Tax Planning by Saving More

In the last post, we figured out how to calculate our tax bill with the new tax brackets. We found out Single Sam who makes $40,000 is going to save $31 every other week in taxes thanks to the new brackets. He is going to be smart and save that money or pay it toward any debts he has. The problem is that right now Sam isn’t saving for retirement and you might not be either. But you should. The younger you are, the more your money will grow and compound over time. That means you need to save today! Not 10 years from now.

This math can be explained here.

The second phase of tax planning is to move beyond just knowing how much you owe to controlling how much you owe. If you choose a retirement account that is tax-deferred then you don’t just get the benefit of a company match and the compound interest. Tax-deferred accounts mean you don’t have to pay taxes on the money until you actually retire, lowering your tax liability now. These tax-deferred accounts include 401(k)s, 403(b)s, 457(b)s, Traditional IRAs and other similar accounts. Contributions to pension plans also lower your taxable income, but if you’re like me, you’ve been contributing to that since day one and have no choice in the matter. These other retirement accounts have a lot of personal choice involved. You can choose how much you want to contribute each year up to the maximum, which is $18,500 this year, for those under 50.

When you contribute to a retirement account, this is considered an adjustment to your income. Every dollar you contribute is subtracted from your gross income when trying to calculate your taxable income. So let’s assume Sam starts off slowly but surely, and contributes $1000 to his employer’s 401(k) plan. Now when he calculates his taxes, his taxable income will be

40000

-1000

-12000

27000

$27,000 which we know will lead to a lower tax liability. Sam will owe

$3,050 in taxes. By contributing $1,000 to his retirement account, he lowered his tax burden by $120. This makes sense because $120 is 12% of $1000. So for every additional $1,000 that Sam contributes to retirement, it will lower his federal tax bill by $120.

And it won’t just lower his federal tax bill either, it will lower his state taxes as well. When we calculated state taxes, we saw that we used the federal AGI to begin the calculation. For Sam, his AGI is $40000-$1000=$39,000 in 2018. Last year, his AGI was $40,000. In Ohio, an AGI of $40,000 or less, allows you to claim a personal exemption worth $2,300. This would make Sam’s taxable income $37,700 and his state tax liability $773 last year, when he didn’t contribute to retirement. Now this year, his Ohio taxable income would be $36,700, making his Ohio tax liability $744. For every $1000 that Sam contributes to retirement his Ohio tax liability will go down by around $29 or $30.

All of this saving is starting to be a lot to keep track of. In the table below, you will see that for every $1,000 saved in a pre-tax account, its implications for federal tax liability and state tax liability. The final column is the sum of the federal and state tax bills. The table goes up to $10,000 just so you get an idea of how much his tax bill could go down if Sam saved 25% of his income.

Dollars Saved Pretax Federal Taxable Income Federal Tax Liability Ohio Taxable Income Ohio Tax Owed Total Tax Bill
0 28000 3170 36700 773 3943
1000 27000 3050 35700 744 3794
2000 26000 2930 34700 713 3643
3000 25000 2810 33700 684 3494
4000 24000 2690 32700 654 3344
5000 23000 2570 31700 625 3195
6000 22000 2450 30700 595 3045
7000 21000 2330 29700 565 2895
8000 20000 2210 28700 536 2746
9000 19000 2090 27700 506 2596
10000 18000 1970 26700 476 2446
For gross income of $40,000

 

When Sam goes from saving nothing to saving $10,000, his total tax bill drops from $3943 to $2446, which is a savings of $1497. While he might have $10,000 in an account he cannot touch (maybe) until he is 59 1/2, he has reduced his yearly take home pay by only $8503.

Find Your Comfort Zone of Saving 

Many sources will tell you to save between 5% and 10% of your income. But the more you save now, the more your wealth will grow. Saving more provides security and options as you progress. I save 20% of my income in pre-tax accounts, and I am looking for ways to be able to increase that percentage.

When using tax planning as part of your personal finance strategy, a lot is going to be about your comfort. Start saving just a bit but then increase as you start to feel more comfortable with the idea. If you are in the 12% tax bracket and were to save $1000 in retirement, you’d reduce your yearly take home by $851 which would turn out to be less than $33 per pay check, if you are paid biweekly. Can you live with $33 less in your pay check? The answer is probably yes. So you can definitely contribute $1000 this year to retirement. Remember that in 10 years, that money will double. When you add more, there is more to double…

If you were to save $2000, your yearly take home would be reduced by $1700, which would be about $65.38 per paycheck you didn’t see. Can you do without $65 of spending every 2 weeks? If you saved $3000, you’d reduce your yearly take home pay by $2551, which would be about $98.12 less per paycheck. Can you do without $100 per pay check? If you saved $10,000, your yearly take home pay would be reduced by $8503, which would be about $327.04 less per pay check. Can you do without spending $327 per pay check? Probably not. Not right away. But you can do without $33; you have my complete vote of confidence. You can definitely start with saving $1000 right now, even if you make “only” $40,000. Work your way up to $10,000 as you earn and learn more.

Saving in pre-tax retirement can seem a little scary to some people because you can’t touch the money. But that’s not always the case and plus, you don’t really need it. Money is a tool often just for security purposes. You have money you’re putting aside for future use and it has this awesome benefit to you now. If you can reduce your take home pay by just a little bit, you can do a lot of good for yourself in the long run. Find your comfort zone of saving and just start. The tax benefit is worth it.

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