Federal Taxes and Investments

Guide for investing in US for beginners who just have a single source of income like salary and just do the basic like 401k match or employer stocks, pay a large sum in tax and have the remaining sitting in a savings account earning a meagre 0.0.1% - 1% interest. So how do we save, maximize our profits as well as avoid tax at the same time?

So let’s start with the basics.

Standard Deduction / Itemized Deduction

First understand what is standard deduction vs itemized deductions and the difference between the two. Suppose you earn a salary of 100,000$ and you are married. Let say 12700$ is the standard deduction. Now your taxable income is 100000 – 12700 = 87700$. Suppose you were going to pay 10% tax. If you did not apply standard deduction, you would pay 10000$ in tax. Since standard deduction is applicable to everyone and set forth by the US government, you get to apply the same. So now your tax reduces to 8770$. So basically you have saved 1230$.  The standard deduction amount changes every year. Most of you will fall into this category.

Now if both spouse and you are working, then there is a chance that you would fall into itemized deduction. Why?? This is because itemized deduction includes state taxes. For a simple example consider, the salaries earned are 100000$ each. Now we have to pay both federal taxes and state taxes. Say we paid 7000$ each in state tax. So total would be 14000$. Now this is greater than the 12700$ which we used above for standard deduction. So now remember your income has increased to 200000$. If you were to apply standard deduction, then the taxable income would be on 187300$ (200000 – 12700). Instead in this case we can use itemized deductions which would be 186000$ (200000 – 14000). Considering the same 10% tax, we would do 10% of 200000 = 20000 and 10% of 186000 = 18600. So the difference is 1400$ and that is saved money. It would have been great if the calculations were going to be so simple. No it’s not. L

Also note when you itemize deductions, there are more ways you can itemize deductions to increase the amount. I will cover them shortly.

Now understand that tax is not going to be 10%. Like your electric bill, it is based on slabs or brackets. The moment you start earning more, you tend to fall in the next slab and the tax rate increases and you have to pay Uncle Sam more. 

For example, for married filing joint the brackets break down as follows

0-18650$ = 10% = 1865$

18651-75900$ = 20% = 20% of 57250 = 11450$

75901-153100$ = 25% = 25% of 77200 = 19300$

153101-233350$ = 28% = 28% of 80250 = 22470$

And so on… Above 470700$ tax is charged at 39.6%

These slabs keep changing yearly. So the calculations also change..

So for 187300$, we would have paid a tax of 1865 + 11450 + 19300 + 9576 = 42191$. This is an effective tax rate of 22.52% (42191 / 187300).

If we go based on 186000$, we would have paid a tax of 1865 + 11450 + 19300 + 9212 = 41827$. This is an effective tax rate of 22.19%. But if you noticed the difference is only 364$, meaning the more you earn the more you pay tax, unless you know how to save on tax by using the initiatives programs, and strategies the government has set forward.

So in the above example, 187300 or 186000 is your taxable income.

Exemptions

So as you have seen standard deductions apply by default or you can itemize, similarly personal and dependent exemptions apply by default for both standard and itemized calculations. Its 4050$ per person and dependent is also 4050$. So if you are married and have 2 kids, then you get a total exemption of 16200$.

So this has now further reduced your taxable income to 169800$ (186000 – 16200). Tax is now 1865 + 11450 + 19300 + 4676 = 37291$

So we have again lowered tax payable by about 4536$

So all the above apply by default. There is nothing extra to do on your side when filing tax returns. We need to reduce it to lower our tax and fall into a lower tax bracket.

Let’s go through the easiest saving methods first,

401k

401k is for retirement purposes. Any sum you contribute is tax deductible but you can withdraw it only after the age of 59 ½. Most companies will match your 401k up to a certain percentage 3%, or 75% of the first 6%, or 50% of the 6% of your income. This is a big addition to savings. For example say you contribute 3000$ to your 401k over the year, and you earn 100000$, which is 3%. The company matches the first 3% which you contribute, which means they add another 3000$ for a total of $6000 to your retirement. So first and foremost make sure you contribute as much as your employer would match. You do not want to leave money on the table which you are getting as an extra bonus.

Remember if you withdraw this earlier than 59 1/2, you have to pay a 10% penalty and the tax rate at that point in time.

How much can you contribute to 401k. The limit keeps changing every year. This year its 18000$ per person with a company sponsored retirement plan. So if your married and both employers are offering a retirement plan, then you get to contribute 36000$ in total. Still it would be 18000$ each per account.

Now how does this lower your tax? In the previous example let’s now deduct the 401k amount 200000 – 14000 – 16200 - 36000 = 133800. 133800 is the new taxable income. If you notice we moved to the 25% slab as our income is below 153100$. So let’s calculate the tax once more. 1865 + 11450 + 14475 = 27790$

So from 37291$ we have brought it down to 27790$. So we have saved 9501$. Basically for a 36000$ investment, you have saved close to 10000$, and you have covered some part of your retirement or investing in yourself and family.

Property taxes and Mortgage Interest

Paying rent for an apartment or owning a house, which is better?

Say you pay 1500$ in rent every month (total 18000$ a year), do you get any returns on it? Plain answer is NO and that money goes down the drain, but it helps promote the economy. 

Buy a house with an affordable EMI which encompasses (Principal + Mortgage Interest + Insurance + Property tax) = 1500$ instead. The principal portion of the EMI, you are investing in your house equity, which when you sell, you get back. Mortgage interest is unavoidable, unless you had boatloads of cash and paid in full for the house. Mortgage Interest is the second itemized deduction category. Property tax is the third itemized deduction category. Out of 18000$ lets divide it in the following manner (6000 + 8000 + 1000 + 3000). Now 8000 + 3000 = 11000 gets added to you itemized deductions which was previously at 14000$. Now it is 25000$ (14000 + 11000).

Let recalculate the tax again.

200000 – 25000 – 16200 – 36000 = 122800. 1865 + 11450 + 11725 = 25040$.

Another 2750$ saved. The savings keep adding up right? I know, it’s good isn’t? J 

Now let me put it forth in a different perspective.. Instead of spending 18000$ in rent, you got back 2750$, you invest 6000$ in equity. So total 8750$ invested. Only 9250$ is spent. But then think about it, you owned a house shouldering more responsibility like your parents did before you, or even better your kids will always call this place as home and have some more good memories. Doesn’t that feel good!!!

Charity Deductions

I have been talking about saving all this time, but then sometimes it’s better to give to save more. This is the 4^th category in itemized deductions.  Say you gave 1000$ to an organization for charity. It adds to the 25000 (14000 + 11000) .. So now we have 26000.

Let recalculate the tax again.

200000 – 26000 – 16200 – 36000 = 121800. 1865 + 11450 + 11475 = 24790$.

So for a 1000$ charity contribution, you get back 250$. So effectively you gave 750$ for charity. Instead of paying the 250$ for tax, it helped someone else J

Personal Property Taxes (Car registrations)

This is the next item in itemized deductions. Guess you have lost track by now how many deductions we covered. Let me remind you. We are at the 5^th item.  

The ad valorem tax that is paid is tax deductible. It comes to about 100 to 200$. So 26200$ is the new itemized deduction amount.

 Let recalculate the tax again.

200000 – 26200 – 16200 – 36000 = 121800. 1865 + 11450 + 11425 = 24740$.

40$ savings. Seems the savings are getting smaller??? Hmmm.. Let’s see if we can reverse the trend.

Child Care, Child Tax Credit and DCFSA

Children go to daycare if both parents are employed and we all know daycare is expensive. How can we best utilize the same for a tax deduction.

The default method the government is providing you with is a tax credit. Please note, I am mentioning this as a credit and not a deduction.

We get upto 3000$ per child if you have spent more than 3000$ in daycare expenses, and 20% of 3000$ is offered as credit = 600$

So for 2 kids, its 1200

So now the tax reduces from 24740 – 1200 = $23540.

Next comes Child Tax Credit, this is at present 1000$ per child, but it has a limit of 110000$ of AGI (Adjusted gross income). AGI can be simply calculated as Gross Income - 401k or any other deduction like educator fees, tution fees etc... If the AGI is above 110000$, then for every 1000$ increase there would be a reduction in 50$ in credit. In this case our AGI is above 110000$ at 164000$, so we cannot claim this credit.. To get even a 50$ credit, the AGI would need to be 129000$.

Now if your employer offers DCFSA go ahead and apply for the same. It’s called Dependent Care Flexible Spending Account. You can contribute 5000$ per child. They would give you debit card which you can use to pay the day care expenses. This 5000$ is reduced from your taxable income..

200000 – 26200 – 16200 – 36000 – (5000 * 2) = 111800 = 1865 + 11450 + 8975 = 22290$

So 24740 – 22290 = 2450$ savings. Now any amount spent over 5000$ can be claimed from the first section of child care credit. So if you spent 8000$ in total per child, the remaining 3000$ per child can be accounted there.

Now we have 22290 – 1200 = 21090$.

So that’s another 3650$ in savings. See we are on the increasing trend again…

Let’s take a look back though, we started off by paying 37291$ and now we are at 21090$. That’s a total of 16201$ in savings in tax, while we invested in retirement and equity.

Sadly for now I have to stop taking back the government money.

I will continue more in Part 2 on more itemized deductions, IRAs etc.

Disclaimer: Please note the calculations may change every year as the deductions changes, the rules changes, the tax brackets changes. So consider this post only to look up some of the very straightforward avenues to save on tax while investing at the same time. For this post I have considered only Federal Tax for Married filing jointly and both spouses working with 2 kids, and taken the 2017 numbers for all calculations, and was based on a round off income of 200000$ as it was easy to work the math out..