Taxes. Oh taxes how I loathe you. Last year in 2016 for 2015’s tax year, you got the best of me and received a nice check at the last day possible. After that moment in Mid-April of 2016, I did not want to go down that path again. I therefore, did y researched, spent time soul-searching for days, weeks and months to come to a plan. Finally, I will say this – I believe this year I kicked Uncle Sam’s ass, and I will show you how!
2015 Tax Year
To break down how this started even further, the year of 2015 had a few unique perspectives. I did not maximize my 401k nor was I doing this pre-tax, shame on me – as I am now a FULL believe of pre-tax investments. Additionally, I had over a 4 digit capital gain – some short and some long-term, which didn’t help my position, at all. Let’s just say, that my overall tax percentage was 14.74%. I know some may think that’s a little, but even after employer withholdings, these other items led to an increase in the $ amount of taxes that I owed at the end of it all.
Now, I am all about paying taxes when/where & how much that is necessary, but if I have to pay even more than what I had planned or projected – that doesn’t sit well with me! Further, that event of paying more tax at the end ate into some capital that I could have used for an investment! Here is a snip from my personal tax return to show you the percentage I paid and that I’m being very open here:
2016 Tax Year – 3 Rounds with Uncle Sam
So Uncle Sam had won round one. However, they don’t call me the Italian Stallion for nothing (sorry Rocky, had to do it!). I got back up, dusted myself off and said “BRING IT” in 2016. I read many sites, articles, the IRS website, the 1040 form, etc.. I did this because I wanted to understand everything that I could do given the expected situation that I would be in. I wanted to maximize wealth on this pursuit to financial freedom, increase my income producing assets – i.e. primarily dividend stocks, and reduce my expenses as much as possible – which taxes is a HUGE Part – see why I aim to save at least 60% of my income each month.
All of this research, soul-searching and discovery let me to employ 3 things as much as I could have in 2016. Here are those items that I had altered/took on/or went max:
Round 1.) I went from a Roth 401k up to my employer’s match to change to a Pre-Tax 401k and MAXIMIZED this as much as I could. However, I could not do the full $18,000, as I had already had amounts taken out for the Roth 401k at the time of switching, but I was able to have over $16.4K go pre-tax into the 401k. This alone, saved over $4,100 in federal taxes! I did this maximizing within the last 4 months. See why I chose to max out my 401k.
Round 2.) Health Savings Account – Not only did I max out my 401k pre-tax to the best of my ability, but in the short time frame I maxed out my Health Savings Account (HSA) in that short duration as well! This was $2,900 in contributions that I was able to do, as my employer contributes $500 every year, which saved me another $725 in federal taxes, that’s what I’m talking about.
Round 3.) Traditional IRA – Yes, the tri-fecta here. As an employee making most of your income via wages, there aren’t too many other things you can do outside of those listed above. However, those two items listed above, if you are fortunate – can reduce your modified adjusted gross income low enough that you may be able to contribute all or some funds into the traditional IRA account, which is then reflected as pre-tax on your return. I used to maximize my Roth IRA each and every year – and not like that’s a bad thing – however, I wanted to take Uncle Sam DOWN and keep him out for the count for 2016. Therefore, based on my thresholds, I contributed $3,379 to the traditional IRA. This saved me roughly another $845 in federal taxes.
Based on those three moves, I was able to reduce the federal tax expense by ~$5,670. How do you like that Uncle Sam?! That’s right, I hear crickets! However, what did that mean on my overall % that was paid or my effective tax rate… well… I reduced it to 10.34%! Here is the snip, as filed:
Tax & Uncle Sam Conclusion
In conclusion – this is about getting better, understanding what one can do with pre-tax investments and building wealth. All of this additionally increased my forward looking income quite a bit in 2016, as well, as they are investments within Vanguard overall market funds that produce quarterly dividends. What I’m also trying to say is – you should work hard at keeping every dollar that you make, every single fricken dollar. I cannot stress that enough – every single dollar counts! For tax savings – those extra funds can be applied in a drastic number of ways – fueling investment accounts, paying down your auto loan, your mortgage, increase your savings, money down on a rental property – you gosh damn can name it! For a basketball player to work hard for you on your team – think they will do it just because? I don’t think so. You need to work hard to keep, maintain and develop that – in order for “that” to work hard for you in return.
Overall – I went toe to toe with Uncle Sam this year and had the three knockout punches to take him down. There is a lot of noise, at the moment, from Donald Trump in regards to potentially removing the 401k tax breaks. Does he want to urge individuals to save or not? I know if this happens, I will stop, no doubt, so that is a curveball in the mix, for sure – so please keep that all in mind everyone, as these circumstances have a chance of being modified and/or changed. However, I am investing today, based on what is fact and not based on the “what-if” scenarios. We shall see what improvements, if any, I can make to my 2017 tax situation, but I found it to be a very fun challenge in 2016 to take on the bout and come out a winner on the other side. I was able to have more money invested/saved and I even had a refund to boot at the end of it, due to this opening up further tax-advantaged situations, like the traditional IRA.
What does everyone think? Employing any of the strategies above? Any questions relating to it that I could help answer? Any holdbacks from doing this? Would love to hear your stories and if you also won a battle with taxes!
-Lanny
I love your tax strategy.
I have a question. Do you have both a Roth IRA and a traditional IRA? and if you don’t , can an individual have both simultaneously?
Keep writing the wonderful content.
Thank you.
Amit –
Thank you for the comment! I do actually have both. If you already know the tax-situation you’ll be in and know that you’ll be able to contribute to a traditional IRA – then do that to the maximum that you think you can. If you know you will be phased out of doing that – then go to the roth! What I plan to do this year, is that I know I’ll have to do at least “some” to a Roth IRA; but will wait, more than likely, until April of 2018 to make my contributions to any IRA account – just to be on the safe side of which account I am allowed to do within IRS limits. Your MAGI – once that starts to rise, will start to phase you out of being allowed to contribute to a traditional IRA. To answer your question, though, you can have both : )
-Lanny
Great stuff Lanny! I expect nothing less from a tax accountant like yourself. I am currently putting about 13k into my 401k, 2500 into my HSA and have been maxing out my ROTH IRAs. The reason for the ROTH IRA is that I believe I will soon be out of the lower tax brackets so I am taking advantage of this right now while giving uncle sam a little more than he wants. Soon I will be all traditional and back dooring into a roth!
Stefan –
AWESOME. Right there, alone, is $15.5 pre-tax + $5,500 post-tax retirement i.e. $21K that you are putting away in tax-advantaged accounts. Think about the milestones you are making and the dent in the journey you’ve come so far. It’s awesome to hear this news. Keep it up SS, talk soon.
-Lanny
Maxing out the tax-advantaged accounts is huge. Gotta love the 401k and the HSA. I would do a trad IRA if I could but I’m just outside the income range so I go with the ROTH IRA and it helps to have a little bit of tax diversification on that end as well since who knows where taxes will actually be 10-20 years from now.
Time –
Yep. I have to “bifurcate” between the roth and traditional; and have to do more in the Roth this year, as opposed to traditional. Play the cards that you know now (i.e. you are allowed pre-tax items now, and that could always change), and we are smart enough to figure out what to do later!
-Lanny
Being from Belgium with a tax rate of 34pct, I can only say…job well done!
Our countries tax systems and social benefits are different, so it is hard to compare. Maxing out pre tax investments is a no brainer to me!
Amber –
Yes, very different! Here in the states we have brackets based on income levels and the way to reduce your tax burden is to simply reduce your income and the best way to do that is pre-tax investments such as the 401(k), Health Savings Account & Traditional IRA, if you are able to. You are able to build your balance sheet and reduce expense in the current period at the same time : )
-Lanny
Hey Lanny,
What other factors did you have when switching from Roth IRA to traditional or was it specifically for tax? I use a Roth to diversify my investment accounts in retirement, as for me right now they are the only ones I have. I’m the younger of the two Dukes, so hoping to get to the outside retirement account wealth level one day.
My thoughts are if I’m using 18K pre-tax, this means in retirement I’ll be paying taxes it on it later. If I use a Roth as well, then some of my income will be tax free -> balance it out. I’ll also have non sheltered retirement accounts by then also.
Could you give some thoughts on your decision process and any other big learnings you had?
Thanks !
Master Duke
Master Duke –
Of course. Here is the big item – Conversion to the Roth with your pre-tax accounts. If you want to retire early, there are chances you have other sources of income that are offset by business expenses. When you go “full” blown no more corporate world – your tax bracket will more than likely be lower. In my current bracket – I pay 25% taxes on income > $37,650. However, when I retire early, I may be in a MUCH LOWER tax bracket. Then – you convert $x from pre-tax to the Roth IRA that is at the lowest taxable event that you can, i.e. 0-10% bracket; and your tax consequences are MUCH lower than if you had performed the ROTH contribution today, as opposed to this conversion. Such as – I would be paying 25%+ taxes on that post-tax contribution to the Roth if I contributed today.
Does that make sense? Let me know and I can dive further!
-Lanny
Yup total sense. Always the big decision point, will you be in a lower or higher bracket when you retire :).
Thanks for the in depth answer !
Great job! Came in at 9.32% myself. The other big item (for DGI folks) is the noise surrounding the ability to credit/offset foreign tax paid on dividends. Gotta love tax reform 🙁
Charlie –
WHOA!!! Below the double digits, you son of a gun! That’s awesome and congratulations, great to hear and see. And yes… the noise on tax reform is quite interesting right now. What’s hard is that you know the initial plan won’t be passed, but what middle ground will occur?
-Lanny
Very nice. Unfortunately here in Australia our taxes are very high. I do not make a huge amount of money but because my student loans are held with the government and our “free” healthcare my effective tax rate is closer to 30% which chews up a lot of capital unfortunately.
BHL –
Agh, high taxes, but the free healthcare system has to be very nice, no? Other benefits of the 30%?
-Lanny
One thing you need to be thinking of, IMHO – Required Minimum Distributions from pre tax retirement accounts. Given the young age you have started, you are going to have a pile of assets that would make Scrooge McDuck drool. No minimum required distributions from Roths, plus all money coming out is tax free ( at least under current tax laws – hope that stays ). Dream a little, if you have a few of million in retirement accounts in the way distant future, who would you want making the decision about the timing of, and the amount to be taken out? You, or the IRS? And how much tax would you want to pay on it then? Zero, or some unknown ungodly rate? Granted I am quite a bit older than you, but I see paying a little more tax now, in order to have greater freedom and control of my money is worth it.
Another thing I like about using a Roth, having a cluster of dividend growth stocks in there will be giving me a growing tax free income. I find that to be exciting beyond words!!
Boyd –
Thanks and love the comment. Agree that the forced withdrawals would be a pain! An article that I haven’t dove fully into writing yet is – converting my pre-tax dollars into Roth accounts, actually, and to do this when I am in a lower tax bracket to pay little taxes when I do convert vs. the higher tax that I would have paid today. Does that make sense? I plan on retiring early & to set things up financially to be in a very low tax bracket, and the conversion of these dollars will be at the lower tax bracket. So in effect, I do plan on experiencing the full benefits of the Roth features. I do also have a Roth, as I have contributed to one for years and years and only recently invested into a traditionally – and I could not even do the full amount in there – so will always be investing portions at least into the Roth : )
-Lanny
Wow, just wow, not even 10.5%….. We probably paid about 3 times that with no chance of getting (much) back. I know we have a very good social system, but I’m kind of jealous when I look at the US and the options to become FI. From a tax perspective, life is so much easier on the other side of the pond. sigh….
CF –
You are right, though, the social benefits that you have are far superior than the prices we have to pay for those here – where – it may end up being more cost effective from where you are : ) Just trying to make the most of the situation and plan accordingly, right? Sometimes… that’s what we can do, eh?
-Lanny
Very good job. But not everybody can do it.
I doubt I will start my own business, but I know I will be in a higher tax bracket than I am now. I will certainly be making more, so will my wife. That is 100% true, so I want that Roth. Taxes will also be higher. I know Trump is trying to lower them, but the government will have to raise taxes to pay the debt eventually. There’s no way around it.
I can’t do the HSA because I don’t have an UHD plan.
Traditional IRA: Don’t have one
Rollover Traditional: Form an old employer, DGI strategy
Roth IRA: Max out every year, my primary investing vehicle along with the Rollover
Like I said, the chances that my income will be higher in retirement than now (with dividends especially) is very good. And when I did the math… say I am in a 28% tax bracket, effective tax = 21%. So, on $5,500 I will pay $1,155 in tax today. That will be $30,000 in 30 years at a 7% compound return. Even at 10%, I will pay $3,000 in taxes.
401(k):
I chose the Roth 401(k) option for the same reason as above. I can take the money out any time, don’t have to worry about taxes. I don’t have to worry about RMDs. And maybe I need long term care: I cant pay for it out of the Roth, but on a traditional I would be hit with taxes.
My employer, however, matches with a pre-tax amount.
I plan to spend the Roth first, then deal with RMDs in my 90s.
Now that’s how its done! Great work Lanny!
Bean Counter –
Thank you very much, was hard work and discipline, but excited for the massive investments in 2016 : )
-Lanny
My head hurts just thinking about taxes. Right now I max out my Roth 401k at work and my Roth IRA. I still don’t know if I made the right decision by going Roth. I don’t believe I’ll be able to retire early Lanny so I don’t know if going traditional is right for me. I have about 22 years before I retire, but we will see.
DP –
It is very stressful and… nauseating at times, no doubt. If you have your destination more determined than not – then you should be fine! Hey – you’re investing and that’s the MOST important thing here! Just remember that : )
-Lanny
This is something we can only be jealous of… Way to go, and interesting to see how big the effect can be while making use of this. Definitely know more about the US tax system because of reading your stories here 😉
Although we pay a higher rate, we do get a lot of money back due to study costs we can retrieve trough taxes.
Divnomics –
Always love to hear non-US residents’ perspective on the system we have. You do have a few other pros to your system, never a bad thing, but also a few drawbacks from a higher tax rate. I always believe that it’s all relative, right?
-Lanny
I have a different view on the tax situation then you, and maybe different than most. But it doesn’t mean that yours isn’t a great strategy, it certainly is. I contribute only up to the match in my 401k and focus on my Roth IRA and Brokerage Account.
I’m losing the front end tax savings, of course, but I want a portfolio that can support me earlier than my 401k will allow me. I view the 401k I’ll accumulate as a “bonus” come the time. Barring some large changes to the way dividends are taxed in the future (which is extremely possible given how far away it is) my tax rate in my early retirement will sit at 15%, I’m good with that rate.
It’s fun seeing other strategies! Which is why the dividend investing community is such a great platform for learning.
LOL!! You’re very funny! It cracked me up reading this post.
Joke aside, 10% tax rate is better than people with make $35-80K without any property or any dividend income.
2016 taxes kicked my butt, as I took a HUGE capital gain so I raise money to buy the new property. My tax bill is $6K. If Mr. and I were single, we both could have gotten money back.
Either way, I kinda knew I had to pay taxes, so I wait until the day of to file taxes. But 2017, I think I’ll get money back, given that I don’t incur any capital gain or one day I’d go crazy and make some sell just because … heheheh LOL 🙂
Boom! That is how it’s done! Understanding taxes and tax implications is what separates the good from the great. Just having at least a little knowledge of the subject can help to increase your net worth and free capital for investing a ton. Keep following your strategy and watch the benefits grow as fast as your portfolio.
Daze –
Love the enthusiasm and motivation to keep going. 4 months in the books with my strategy this year as well, no looking back now and the net worth is exponentially growing, but more specifically – forward income : )
-Lanny
Nice work. Now open Dividend Diplomats, LLC and start writing off more expenses. 😉
I’m pretty sure they already have that going. Smart to use it to their advantage though when possible.