Author Topic: Optimizing Taxes and 401K Contributions  (Read 8775 times)

kwh03001

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Optimizing Taxes and 401K Contributions
« on: March 25, 2015, 07:47:53 AM »
Hello all,
I am a fairly new member, and I just wanted to get an opinion on using my 401K to optimize my tax burden,

DW and I are a single income family with 3 children.  For 2015 we will be "Married Filing Jointly" and have a total of 5 dependents with 3 eligible for a child tax credit of $1,000 per child.

Because the US government is so generous, we will have an easy time getting our federal tax burden down to $0.

Our estimated pre-tax income is around $73,000 for the year. 

My question is this:

Should I contribute to my 401K until I have a $0 tax burden, or should I max out the 401K to continue contributing pre-tax money to the account even though I would have no tax on it?

My initial thought is to contribute to the 401K until the "tipping point" where our tax bill is $0, and then invest the money in a post-tax account where investment income will likely be offset by the deductions of the same year for the forseeable future.  This would allow me to use the 401K as a lever to always optimize my tax bill, while also keeping after tax money handy in the event of FIRE.

Any thoughts?

Fuzzy Buttons

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Re: Optimizing Taxes and 401K Contributions
« Reply #1 on: March 25, 2015, 07:58:30 AM »
Sounds right to me.  There's no sense in putting money in a tax-deferred vehicle if there is no tax to defer.  That would apply to both a traditional 401(k) and a traditional IRA.  The only exception being if there is an employer match of money in the 401(k), of course. 

After that, I'd put the rest in a Roth IRA, and then once that was full go for taxable.  Pay the tax now while your deductions are high, and the tax rate is zero.  It's not gonna get any lower!  :)

seattlecyclone

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Re: Optimizing Taxes and 401K Contributions
« Reply #2 on: March 25, 2015, 08:14:31 AM »
Do you have a Roth option in your 401(k)? You may want to contribute to that before you do taxable investing. You may even want to do that before your tax burden goes all the way down to zero. The general guideline in the Roth vs. traditional calculation is that traditional may be better when your tax bracket will be the same or lower in retirement, while Roth may be better if your tax bracket will be higher in retirement. Your tax credits kids won't live with you forever, so it's possible (if not likely) that your retirement taxes will be higher than they are now.

rmendpara

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Re: Optimizing Taxes and 401K Contributions
« Reply #3 on: March 25, 2015, 08:21:49 AM »
After contributing to the 401k, I'd put any aftertax funds into a Roth. If you have to pay taxes (or even if none) today, might as well have deferred/none for the rest of your life.

On top of the obvious benefit for all retirement accounts (regardless of whether you pay today for a Roth or pay at the end for a pre-tax 401k/IRA), another HUGE benefit is the deferral of all realized gains and income for all of the interim years.

That is a very significant benefit. It also depends on what income level you expect to be at in the future. If you expect to almost forever be in the 0% federal (after credits and all) or maybe just a little bit in 15%, then it becomes a bit of a wash over time since you won't have much to pay anyway.

If it were me, I would do the following:
1) 401k up to full match (hey bro, free money!)
2) HSA at least partial if not more... who doesn't like paying pretax on health costs??
3) up to 5.5k in Roth
4) taxable accounts

You can mix up the variations, but hitting a little in each bucket will spread you out extremely well and greatly reduce the likelihood and quantity of taxes paid over a period of time.

If you'd like, after doing #1, you could fund a taxable account for a few years to get some liquid assets that are easily and readily available, and then start going into #2 and #3. Great position to be in, so do what feels most comfortable.
« Last Edit: March 25, 2015, 08:24:11 AM by rmendpara »

Aphalite

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Re: Optimizing Taxes and 401K Contributions
« Reply #4 on: March 25, 2015, 08:23:49 AM »
Couldn't you get a credit beyond 0 tax? As in, you contribute the max to 401k, then because you don't make enough, the government pays you money?

NathanP

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Re: Optimizing Taxes and 401K Contributions
« Reply #5 on: March 25, 2015, 09:25:16 AM »
The child tax credits are refundable. I played with your numbers using this: https://turbotax.intuit.com/tax-tools/calculators/taxcaster/ . You can get back a larger refund by contributing to the 401k to lower your taxable income from 73k to 55k. Of course you may decide to pay taxes now in the 10% bracket since it is unlikely that rates will ever be lower than that.

You can then consider doing a Roth IRA for you and wife to put away after tax money. I didn't try adding a Traditional IRA to taxcaster to see what the benefit would be.

boarder42

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Re: Optimizing Taxes and 401K Contributions
« Reply #6 on: March 25, 2015, 09:28:06 AM »
so i'd put up to company match in 401k then HSA max ... then you have to evaluate where you are.  You contribute to your 401k til you reach that tipping point.  Then you go roth(if your work has a roth 401k you switch to that til you hit 18k) if not you max you and you're wife's Roth IRAs and the rest goes taxable.

kwh03001

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Re: Optimizing Taxes and 401K Contributions
« Reply #7 on: March 25, 2015, 11:19:41 AM »
I like where this is going.

I think the plan will be to increase my 401K contributions to $13,500 for the year (which will surpass the employer match limit and give me $0 federal taxes), max out the Roth IRA to $5,500, put another $4,500 into the Roth 401K to reach my $18K limit, and then do post-tax investing with whatever is left.

I looked into the credits pushing my tax bill negative so I will essentially get paid to go to work by Uncle Sam, but I don't think that it is possible.

Unfortunately, I cannot add to DW's Roth IRA because she does not have any earned income. (Lame)

Thanks for all of the advice, now I can start implementing this excellent plan.

YTProphet

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Re: Optimizing Taxes and 401K Contributions
« Reply #8 on: March 25, 2015, 11:34:32 AM »

Unfortunately, I cannot add to DW's Roth IRA because she does not have any earned income. (Lame)


IRA rules allow you to contribute to a non-working spouse's Roth IRA even if they don't have any earned income. It's called a Spousal IRA. So, you're free to max out her Roth assuming it's in her name only and your Roth IRA is in your name only.

boarder42

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Re: Optimizing Taxes and 401K Contributions
« Reply #9 on: March 25, 2015, 11:44:08 AM »
I like where this is going.

I think the plan will be to increase my 401K contributions to $13,500 for the year (which will surpass the employer match limit and give me $0 federal taxes), max out the Roth IRA to $5,500, put another $4,500 into the Roth 401K to reach my $18K limit, and then do post-tax investing with whatever is left.

I looked into the credits pushing my tax bill negative so I will essentially get paid to go to work by Uncle Sam, but I don't think that it is possible.

Unfortunately, I cannot add to DW's Roth IRA because she does not have any earned income. (Lame)

Thanks for all of the advice, now I can start implementing this excellent plan.

are you not on an HDHP that you can open an HSA if so you're missing out on FICA savings possibly on top of the tax exposure

teen persuasion

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Re: Optimizing Taxes and 401K Contributions
« Reply #10 on: March 25, 2015, 11:52:45 AM »
I like where this is going.

I think the plan will be to increase my 401K contributions to $13,500 for the year (which will surpass the employer match limit and give me $0 federal taxes), max out the Roth IRA to $5,500, put another $4,500 into the Roth 401K to reach my $18K limit, and then do post-tax investing with whatever is left.

I looked into the credits pushing my tax bill negative so I will essentially get paid to go to work by Uncle Sam, but I don't think that it is possible.

Unfortunately, I cannot add to DW's Roth IRA because she does not have any earned income. (Lame)

Thanks for all of the advice, now I can start implementing this excellent plan.
Why don't you think a refund is possible?  This I what I do.  DH contributes to his 401k, which brings our AGI down, making us eligible for a greater EITC.  That plus the CTC and our state matching credits has been enough to fund Roths for both DH and me in past years!  We used our kid related refunds in the early years to pay down our mortgage, then when that was gone switched to funding Roths.  I wish I had figured out about the spousal IRA when I was a SAHM, I would have done that for me earlier, since I don't have access to a 401k at my job now.

As another poster alluded, things change greatly, taxwise, as the kids age out of the CTC.  Our refunds now aren't quite as generous as they were before the older kids got above 16 and went to college.

DK

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Re: Optimizing Taxes and 401K Contributions
« Reply #11 on: March 25, 2015, 12:11:11 PM »
Sounds like a good plan. I might look into switching when I hit the 10% bracket rather than 0%.

Aphalite

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Re: Optimizing Taxes and 401K Contributions
« Reply #12 on: March 25, 2015, 02:47:05 PM »
I looked into the credits pushing my tax bill negative so I will essentially get paid to go to work by Uncle Sam, but I don't think that it is possible.

You're misinterpreting our suggestion

The suggestion is that because the refunds are tax CREDITS and not tax DEDUCTIONS, that means you should try to maximize your deductions because the credits are paid to you regardless

That means you lower your taxable income by maxing out 401k and HSA, then get paid $3000-$5000 depending on child/EITC in refund even though you are paying 0 tax - tax CREDITS are refunded to you no matter how much tax you pay, tax DEDUCTIONS end at 0 tax paid (401k, home interest paid, etc. are deductions, child credit and earned income tax credit are credits)

seattlecyclone

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Re: Optimizing Taxes and 401K Contributions
« Reply #13 on: March 25, 2015, 02:53:21 PM »
Tax CREDITS are refunded to you no matter how much tax you pay, tax DEDUCTIONS end at 0 tax paid (401k, home interest paid, etc. are deductions, child credit and earned income tax credit are credits)

This is not quite right. Tax deductions act to lower the amount of your income that is subject to tax, which means deductions are more valuable in higher tax brackets than lower ones. Tax credits lower your tax directly, dollar for dollar. Most tax credits will not let your total tax bill be negative. Some (like the child tax credit and the EITC) are "refundable" tax credits, which means they don't stop once your tax bill hits zero, they can actually result in the government paying you.

Aphalite

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Re: Optimizing Taxes and 401K Contributions
« Reply #14 on: March 25, 2015, 03:16:53 PM »
This is not quite right. Tax deductions act to lower the amount of your income that is subject to tax, which means deductions are more valuable in higher tax brackets than lower ones. Tax credits lower your tax directly, dollar for dollar. Most tax credits will not let your total tax bill be negative. Some (like the child tax credit and the EITC) are "refundable" tax credits, which means they don't stop once your tax bill hits zero, they can actually result in the government paying you.

Upvote - I forgot to mention that some credits are nonrefundable. But as seattle is saying, the ones we have been discussing in this thread is refundable. That said, it can also be to your advantage to lock in a 10% tax rate now using Roth, but that's up to your situation in the future and how you guys are planning to utilize the (currently available) 0% capital tax room

zolotiyeruki

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Re: Optimizing Taxes and 401K Contributions
« Reply #15 on: March 25, 2015, 03:43:26 PM »
I am in this exact situation.  Actually, an even more extreme version--I'm contributing to our 401(k) just enough to max my employer's match, and we're still WAY into negative tax territory with our child tax credits.

That said, your marginal tax rate is NOT 0%, unless your taxable income is $0.  If your taxable income is $0 (line 43 on your Form 1040), then by all means dump as much as you can into a Roth/Roth 401k, and skip the rest of this post. 

If your taxable income is over $0, you still have a marginal tax rate--10% if you're under $18k or so, 15% above that.  Your tax, on line 44, will still be positive.  If your taxable income is $17k and you reduce it (via increasing 401k contributions) to $16k, your tax on line 44 will decrease by $100 and your refund will increase by $100.  Depending on your location, you might also have a state income tax that will increase your overall marginal tax rate anywhere up to 20% (if you're unfortunate enough to live in CA).

What do I plan to do?  When we retire, I plan to move to a low-tax state, like TN or CO.  As a result, I anticipate that my total (federal + state) effective tax rate will be lower than the 10% federal + 5% state I'm paying now.  For me, that means extra money goes into the pre-tax accounts.

teen persuasion

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Re: Optimizing Taxes and 401K Contributions
« Reply #16 on: March 25, 2015, 04:17:26 PM »
I am in this exact situation.  Actually, an even more extreme version--I'm contributing to our 401(k) just enough to max my employer's match, and we're still WAY into negative tax territory with our child tax credits.

That said, your marginal tax rate is NOT 0%, unless your taxable income is $0.  If your taxable income is $0 (line 43 on your Form 1040), then by all means dump as much as you can into a Roth/Roth 401k, and skip the rest of this post. 

If your taxable income is over $0, you still have a marginal tax rate--10% if you're under $18k or so, 15% above that.  Your tax, on line 44, will still be positive.  If your taxable income is $17k and you reduce it (via increasing 401k contributions) to $16k, your tax on line 44 will decrease by $100 and your refund will increase by $100.  Depending on your location, you might also have a state income tax that will increase your overall marginal tax rate anywhere up to 20% (if you're unfortunate enough to live in CA).

What do I plan to do?  When we retire, I plan to move to a low-tax state, like TN or CO.  As a result, I anticipate that my total (federal + state) effective tax rate will be lower than the 10% federal + 5% state I'm paying now.  For me, that means extra money goes into the pre-tax accounts.

Even when your taxable income is at zero, it can be beneficial to continue contributing to tax deferred accounts, if you are eligible for EITC.  We hit zero taxable at around $32k with MFJ and three kids still at home, but the phaseout rate for the EITC for us is around 21%.  Our state matches EITC at 30%, so that is really like another 6.3%.  IOW, every additional $ DH puts in his 401k increases our refund by 27.3% even after reaching zero fed taxes!  Actually, since our state is stingy with exemptions/deductions, it is 31.3% due to 4% state tax saved, too.  Even when he had no match, that was a pretty good return.

kpd905

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Re: Optimizing Taxes and 401K Contributions
« Reply #17 on: March 25, 2015, 06:03:50 PM »
Just so you know, you can also max out a Roth IRA for your wife, even if she doesn't have earned income.

kwh03001

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Re: Optimizing Taxes and 401K Contributions
« Reply #18 on: March 26, 2015, 06:18:45 AM »
This is a lot of information to digest.

It seems like a breakdown of my yearly ins/outs might be in order.  (from a tax perspective)

Gross Income:                   $73,000
Healthcare Expenses:       -$3,400
401K Contribution:          -$18,000
Total Earned Income:         $51,600

Standard Deduction:         -$12,600
Dependent Exemption:      -$3,950 x 5
Taxable Income:                 $19,250

Tax Due:                             $1,965
Child Tax Credit:                -$3,000
EITC:                                 -$169
Total Return:                    $1204

Because my earned income is close to the limit for the EITC, it does not come out to much for me at the end of the year.  Am I missing something? 

Gin1984

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Re: Optimizing Taxes and 401K Contributions
« Reply #19 on: March 26, 2015, 06:24:53 AM »
Quick thing, dependent exception is $4000.

MDM

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Re: Optimizing Taxes and 401K Contributions
« Reply #20 on: March 26, 2015, 07:14:13 AM »
This is a lot of information to digest.

It seems like a breakdown of my yearly ins/outs might be in order.  (from a tax perspective)

Gross Income:                   $73,000
Healthcare Expenses:       -$3,400
401K Contribution:          -$18,000
Total Earned Income:         $51,600

Standard Deduction:         -$12,600
Dependent Exemption:      -$3,950 x 5
Taxable Income:                 $19,250

Tax Due:                             $1,965
Child Tax Credit:                -$3,000
EITC:                                 -$169
Total Return:                    $1204

Because my earned income is close to the limit for the EITC, it does not come out to much for me at the end of the year.  Am I missing something?
Looks about right.  As Gin1984 notes, for 2015 you get $4K/exemption.  Also the 2015 EITC calculation (were you using 2014 or 2015 for EITC?) may give you ~$351 instead of $169.  That's not a big difference - but if you could lower your earned income (e.g., by contributing to HSA, FSA, whatever pre-tax deductions you have available) your EITC credit would grow.

Aphalite

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Re: Optimizing Taxes and 401K Contributions
« Reply #21 on: March 26, 2015, 08:18:47 AM »
an HSA would lower your earned income more - but might not be a huge return in terms of EITC refund. However, the maximum would lower your taxable down to ~14k, which means you pick up another $500 from lower taxes. OVerall maxing your HSA might give you ~$750 (too lazy to do exact math on EITC)

Gin1984

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Re: Optimizing Taxes and 401K Contributions
« Reply #22 on: March 26, 2015, 08:29:37 AM »
an HSA would lower your earned income more - but might not be a huge return in terms of EITC refund. However, the maximum would lower your taxable down to ~14k, which means you pick up another $500 from lower taxes. OVerall maxing your HSA might give you ~$750 (too lazy to do exact math on EITC)
Plus the decrease in FICA......

Aphalite

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Re: Optimizing Taxes and 401K Contributions
« Reply #23 on: March 26, 2015, 08:42:40 AM »
Only if he is able to have it be withdrawn directly from his paycheck - some employers don't offer HSA in which case he would have to find his own

seattlecyclone

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Re: Optimizing Taxes and 401K Contributions
« Reply #24 on: March 26, 2015, 09:41:26 AM »
Based on the numbers you provided, you
This is a lot of information to digest.

It seems like a breakdown of my yearly ins/outs might be in order.  (from a tax perspective)

Gross Income:                   $73,000
Healthcare Expenses:       -$3,400
401K Contribution:          -$18,000
Total Earned Income:         $51,600

Standard Deduction:         -$12,600
Dependent Exemption:      -$3,950 x 5
Taxable Income:                 $19,250

Tax Due:                             $1,965
Child Tax Credit:                -$3,000
EITC:                                 -$169
Total Return:                    $1204

Because my earned income is close to the limit for the EITC, it does not come out to much for me at the end of the year.  Am I missing something? 

Based on these numbers, you should also be eligible for a $200 retirement savings contribution credit. If you contribute at least $2,000 to an IRA (traditional or Roth) in your wife's name, the credit goes up to $400. If you do that and get your AGI below ~$39,000 by maxing out traditional IRAs and contributing to an HSA, the credit would go up to $800.

Let's see how this looks now:
Gross income:          $73,000
Health insurance:     ($ 3,400)
401(k)                ($18,000)
Traditional IRA       ($11,000)
HSA                   ($ 6,650)
-------------------------------
Adjusted Gross Income  $33,950
Standard Deduction    ($12,600)
5 Personal Exemptions ($20,000)
-------------------------------
Taxable Income         $ 1,350

Tax                    $   135
Saver's credit        ($   135)
Child tax credit      ($ 3,000)
Earned income credit  ($   169)
-------------------------------
Total tax             ($ 3,169)


A couple of things to note here:
  • The saver's credit is non-refundable, so even though you would qualify for up to $800 of credit, you only get $135 in this scenario because your tax was too low before the credit. If you reduce your IRA contributions (or make Roth contributions instead), your tax would go up, but so would your saver's credit. The optimal place would be to have just enough income that your tax before credits is exactly $800. Remember that you need at least $2,000 of IRA contributions in your wife's name to get the full saver's credit.
  • I used the 2014 tables for the EITC. It would likely be higher in 2015. Also, if you can sign up for an HSA through work and have the contributions withdrawn directly from your paycheck, this would bring down your earned income for EITC purposes, which could cause your EITC to be at least $1,500.

I don't know if your current budget can handle this much saving, but it's something to work toward.

kwh03001

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Re: Optimizing Taxes and 401K Contributions
« Reply #25 on: March 26, 2015, 12:31:22 PM »
OK, I think I have it down.  Unfortunately I cannot contribute to an HSA due to our company funding an HRA for us, but the rest looks pretty good.

Gross income:          $73,000
Health insurance:     ($ 3,400)
401(k)                ($18,000)
Traditional IRA       ($11,000)
HSA                   Cannot contribute due to HRA
-------------------------------
Adjusted Gross Income  $40,600

Standard Deduction    ($12,600)
5 Personal Exemptions ($20,000)
-------------------------------
Taxable Income         $ 8,000

Tax                    $   800
Saver's credit        ($   400)
Child tax credit      ($ 3,000)
Earned income credit  ($   169)
-------------------------------
Total tax             ($ 2,769)

Thanks Everyone!

MDM

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Re: Optimizing Taxes and 401K Contributions
« Reply #26 on: March 26, 2015, 01:22:44 PM »
Just checking: could anyone confirm (with a reference) whether the 2015 EIC should be $169 or $351 (or something else) with the OP's inputs?  A $182 difference won't make or break anything but I'd like to revise the case study spreadsheet to keep it accurate if needed.  Thanks.  Numbers I get from it:

AGI$40,600
Std. Deduct.$12,600
Exemption$20,000
Taxable$8,000
Tax$800
Savers' credit$400
Tax after n-r credit$400
Child Tax Cred.$3,000
EIC$351
Net Tax-$2,951