It’s Not What You Earn, It’s What You Keep
You make money. You spend money. That’s the cycle. Financial independence comes from doing the following 3 steps:
- Earning more
- Spending less, and
- Investing the difference
It is really that simple.
Today I want to focus on Step 2: Spending Less.
Spending comes in all forms. You buy things you need like food, clothes, shelter.
You buy things you want like iPhones, high-end clothes, big-screen TVs, etc.
And some things are skimmed off the top before your paycheck reaches your hand. In other words…..taxes.
A Brief History of The Income Tax
Believe it or not, the United States didn’t always have an income tax. There’s an interesting history on what led Congress to pass the 16th amendment (ratified in 1913) which states:
The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.
In 1913, there were 7 brackets with the highest bracket being 7% on income over $500,000 ($12,400,000 in today’s dollars). Since 1913, the top tax bracket fluctuated to as high as 92% but has come down to the current level of 37%.
Government Incentivizes Some Good Behavior
The government hopes that people buy homes, saves for retirement, helps kids go to college, gives to charity, and gets healthcare. The general thinking is that these behaviors creates a more prosperous society.
This is why they subsidize the home mortgage industry, allow citizens to fund retirement with pre-tax dollars, pay for college with untaxed earnings on investments, allows you to do charitable works with untaxed dollars, and allows you to pay for healthcare with untaxed money.
But for some people, renting a home may be a better choice than buying a home. For other people, college may not be the best option. For others, they may not have the burning desire to give to charitable causes.
Regardless, the government incentivizes these behaviors. For our personal situation, we feel that doing all those things will help us living better, happier, and healthier lives.
Strategies to Reduce How Much Tax We Pay
I’ve tried to maximize these incentives mainly because they all make sense for our personal situation. Our second reason is that it leads to a lower tax liability.
Here is a brief list of how we keep more of my income by deferring, delaying, or eliminating taxes:
- We both max out my 401k to the limit of $18,000
- I contribute $30,000 to a Roth IRA via the mega backdoor Roth
- We keep the mortgage on our home (even though we have the funds to pay it off) because we can deduct the interest on the mortgage.
- Property tax we pay on the home is deducted from our income. We look at property tax as the cost of sending four children to school annually using pre-tax dollars.
- State income taxes are paid with pre-tax dollars
- We give 10% of our gross income to charity via our Fidelity donor-advised fund (DAF).
- We set aside money in a flexible savings account with pre-tax income.
- We set aside money in a dependent care plan with pre-tax income.
- We have set aside 6 figures our child’s 529 plans where the gains will never be taxed if used for higher education
- We contribute over 6 figures in a defined benefit pension plan.
- We have four children that will now qualify the $2,000/child tax credit
- We pay for insurance premiums through my employer with pre-tax income.
These tactics have allowed us to have an effective tax rate of 20% in 2017.
What’s an effective tax rate? In a nutshell, your effective tax rate is the total amount of federal income tax you pay, as a percentage of your total income. For example, if I earned a total of $50,000 last year and paid $5,000 in federal income tax, my effective tax rate would be 10%, even though our marginal tax bracket would be a higher rate.
In past years, we’ve been able to eek out a 16% effective tax rate even though our marginal tax rate has been at the highest brackets.
With the new tax laws, we’ll lose the ability to deduct the full amount we pay for state and property taxes, but we hope to make it up in the child tax credit and the higher income threshold with the alternative minimum tax.
So, going back to the 3 steps to financial independence mentioned at the beginning, we’re trying to earn more, spend less on things we want, but also pay less in taxes.
Besides spending less money on things you want, what are other ways you are keeping more of your money?