Learning, Sharing, and Teaching > Taxes

The Mustache Tax Guide (U.S. Version)

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Cheddar Stacker:
Introduction

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/#/fd
http://www.irs.gov/uac/Free-File:-Do-Your-Federal-Taxes-for-Free
http://www.mymoneyblog.com/free-online-tax-e-filing-options-for-all-50-states.html

Acknowledgements:
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.

Cheddar Stacker:
Form 1040 Savings Measures (The Retirement Years):

Congrats, you’re done trading your time for more money! Hopefully you have plenty of time left, and hopefully this guide will help you preserve your portfolio to fund your remaining time.

This list sequential, meaning it roughly follows the lines on a 1040.

Wages should be $0, so let’s skip that line. No more of that FICA guy. However, there are some serious benefits to earning a little bit of income, including the earned income credit. It's worth considering the idea of earning a little bit of income if there's something you really want to do.

Taxable interest will come from checking/savings accounts, CD’s, corporate bonds, and some other sources. It’s important to keep some of your wealth in stable places, but there are also solid reasons to avoid this type of income. Aside from the fact it’s harder for your portfolio to keep pace with inflation, interest is taxed at ordinary rates.

Tax-exempt interest will come from municipal/government bonds. As of the writing of this guide it would be hard to receive a great return on these, but when interest rates return to normal levels this can be a solid place to park your stable funds to avoid taxes. Purchasing bonds issued within your own state can also help you avoid paying state income taxes, as these are not necessarily exempt from state taxes.

Ordinary Dividends will come from dividend paying stocks/mutual funds held in a taxable brokerage account. These are also taxed at ordinary tax rates, so you should attempt to keep them to a minimum. You can do this by either purchasing securities that pay less (or no) dividends, or by purchasing stocks/mutual funds that pay Qualified dividends.

Note: REITs pay heavy dividends, are generally a good investment, and can be a great way to diversify your portfolio. However, their dividends are Ordinary (never qualified) so keep that in mind during tax planning.

Qualified Dividends are ordinary dividends that are paid by a U.S. corporation, or a corporation traded on an established U.S. stock market, and meet the holding requirements (basically 60 days). These are taxed at Qualified tax rates which is a very, very good thing. With proper planning you can pay $0 tax on these, and they should be considered a good option for any early retiree.

When you purchase individual stocks and hold them long-term, you will receive Qualified dividends. When you purchase mutual funds, a high turnover of stocks held by the fund will produce Ordinary dividends, so you have less control over the Ordinary vs. Qualified. Pay attention to the type of dividends typically paid by a mutual fund when selecting them for purchase, because they can vary widely. Consider whether the fund itself has a buy and hold strategy, because high turnover creates higher taxes for you. *

Capital Gains (Losses) are reported when you sell securities. If you hold them for less than 365 days you will pay ordinary tax rates, and if you hold them for more than 365 days you will pay Qualified tax rates. So…..hold them for at least 1 year whenever possible. This is the area of your return where the Tax Loss Harvesting and Tax Gain Harvesting will be reported. Depending on your circumstances, you can create a lot of tax free income in this area while staying within the 15% tax bracket.

IRA Distributions are currently reported on line 15a. If they are distributions from a Roth IRA they will NOT be reported on line 15b. This means they will not become income so they don’t increase your AGI. If they are distributions from a Traditional IRA they will carry over to line 15b and become income which increases AGI. Anything reported on this line will be subject to Ordinary tax rates. This is where the Roth IRA Pipeline conversions will appear each year when you move them out of Traditional into Roth, and when you then withdraw them from the Roth later on.

401k Distributions, Pensions and annuities are currently reported on line 16a. If they are distributions from a Roth 401k (or tax free transfers out of a 401k into another tax deferred account) they will NOT be reported on line 16b. This means they will not become income so they don’t increase your AGI. If they are distributions from a Traditional 401k, a Pension, or an annuity they will carry over to line 16b and become income which increases AGI. Anything reported on this line will be subject to Ordinary tax rates.

Social Security Benefits are currently reported on line 20a but they are not necessarily taxable so not all of them carry over to line 20b. Up to 85% of your SS benefits may be taxable. In order to find out exactly what to put on line 20b you need to complete This Worksheet but if you are MFJ you have to reach about $44K of income (including 50% of SS benefits) before anything related to SS benefits will become taxable. If you have time, it’s in your best interest to convert all possible Traditional funds into Roth funds before you begin drawing SS benefits, and before RMD’s begin.

Deductions/Exemptions: See the original post. Almost everything up there still applies, and there isn’t a lot to add. Unfortunately most of the credits mentioned up there are no longer applicable since you need earned income to qualify, with the child tax credit being the only exception.


Other notes/strategies/highlights:

-Utilize tax exempt or qualified rates whenever possible.

-Deductions/Exemptions will reduce Ordinary income first. If you have $40K Ordinary income, $60K Qualified income, and $35K deductions exemptions, you only have $5K in Ordinary taxable income and will only pay $500 in tax (10% bracket). You should create enough income to offset your Deductions/Exemptions. If you have any credits (Child tax credit, tuition credits, etc.) you should create enough income to offset those as well. I plan to create at least $40K income each year post FIRE while I still have 2 kids at home.

-Deplete Traditional accounts as fast as possible with the lowest possible effective tax rate. You might be able to pay 0% tax on your Traditional accounts, but if not project out the next 20 years and determine a reasonable amount to convert. Maybe a 5% effective rate averaged over 20 years is your best bet.

-Consider eligibility for ACA subsidies, and FAFSA in any strategy you utilize. There are entire threads devoted to this topic on the forum like this one and not enough room here to discuss them.

-While Qualified tax rates are wonderful, not all states follow suit. Check local listings, and if you don’t like the rules in your state plan accordingly or move to a more favorable locale.

-Once you have a plan in place and understand the basics, you only need 7 minutes per year to maximize your tax free space. Your hourly pay rate will be substantial, so take the time to learn this stuff.

-Consider a HELOC as a tax free source of cash during the first 5 years of the Roth Pipeline if there is ever a shortfall. It's a temporary fix, but could be better than another alternative.

What to avoid (from a tax-optimization standpoint):

-Annuities. Some people love these. Some very well respected, long-time early retirees even suggest these as a way to reduce the risk of portfolio failure. While they are one method for accomplishing reduced risk (although in my opinion a sub-optimal one), they are horrible in terms of tax strategy. You are essentially trading your potential Qualified taxable income for Ordinary taxable income.

Good luck, and let me know if I missed anything.

* Taxes should not be the only consideration when investing, but they shouldn't be ignored either. If a fund with a high turnover consistently beats the fund with a low turnover by 3%, but produces additional taxes, the net return of each option should be considered. Weigh the opportunity cost, and don't ignore the potential for a 12% return because you might have to pay a little more tax.

tweezers:
This is EXACTLY what I was hoping to see in a sticky when this new sub-forum was started.  THANK YOU!!!

Kris:
Following the hell out of this.  Hope it gets stickied.

Axecleaver:
Great post, Cheddar.

For future posts, I'd love to see targeted tax advice for people in high-income accumulation years, and/or small business owners (S corp/C corp/LLC decision tree, for example).

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