Disclaimer: I am not a professional financial adviser, and this series in not meant to provide individualized financial advice. I am just one guy who did well enough to become financially independent at age 35. This series simply shares the lessons I learned for your entertainment.
By The Pointer
Travis has taken action to get himself going on the path to Financial Independence. He knows his goals, and he’s cut his expenses and raised his income in order to reach them. Recently, he just increased his income, but what’s critical in determining his time to FI is his post-tax income and savings. There are things he can do to legally reduce his tax burden. That’s what we’ll cover in this installment, but we’ll start with some background.
How do earned income taxes work?
The United States, like most countries, has a progressive income tax system. That means all income isn’t taxed in the same way. Typically, people with lower incomes are intended to pay a lower tax rate (not just lower total taxes, but a lower percentage of their total income goes to taxes) than people with higher incomes. That’s because each segment of your potential income is taxed at a different rate. This chart has those rates:
If we use Travis as an example, he just got a raise from $80,939 to $92,000. If he’s single, does that mean he went from paying tax on 22% of his income to paying tax on 24% of his income? Well, no. It’s actually much lower than that. For a few reasons:
- Standard or Itemized Deductions: All of us are allowed to subtract a certain amount from our gross income to calculate our taxes. Most people will use the standard deduction. If you’re single, like Travis, that means you can subtract $12,200 from your total income in order to calculate the taxes you owe. The alternative is to itemize your deductions. That basically means adding up all of the smaller things you’re allowed to deduct from your income. You can deduct charitable contribution, state income taxes, local property taxes and a number of other things (although with lots of limitations). If those itemized deductions total less than the standard deduction ($12,200 if single, $24,200 if married filing jointly), then you’re better off taking the standard deduction.
- Special Contributions: This is money for things like 401k savings, health savings accounts and other tax advantaged vehicles. We’ll go into more detail on the power of these things later in the next installment of this series. For now, we’ll assume the only special consideration for Travis is that he pays $100/year out of his paycheck for a dental insurance plan.
To figure out what he’ll owe in income taxes, we start by taking his gross income, $92,000. Then, we subtract the money he paid for dental insurance ($100). That brings his “income” down to $91,900. Next, after doing some research, we determine he’s better off taking a standard deduction (like most people) than itemizing his deductions. That takes another $12,200 off his income so we’re now at $79,700.
Now, we apply the tax rate for each tax bracket to Travis’s $79,700 of taxable income to find that he’ll owe $13,393 in federal income taxes.
That means his effective income tax rate (actual tax paid or $13,393 ÷ gross income or $92,000) is 14.6%. His marginal income tax rate is 22% because each dollar he earns beyond his current taxable income of $79,700 is taxed at 22% (since he’s in the 22% income tax bracket). If his taxable income goes above $84,200, he’ll pay 24% of each additional dollar he earns beyond that threshold.
Don’t Forget About Payroll Taxes
What we call “income tax” is separate from payroll (or FICA) taxes. Most employees have to pay social security and Medicare taxes (also known as payroll taxes or FICA taxes). In 2019, that’s 7.65% (6.2% for social security and 1.45% for Medicare). The employee pays half of this tax, and the employer pays the other half. That means that if you’re self-employed, you’re paying double (15.3%).
Payroll taxes are usually more straightforward to calculate because there aren’t many ways to avoid them. For Travis, it would be 7.65% x $92,000 (his gross income) = $7,038. You can’t change your taxable income here with the standard deduction, itemized deductions or health insurance premiums.
If you combine Travis’s income taxes and payroll taxes, he’s effectively paying $20,431 to the federal government each year (22.2% of his gross income).
Capital Gains Taxes
Until now, we’ve been talking about earned income (also known as ordinary income or W-2 income). That’s the term for the type of income most employees earn. Remember when I said most people are working jobs where they trade time for money, but it’s better to have passive income through stocks and other investments? One of the primary reasons is that there are lower tax rates on long-term capital gains, which is money earned from selling investments that you’ve owned for more than one year. Here are the brackets:
Um…yes, please! Let’s see what Travis would have paid if instead of making $92,000 of earned income, he simply sold $92,000 of stock that he had owned for more than a year. Let’s assume he originally paid $60,000 for that stock, and it’s now worth $92,000. His capital gains tax would only apply to the difference between what he paid ($60,000) and what he sold it for ($92,000), which is $32,000. If that’s his only income, he WILL NOT PAY ANY TAX on those gains because they’re under the $39,475 threshold. Not to mention, payroll or FICA taxes don’t apply to capital gains as long as you’re earning them through personal investments, and not a business. Paying $0 sounds much better to me than paying $20,431.
Sure, this tax-free living requires that you have investments to sell, but that’s what we’re working on. We’ve discussed decreasing costs and increasing income to enable savings that can be invested. Soon, we’ll discuss how to invest, but here, you can see the power of investing versus working for someone else.
Never Pay Taxes Again
Personally, I hope to leverage this difference in how earned income and long-term capital gains are treated to never pay federal income taxes again. I learned about this approach from a well-known post by Jeremy from Go Curry Cracker.
The example that we just looked at shows how this is possible, but how far can we push it? Well, long-term capital gains are also income that can be reduced by the standard deduction. Our calculation above was actually incomplete because Travis’s taxable income would be his $32,000 in capital gains minus his $12,200 standard deduction = $19,800. That means could still earn another $19,675 before he has to pay any taxes on his long-term capital gains.
In other words, if Travis didn’t have ordinary earned income, he could earn up to $12,200 (standard deduction) + $39,475 (upper end of 0% long-term capital gains tax bracket) = $51,675 WITHOUT OWING ANY INCOME TAX. Remember, that’s just the gains. Depending on the investments he’s selling, he could getting $100,000 in cash in order to end up with $51,575 of gains.
Remember, after just cutting his mobile phone and car payments, Travis’s annual expense were at $54,714. That’s without much effort or focus. When he reaches FI, he should have zero problem paying for his lifestyle without having to pay a dime of federal income taxes.
Don’t hate the player; hate the game!
You probably wouldn’t be surprised to learn that many people on the internet have a problem with this approach. I was shocked to learn that there are disagreements on the interwebs as well. Still, I’d like to offer some preemptive responses to common objections.
One common concern is that this must be illegal (it’s not), and if not, it’s unethical not to contribute to society’s costs. Congress enacts laws to raise revenue. There are all sorts of rules for how these taxes work, but what is taxed and what is not is the will on Congress (ie. your elected representatives). Here, they’ve given certain people living modestly a way to live without paying federal income taxes. Whether or not something is ethical is personal, but I can tell you it’s not illegal, and that I don’t feel ashamed to be planning to take advantage of it. Regardless, your primarily quarrel is with the system, not me, so don’t hate the player; hate the game.
The other common argument: it isn’t fair to people who work hard every day to face a higher tax rate because they earned their money from their time and not investing. I agree! It’s silly that capital gains get preferential treatment, but that’s the system we find ourselves in. Warren Buffet benefits from this system, and he feels the same way. He’s famous for saying that he actually pays a lower tax rate than his secretary, and that the law should be changed so he has to pay higher taxes. You can always run for office or support representatives that would change the tax system. Again, don’t hate the player; hate the game!
Ways to Reduce Earned Income While Saving
OK, it’s good to know how wonderful the tax treatment of capital gains is for people who have low to moderate “incomes”, but most people aren’t at the point where they can live off their investments. How can Travis and most others reduce the amount they owe in federal income taxes while saving for financial independence? In the next installment, we’ll discuss what some of these vehicles are, and we’ll get into how to leverage them.
The Living Freely Series Table of Contents
Step 3, Part 1: Cutting Expenses
Step 3, Part 2: Increasing Income
Step 3, Part 3: (Legally) Avoiding Taxes - Part 1
Step 3, Part 4: (Legally) Avoiding Taxes - Part 2
Step 4: How To Invest Your Savings
Step 5: Achieving Financial Independence