in expenses for two or more kids. This can result in a credit of up to $2,100 if all the cards fall into place for you. The qualifying expenses are limited to the lesser of the two parents’ taxable income, so pre-tax deductions can actually work against you here. Plan accordingly. One side note on this credit – the instructions are very clear that if you have two kids, but only one of them is in daycare, you can claim both of the kids on this form opening up the full 6,000 in expenses and potentially doubling the credit.The Saver’s Credit
is something to shoot for if you earn a low income, or you are able to reduce your AGI to an extremely low level via Pre-Tax Deductions. The maximum credit is $1,000/person, so $2,000 for married couples. However, it can be very difficult to reach the maximum level of this credit as described here
by teen persuasion. It’s a paradox. This is also one of the few legitimate "tax cliffs" out there where it's not a phase-out. You don't want to go $1 over the limits or you will not like the result.The Child Tax Credit
is awesome. Step 1, have a kid or 7. Step 2, pay less tax. Unfortunately it’s not quite that simple. The credit is up to $1,000 per child under age 17 at the end of the tax year, and it’s refundable through the additional child tax credit. Much like the student loan interest deduction, it has a phase out range. This credit is gradually phased out as your AGI grows from $110K-$150K (MFJ for 2014). So if you have 2 qualifying kids and a potential child tax credit of $2,000, but your AGI is $130K, you will receive a child tax credit of $1,000.The Earned Income Credit
or EIC is also something to shoot for if you earn a low income, or you are able to reduce your AGI to an extremely low level via Pre-Tax Deductions. This credit becomes much easier to qualify for when you have a few children. Investment income must be no more than $3,350 for the year.Resources:Key Facts and Figures
is one of the best resources I’ve found online that summarizes a lot of data into just 2 pages. I keep a printed copy in my top desk drawer and refer to it often. You can get an updated version of this each year with this search: 2016 key facts and figures.Annual Limits
is another fine resource listing much of the same information, but different enough that both should be reviewed.MDM’s Case Study Spreadsheet
began as something to help organize case study posts. That ability remains, and it has evolved to deal with common Mustachian tax issues, calculating most of the credits and deductions mentioned above. It also includes a simple "time to FI" section. One might consider it a gateway drug to more advanced tax and FI calculation tools.The 1040 Instructions
are great if you want to dig into an specific line item on the tax return.IRS.GOV
is great when all else fails, or if you just prefer going straight to one of the best online detailed sources of tax code, forms, instructions, bulletins, and revenue rulings.FAQ:
How can I estimate the impact of particular tax planning events in my life?The Taxcaster
Can I (should I) prepare my own taxes?
You certainly can. Whether you should or not will vary a lot based on your specific tax situation, and your technical ability for DIY. There are many people around here who do their own complex returns as well as any CPA could. There are also many extremely brilliant people around here with complex tax situations who hire the experts. There's no shame in paying someone else to do it for you, but always remember you are your best advocate
. Your tax preparer can't advise you properly without your help, so you need to know the basics as well.
What should I use to prepare my tax return?
Pencil and Paper is a strategy recommended by some around here. I’ve never done that myself, but I can understand how it can be of great benefit to do this. You must learn the nuances of each line on the 1040 in order to do it properly, so it will certainly give you an edge.
Creating a spreadsheet to reproduce your own tax return is also a good way to learn how the tax code works. It can also predict tax consequences for the coming year (e.g., add a column for the new year and start by copying the previous year).
Tax software: Turbotax, TaxAct, Taxslayer
Free tax filing methods:https://www.freefilefillableforms.com/#/fdhttp://www.irs.gov/uac/Free-File:-Do-Your-Federal-Taxes-for-Freehttp://www.mymoneyblog.com/free-online-tax-e-filing-options-for-all-50-states.htmlAcknowledgements:
I obviously leaned heavily on many FI bloggers for links. Why re-create the wheel? But honestly I couldn’t really expand much on what they’ve already said. This is just a nice way to bring all these ideas into one place.
Special thanks to MDM for assisting with the creation and editing of this post.
Special thanks to everyone else on the forum who discusses these tax strategies regularly – you know who you are. I’ve learned a lot from all of you, and I hope you can say the same about me.