The regular income tax filing deadline is quickly approaching (April 18th this year). Are you finished with your 2016 taxes yet? Have you ever looked at how much cumulative taxes you’ve paid? You may be astonished.
We recently finished up our 2016 taxes. We were pleased to learn that 2016 was our highest earning year yet, however this also meant we paid the most in taxes too! Double-edged sword, right?
VOYEUR FIX ALERT!
Here are some juicy numbers for all those number lovers! For 2016, we paid almost $150,000 in Federal, State, FICA, and Real Estate Taxes. In just Federal Income taxes alone, we paid around $93,000! Combined, we paid around 39% of our adjusted income to taxes (income plus real estate taxes).
WHY WAS OUR TAX BILL SO HIGH?
Short Answer: Rich People Problems 😉
Long Answer: See details below.
- Alternative Minimum Tax (AMT) – this added around $7,000 to our 2016 tax bill
- ACA Taxes:
- ACA Medicare Surtax (an extra 0.9% on income above $250,000 for couples). This added around $1,400 to our Medicare Taxes this year.
- ACA Medicare Net Investment Income tax of 3.8% (lesser of MAGI over $250,000 for couples or net investment income). Thankfully this was a very small $230 this year.
- Reduced itemized deductions and exemptions thanks to…
- Personal Exemption Phaseout (PEP) eliminates 2% for every $2,500 earned over the threshold. Instead of $16,200 we were only able to exempt around $6,800. This results in adding approximately $3,100 to our Federal tax bill.
- Pease Limitations reduces itemized deductions by 3% of your Adjusted Gross Income (AGI) to a max of 80%. Thankfully, it appears this only knocked off around $2,000 in itemized deductions in 2016 for us. That’s around another $660 in extra Federal taxes.
- No Child Credits even though we still had one kid that would have qualified (child has to be age 17 at the end of the tax year, but also Married Filing Jointly (MFJ) AGI must be below $110,000 – we haven’t received a credit for our kids for many years)
- No Education Tax breaks even though we paid over $11,000 in college expenses (for example, phase-out for AOTC starts at $160,000 for MFJ).
JEEZ – DIDN’T WE USE ANY STRATEGIES TO REDUCE OUR TAXABLE INCOME?
Yes, of course we did. Here are the best examples which were not diminished by the hit-list above:
- Maxed out our deductible workplace 401(k) contributions ($18,000 each)
- Maxed out our deductible Health Savings Account (HSA) contributions ($6,750 in 2016 for family)
- Used a deductible Limited Purpose Flexible Spending Account (LPFSA) for dental and vision expenses (we did $1,000 in 2016)
- Maxed out our State tax deductions by contributing to Maryland 529s for our two sons
- Paid for workplace health and dental coverage with pretax dollars
I don’t by nature live an envious life, but I do have a little of the green monster when it comes to the self-employed and small business owners. They can save more in retirement vehicles because they can contribute as both the employee and employer. People who can contribute to 403(b) AND 457 plans can also save more on a tax preferred basis.
When all things were said and done, we owed the Federal government over $4,000 for 2016 on top of the significant withholdings taken throughout the year. It pains me to owe so much when we try to plan carefully to avoid such a high delta. There was a little comfort when I learned that a coworker owed over $20,000 this year – oh boy!
HOW COULD WE HAVE BEEN THAT FAR OFF IN OUR TAX PROJECTIONS?
Well, one of the problems is that although an employer will apply the 0.9% Medicare Surtax to an employee’s income once you cross over the individual $200,000 limit, they have no idea what your spouse’s earnings are and together a couple of high earners could easily go over the $250,000 MAGI threshold which we do. There is similar complexity surrounding the Net Investment Income tax of 3.8%. Furthermore, although our deductions and exemptions were also reduced in 2015, we had even higher earnings in 2016 which meant they were reduced even further than we had expected. Lastly, I don’t know about you guys, but I find that it’s hard to predict what our taxable investment income (mostly dividends) will look like from one year the next. We have more certainty over our interest bearing accounts, but taxable dividends and capital gains not so much.
For a good summary of how both ACA Medicare taxes work with some examples, read this summary on Fidelity’s site.
For a thorough discussion on both the PEP and Pease limits, read this Kitces article . Note: he somehow argues that if you are subject to the AMT, that the Pease limit doesn’t touch you – but upon looking at our actual return this year, I don’t think that was true for us based on the reductions (and extra AMT) applied to our return. We are certainly not tax experts so YMMV!
For 2017, we will rinse and repeat all the strategies above. Two things are likely to affect our taxes for 2017. It looks like our oldest son will no longer qualify as a dependent and our income is likely to be a little less in 2017 due to smaller annual bonuses. The unknown factor is what the Trump tax reforms will look like, if passed this year.
BACK TO THAT CUMULATIVE VIEW!
Here is a view of our tax history over the last 30 years! Holy cow.
It wasn’t until recently that our earnings have really accelerated. This will thankfully help us fund our Early Retirement goals faster!
A BIG SCARY NUMBER
What if you add them all up? The total is a really big number, y’all. When you add up all the Federal, State, FICA, and Real Estate taxes we’ve paid over the last 30 years it’s over $1,200,000! Of course that doesn’t include consumption taxes (sales tax, which is currently 6% in Maryland), gasoline tax, surcharges and taxes on utilities, etc.
WHAT HAVE WE RECEIVED IN RETURN?
We don’t want this to go off the charts into a political discussion, but we recognize that we’ve enjoyed many services for our investment in our government and in our communities. Here are just a few that come immediately to mind that we are very thankful for:
- Public Education (we and our children attended public schools)
- Community Services (we appreciate our fire departments, police, and other public servants – thank you!)
- Military Defense (not only are we glad we live in America, one of our jobs is directly tied to servicing the defense industry so our income is also dependent somewhat on defense spending)
- Supporting our less fortunate neighbors
TAKING THE LONG VIEW
Since we are in hot pursuit of Early Retirement, we know that there will be many years to come that we pay little or maybe even no income taxes once we leave our primary careers. To some extent, we are front-loading our taxes and will continue to enjoy the benefits during our retirement years.
At all income levels, most Early Retirees generally experience a peak in income taxes right before they retire. The unknown for us (and maybe you too) is if our income taxes will stay low in our Traditional Retirement years (especially after hitting 70.5 when Required Minimum Distributions kick in). We recently shared some of our concerns about RMDs here. Since our retirement will hopefully last 30 – 40+ years, we don’t know exactly what tax rates are going to be then or how much we will need to draw down from our taxable sources.
By Tax-Free Income (the orange sections), we are referring to the portion of your income that is free of taxation due to standard deductions and personal exemptions. This is how our current income tax system works. When we very young in high school and college, we paid little if any taxes (the blue taxable income bar would be so small in scale it wouldn’t show on this illustration).
As you can see, we hope to revert to no or low income taxes in our 50’s when we stop working. These are our ‘Gap’ Retirement years.
We don’t want to pay any more in taxes than we are required to. This keeps us focused on balancing the tax savings we get now with those that we get later on when we need to actually use these savings.
For us, it’s a combination three pronged strategy using all of the primary Tax Preferred Retirement Saving tools.
Unfortunately, the majority of our retirement savings is in the middle section (Traditional IRA and 401k sources). Although we will be planning on doing Roth conversions in our early retirement years, we want to be careful to mitigate our taxes during the conversion process by only doing a little at a time. This means that we will still have a significant amount of money saved in our taxable retirement accounts in our 60’s. (Our earnings are too high now to fund Roth IRAs directly and neither of our employers offer Roth 401k options).
You can’t forget about Health Savings Accounts (HSAs)! With HSAs, these funds can be used tax-free at any time for health care expenses. Over the decades of our retirement, we are certain to have health care needs and so funding our HSAs is also an important priority for us. We’ll keep doing this as long as we can. We have a few posts on HSAs – this one debunks the fears of HSAs and this one gives our thoughts on what would make HSAs even better.
Then of course there are future Social Security benefits. According to the totals so far, we’ve jointly paid around $250,000 in Medicare and Social Security taxes. In theory, those $250,000 taxes paid already are an investment in future Medicare and Social Security benefits yet to be realized. But….
- Depending on other income at the time, we will have to pay more taxes on this Social Security Income when we eventually start collecting these benefits.
- Medicare is also not free. You have to pay premiums for Part B and most likely you will want to purchase a supplemental insurance policy and prescription drug coverage as well (if not bundled together). Plus, if your income is rather high, you may pay higher premiums than other people due to the surcharges they put on high earners.
- If we were to become disabled prior to retirement, we would be grateful to have disability income from Social Security.
Our updated projections show that if we file for Social Security around Normal Retirement (Age 67) we would jointly collect around $50,000 a year. If we paid an additional $140,000 in FICA over the next 7 years, we would pay a total of $390,000 in FICA taxes and our simplified break even point would be approximately 7.8 years (just shy of age 75). These projections are based on the AARP calculator on our average earnings through age 51 only (since we plan to stop working).
If we continue to work for another 7 years and continue to have similar earnings and taxes during this time, than we estimate we will pay another $875,000 on top of the $1,200,000 we’ve already paid in Income, FICA, and Real Estate taxes. That would be over $2,000,000!
What a sobering exercise. That is a lot of money!
Have you ever totaled up your paid taxes? How do you think tax reforms will affect you in the near future and long term?