A 30 year old married couple invests $8,988 each year for 20 years and stops investing this sum by age 50. By the time they reach age 70, their investment will be worth $1,060,375 compounded annually at a 6% rate of return.
You may be asking yourself, “Where can we find an additional $8,988 per year?” Hmmm. Have you looked at how much you’re sending to the government in the form of federal tax? What if you could pay those dollars to yourself and invest them instead of sending them to Uncle Sam?
The Tax Cuts and Jobs Act signed by the President last December effectively overhauled the tax code. When looking at the new tax brackets, one thing jumps out at me. A couple that is married, filing jointly with an income of $77,400 has a 12% tax rate. Increase the income by $1 and the tax rate jumps to 22%. A 10% increase! So, how can you stay below the $77,400 threshold if your taxable income is above it? Save more in tax favored accounts!
Let’s use an example of a married couple, filing jointly with a combined income of $130,000. They are a working couple, each with access to a 401K and they also have two children. Notice their income falls right in the middle of the 22% tax bracket. This couple does not save anything into tax favored plans, but they do have health insurance which costs $4600 and reduces their taxable income to $125,400. After reducing their taxable income by the $24,000 standard deduction, they would be paying the government $12,387 in federal tax, resulting in a 9.88% effective tax rate.
Let’s take a look at a more optimized plan.This same couple decides at age 30 to go from Middle Class to Kick Ass. They increase their savings rate and look to max out their tax favored plans. They switch from traditional health insurance to an HSA and max it out. They both max out their 401Ks and Traditional IRAs. (For 2018, the IRS contribution limit for an HSA is $6,900 for a family or $3,450 for a single person. Regarding a 401K and Traditional IRA, the 2018 IRS limit is $18,500 and $5,500 respectively.)
By choosing a more optimized plan, this Kick Ass couple not only saved $54,900 into tax favored plans, they also reduced the amount they will pay the government by $8,988 per year (tax reform estimated taxes $12,387-$3,399). In reality, they increased their saving by $45,912 and reallocated the money they were already sending to Uncle Sam and redirected it to their savings. I know, I know, you can’t possibly save $45,912 per year. Really? So what you are telling me is that you can’t live on $70,500 per year? Drop the middle class mentality and adopt a Kick Ass one.
As seen above, just investing the tax savings over the course of a twenty year career (if you’re an early retiree) amounts to some crazy money going into Uncle Sam’s pockets. Also, notice how this Kick Ass couple’s effective tax rate went from 9.88% to what is in reality, 2.71% based on a taxable income of $125,400. And this does not include any other deductions for educational or medical expenses which would further reduce the tax liability. Another bonus with the new tax plan is that if your income is below $65,000 as a single filer, you can deduct up to $2,500 in student loan interest and it becomes a top line deduction. This means it will reduce your adjusted gross income. In addition, any medical expenses greater than 7.5% of your adjusted gross income are also deductible. Qualified dividends and capital gains are now subject to a 0% tax rate for taxable income up to $38,600 for single filers and $77,200 for joint filers. These are great benefits that can further reduce your tax liability just by saving more in tax favored accounts.
Play with the numbers for yourself with this investing calculator. Compound interest will blow your mind. By the way, use whatever legal means necessary to reduce your tax liability. It’s not only smart, it’s your patriotic duty.