Want to save on taxes and also save for retirement? Awesome. Two of our favorite goals. Today we are talking about how being mindful of your taxable income level, certain tax deductions and credits, and being flexible on where to stuff your savings can get you further ahead financially.
This is a long post with a copious amount of tables and charts, but hopefully it’s worth your time to read through the end. We have a follow-up post that covers the implications for a married couple.
Although reducing taxes and saving for retirement are universal topics, we are using our oldest son’s situation as an example of how to mitigate taxes and save for retirement at the same time. The reason is simplicity. He’s 19, single, still lives at home and his earning potential is on the low end at this stage in his life. He is also no longer our dependent for tax purposes because he currently is not in school full-time. Perhaps we will have a post on his no college decision in the future.
We are using the name Ben because our son is a history buff and also because he is very frugal. Naturally, these 2 things make me think of the big guy on the hundred dollar bill!
Let’s First Talk About Ben’s Goals
Ben decided recently that college was not for him. He was frankly tired of being in the classroom and found traditional learning to be slow and rather boring (maybe his mind will change with age). For right now, he’s decided that he would like a faster route to earning money and becoming independent. What is on Ben’s mind right now?
- Ben wants to have independence. He recognizes that independence in the larger sense is built on financial independence and he is interested in saving and investing.
- He is concerned about making a decent wage and finding ways to increase his earnings. He’s willing to change jobs to move up the wage ladder.
- He wants to see cool stuff and for this reason he is interested in careers that have ever-changing scenery and a certain level of excitement. In other words, no cube job for Ben!
- Lastly, he wants to pay as little taxes as possible because they will slow him down from achieving goals 1 and 3.
Ben’s Illustrative Earnings
Since Ben didn’t go to college, he is slowly working his way up to higher paying jobs. He is smart and a hard worker, so he doesn’t mind working full-time hours. However, his wages are low simply because he isn’t qualified for higher paying jobs without more training or experience.
For this discussion, we will assume Ben makes $12 an hour and works full-time (~2080 hours a year). This would yield him a salary of $24,960 with no over-time pay. (He may occasionally earn over-time but he also doesn’t have paid holidays, vacation or sick days so we are assuming these will cancel each other out).
Ben does not have a 401(k) or other workplace retirement plan, so he is limited to $5,500 a year in IRA contributions.
Ben’s Tax Bracket
We will be unable to take a deduction for Ben in 2017 because he is no longer a FT student. This year, he will file as a single person. The standard deduction is $6,350 plus he can take the personal exemption of $4,050 for himself. This means that he would pay no federal income taxes on the first $10,400!
The remaining $14,560 will be split into the 10% and 15% tax brackets. The first $9,325 is taxed at 10% and the remaining $5,235 is taxed at 15%.
Here’s how it’s looking so far:
So Ben makes $24,960, but owes $1,718 in Federal income tax (we are omitting State Income tax considerations for simplicity as well) so he would have around $23,242 to spend (or save!).
How Can He Reduce His Taxes and Also Save For Goal 1 (Independence)?
Quick answer is Retirement Savings! But let’s go deeper to see how Mixing & Matching can help Ben save even more…
Ben knows about the advantages to saving for retirement early and letting time grow your investments through compounding. We helped Ben open a Roth IRA when he got his first part-time job in high school and he wants to continue to save for retirement. The maximum contribution for 2017 is $5,500. If Ben contributes the full amount into his retirement fund, this is around 22% of his pay.
When Ben contributes to a retirement account, he qualifies for the Saver’s Credit which allows him to get a full $1,000 as an incentive for saving for retirement (50% credit for an single filer with AGI under $18,500, 20% above $18,500, then 10% and phased out at AGI over $31,000). If you are a full-time student, or claimed as a dependent on another person’s return, you cannot claim the Saver’s Credit!
So, if Ben contributes all $5,500 into a Roth IRA, the Saver’s Credit of $1,000 would reduce his tax bill to $718 Sweet!
Under this scenario, he has $24,242 leftover instead, but he’s invested $5,500 of this into his retirement fund so this leaves him with a net of $18,742.
Can He Do Better?
What if Ben contributed $5,500 to a Traditional IRA instead?
Under this scenario, he’d still have $18,742 after his contribution of $5,500 and his tax bill is still zero.
You may be wondering, why Ben did not get the full $1,000 Saver’s Credit and get a refund of $94? The Saver’s Credit is not refundable. The Credit reduces the amount of tax he owes dollar for dollar, but he wouldn’t get more than he owes.
Is this the end of the post? Ben has achieved a $0 tax bill and he saved $5,500 in his IRA and kept all of his earnings. He’s golden, right? But wait…there’s more!
Mix & Match Is the Optimal Tax Situation!
If Ben chose to Mix & Match his contributions instead, he could do a combination of both Traditional IRA and Roth IRA contributions and still pay zero in taxes. The benefit of this is he will preserve more of his money in the Roth IRA which will provide him more flexibility in retirement with tax-free withdrawals. All other things equal, if you have the opportunity to invest in a Roth with earnings that are exempt from income taxes, this is the best choice because those dollars will never be taxed (assuming no changes to tax law).
If he splits his $5,500 between Roth and Traditional IRA, his tax bill could still be zero, and he would still have $18,742 after contributions. The key here is he has the same amount of money leftover, but he has decided to Mix & Match his contributions instead of all one or the other.
Obviously, there is not a huge dollar difference in the chart directly above, but that is because our illustrative earnings are near the top of the Mix & Match Range. Let’s look at some other income levels to see there is a sweet spot between $20,000 and $25,000 where this strategy may make sense for a single tax payer.
Here, our illustrative wages of $24,960 are highlighted in yellow near the top of this range. We start to see value in the Mix & Match strategy around $20,000. If your earnings are closer to $20,000, you can put a much higher percentage into the Roth IRA and still pay zero in taxes. Under $20,000, you are not taking advantage of the full $1,000 Saver’s Credit but still saving $5,500 for retirement.
At $26,000+, the Traditional IRA provides the best opportunity to reduce your tax bill as much as possible. If you make $26,000 and over, you can still decide to mix Traditional and Roth IRAs. You may consider paying a little bit in taxes at this low end worthwhile if you think your earnings will escalate in the future. You will pay some in taxes, because of the cap on the Saver’s Credit at $1,000.
There is a unique opportunity for you to fund your Roth account while your earnings are low to lock in those tax-free retirement savings!
Here is another way to look at the Mix & Match Range:
Sometimes A Combination Strategy Is Best!
If you think your income is going to be within this Mix & Match range, you may want to consider holding off on Roth contributions or Traditional IRA contributions until you are more certain. However, there is a way you can recharacterize contributions as well.
We are not tax professionals so please do your own research if you are considering a Mix & Match approach. You should fully appreciate the pros and cons of Roth vs. Traditional IRAs before contributing and you should be comfortable with investing.
We also want to mention the Earned Income Tax Credit (EITC). In Ben’s situation, he is ineligible for the EITC since he is under the age of 25. But if you are over age 25, and your AGI is under $15,010, the EITC could give you a $510 refund when you file your taxes. The EITC is refundable but the Saver’s Credit is not. It is permissible to claim both, if you qualify. To qualify for the EITC if you are Married Filed Jointly with no children, your AGI must be under $20,600.
It’s possible to save for retirement and also minimize your income taxes on a modest income. If Ben avoids slipping into a spendy lifestyle, he can save like a bad-ass for his own retirement.
For the last few years we’ve been focused on tax breaks for high-earners to save as much as we can for our own retirement. Now we have the chance to help our son make good decisions and reduce his own taxes on a modest income.
You are probably thinking there is no way that you could convince your 19-year old self (or your own child) to save such a high amount into tax-favored accounts. Remember you can withdraw your contributions any time from a Roth IRA tax and penalty-free (but not the earnings). Earnings could also be tapped for a first-time home purchase, education expenses, for medical expenses or if you become disabled.*
*Taxes and penalties on the earnings depend on whether you’ve held them for less than or more than 5 years.
Do you blend tax and retirement saving strategies?
Are there any tips for an unmarried (or married), lower wage earner with no children that we missed?