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November 12, 2013

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Thanks for sharing your reader's financial income, I really enjoyed reading his income and expenses. Surely I will look forward in your next reader guest profile.

Wow. This interview resonated with me more than any other

Except for the brokerage thing. Kudos to the interviewee for doing it AND being good at it. I used to pick my own stocks but it took too much time and I'm not confident enough in the future of specific stocks to put my family's money on the line. I much prefer index stocks or a mix of low load mutual funds.

Also, it is nice to see someone who doesn't make over 6 figures use their money so wisely so early. It's always interesting but a bit hard to read the millionaire interviews about folks who make gigantic incomes (well into 6 figures) because I'm so far away from that scenario.

2 questions... Do most people include 529 accounts in their networth calculations? I don't because I consider the ownership of that money the child's. Secondly, are you able to contribute to an IRA for someone who has no income? I see the wife is a full time stay at home mom in this profile which causes me to assume no income.

K --

1. I used to include 529 values when the kids were young, but as they've gotten closer, I've begun to offset that "value" with a "debt" account in Quicken, so by the time they get to college the two will net out to zero.

2. I don't think you can contribute to an IRA when someone has no income...

You can contribute to a spousal IRA if they have no income. I believe it is for a traditional IRA only (no Roth option).

You can contribute to a Roth IRA for a spouse with no income, provided that you file jointly.

http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits

http://www.irs.gov/pub/irs-pdf/p590.pdf

K --

1. I understand why you'd exclude the value in your 529 account from your net worth calculation. But according to your view (that this value is not yours but the child's), then what about costs for baby food, preschool, diapers, and day care? Do you have these costs included in your Liabilities to offset your Assets? If not, why not? You know you'll use that money for your child, which means that money is his/hers as well.

2. SR is correct -- both spouses may contribute if they file jointly.

You are allowed to contribute to either a traditional IRA or a Roth IRA for a spouse with no income under the spousal IRA rules. You still have income restrictions to be aware of, but we are nowhere near those for her. My only option is a Roth IRA due to the company 401k plan, but as I mentioned I no longer desire to fund my IRA anyways.

As for the 529's I include them in my net worth as legally speaking my wife and I are the account owner's and the kids are the beneficiary's. Also, it is my hope that when that time comes the kids will have scholarships. If that is the case, then we will get to withdraw that money penalty free and move it directly into our other savings.

After a certain income level you can't contribute to traditional IRA for a non-working spouse, you can put the money in IRA but you can't deduct them from your joint filing. I don't remember the exact threshold, but one year I inadvertently exceeded it and IRS sent me a "nice" note about it next year and collected interest. That's when I stopped doing my own taxes :-)
However, with the backdoor Roth option this is now not a problem, you put the spousal (or yours) contribution in an IRA account and convert them to a Roth account next day. No interest, no deductions, just filling a form 8606.

you seem to be in very good shape...kudos. However, you mention you want to take full advantage of your tax situation. Perhaps I'm missing something obvious, but you are currently investing $9,600 in pretax earnings in the 401k and $18,000 in post-tax brokerage accounts. It seems obvious that you could flip the amounts you place in 401k versus brokerage - i.e. max out your 401k at $17,500, reduce the brokerage savings to $10,100 - which would immediately reduce your taxable income by $7,900. A pretty big immediate win for you...

EAS, thank you for the compliments. As appealing as it sounds to reduce my tax burden even further, the additional savings do not outweigh the opportunity cost of putting that money into an account that I can't access for another 30 years. I should be safe after the age of 60 without any additional 401k contributions, so my goal to quit working as an employee trumps the immediate savings.

EAS, I believe CH is doing the right thing. No need to contribute anything extra to a 401K if you are in the 15% tax bracket. Just contibute enough to get the match. In my case, I contribute 10K to my regular 401K and 7.5K to my Roth 401K. This keeps me right at the 15% - 25% bracket cutoff.

JW

CH: To each his own I guess....but from a factual standpoint (JW), CH is in the 25% tax bracket. Even if he wasn't, I'm not sure what your point is - increasing 401k contributions would only serve to "decrease" your taxable income.

The gist of my comment was that he currently grosses $94,000, has taxable income of $84,400, and saves about $27,600 between both 401k and after tax brokerage accounts.

I proposed he could instead have a gross of $94,000, taxable income of $76,500 and still save the exact same $27,600 between both accounts. For those counting, that nets CH an additional $1,975 in extra money annually (he's in the 25% tax bracket).

Over time, that can be significant. CH could take that $1,975 and increase his annual savings from $27,600 to $29,575 - without actually saving another dime. You don't have to be a mathematician to extrapolate what that money could turn into over time.

I suppose there are reasons to want that money available and not locked in a 401k. Personally, I have found this to be a great tactic to protect yourself from yourself. Sometimes the ability not to get to your money is a good thing. I am 45 and can promise you the time will go quicker than you think.....If I went back in time and witnessed the 29 year old me try to reduce 401k contributions, there would be a fistfight.....

EAS, I am already in the 15% bracket. You are leaving out all of the other deductions. My actual W-2 income is looking to be a little less than I estimated when I wrote this. It will probably be about $92,000 pre 401k contributions. Take out 6% for the 401k, $6450 for the max HSA deduction, $5500 for my wife's IRA, $3900x4 for personal exemptions, and about $16,000 for itemized deductions and I will have only about $43,000 in taxable income; excluding capital gains.

I will then be reporting about $30,000 in capital gains and qualified dividends at a 0% tax rate, since as long as the total of your capital gains and other income stays under the 25% bracket threshold the capital gains are tax free.

In this way, I can continue to strategically record my cap gains so that my "taxable" brokerage account essentially works exactly like a Roth IRA. Now I'm sure (hopefully anyways) my gains and income will exceed the threshold to the point that my capital gains will be taxed in the future, but they will still only be subject to the standard 15% cap gain tax rate.

In essence, this gives my salary room to grow to over $110,000-120,000 (depending on if you count IRA and/or HSA contributions in future years) before anything hits the 25% income tax bracket. If I were to max out my 401k, it would save me roughly $1500 on my tax bill now, but of course it would be taxable as income when I withdraw it. In actuality I have the best of both worlds right now. A brokerage account that is taxed like a Roth and the freedom to access the money at any time! Hence my advice to understand tax law and how to make it work in your favor!

Besides all of this, as I mentioned I anticipate having plenty of money in our retirement accounts by the time we are 60 to live the type of life we would want. Regardless of the tax situation, it does me no good to have any more money in those accounts than I could otherwise spend if that money can benefit me some time significantly sooner.

CH: Fair enough - just my two cents. I wasn't sure what your deductions would be. (1) Given what you describe, I would imagine you are certainly in the sweet spot for the dreaded Alternative Minimum Tax and that continues to be a trap you'll find yourself in with our government searching high and low for revenue....I can't imagine you avoided the AMT on your last tax return(2) $1,500 is still not growing on trees where I live, but I will be on the lookout, and (3) to each his own! Good luck...

EAS: No worries! I never would have submitted the reader profile if I wasn't ready for a counterpoint or two, so I welcome the dialogue.

As for the AMT, I am a ways off before it would apply due to the preferential treatment it gives to the mortgage tax deduction and above the line deductions. I can't give you the exact numbers without refiguring it, but last time I did I know I was far enough away to not worry too much about it.

The AMT was designed to tax those that are taking a bunch of deductions, not those that have lower rates due to capital gains. My itemized deductions will be less than $4000 over the standard deduction. My schedule D is relatively straightforward as it only deals with stock and I have never had a loss carryover that would affect AMT. In a nutshell, the only addition to my income in regards to the AMT is for local taxes since even the AMT allows for the mortgage interest deduction.

@EAS,

CH is no where near owing AMT tax. My AGI has been north of 160K for a few years with Taxable income north of 110K, well into the 25% bracket and I have never paid AMT. Granted I am getting pretty close, but CH's numbers are far less than that.

Concerning the tax deferral argument, your take seems to be that the best tax strategy is to always pay the least amount of tax you can in each year possible because that is giving you "more money." This is incorrect tax planning strategy. Most people do fall into this kind of thinking about taxes but it overlooks the more complicated long term implications of various tax decisions. The correct strategy in most situations is something called tax smoothing. That is to smooth out your taxable income over longer periods of time. If you talk to good tax accountants they will tell you this is a key aspect of good tax planing (among other things), but that most people are more interested in paying as little tax as possible on the current year return because they believe this saves them money, but that is incorrect.

If you know you are going to have a relatively high or increasing income and are likely to continue to have a relatively high and perhaps even higher income later in life the correct strategy is not to minimize taxes now but to make sure not to push off too much tax for later when it will be taxed at higher rates.

CH is doing something extremely smart here and not understood by many. In fact I will use a phrase I have used in describing this to others. If CH were to allow his taxable income to fall significantly below the 15/25% bracket cut-off he would be doing something that I refer to as "wasting his 15% bracket." The tax code is designed to give lower income earners lower tax rates. It does this in a way that gives everyone a certain amount of income that is taxed at lower rates. Even if you make a very high income, you get the same amount of your income taxed at lower rates as someone making much less than you does. But this is done in a way that cannot be shared across tax years. Each year there is only a certain amount of income that you can have taxed at 15% or less. If you do not use it all in a given year, you lose it, FOREVER. That means if you do things to get your income artificially lower in a given year or years relative to your long term average then you have wasted a portion of your cheaper tax rate that results from the tax bracket system. Eventually you will pay tax on that money because the taxable nature of it has not been eliminated, only deferred. You will pay tax on the deferred money as well as any gains on it. If you will be in a bracket higher than 15% when you pay tax on it, what looked like a money savings is now a money loss.

As an example that is not 401k related, my dad is a farmer so he has the ability to move expenses and income around from year to year by paying some expenses ahead and deferring some income into future years by selling grain but having the buyer hold the check until the next year. Farmers play these games all the time to affect their taxes. Unfortunately it is not always used in the wisest manner. My dad one year told me proudly how he had gotten his taxable income down to 17K and would owe very little tax that year. He was very happy with himself. Unfortunately it was already too late for him to fix this very costly mistake. He had gotten his income so low that he had "wasted" his entire 15% bracket for that year. He is retired now and getting rent from his land, drawing down his retirement funds based on required minimum distributions, and collecting social security. His taxable income exceeds 100k every year, well into the 25% bracket. He constantly complains how he pays way too much tax and cannot get his taxable income down to a number he would be satisfied with. In fact he is still playing games trying to keep his income lower by taking his rent payments for one year in the next year. This is not an advisable situation to let yourself get into. What he would give now to have paid some cheaper tax 10 years ago on an extra 50K. Trying to defer too much income into the future to pay less taxes now is a mistake.

In essence that is exactly what a 401k is doing. Using a 401k to drastically lower income when your taxable bracket is already pretty low and likely lower than it will be in the future is not good tax planning. Furthermore based on his current capital gain strategy he is taxing his current gains at 0%, not even the typical capital gains rate but at 0%. If he were to put more into his 401k, that extra money would not only likely be taxed in the future at 25% but his gains would as well because gains in a 401k do not even get preferable capital gains treatment. When he gets into a higher bracket, his gains that are outside his 401k will still get preferable capital gains tax treatment but the gains in the 401k will not, and will all be taxed in a higher bracket.

What looks like an immediate $1500 savings right now is not a savings at all. It's a loss when you go to actually get your hands on the money.

Apex, well stated.

Apex: Whoa - trying to make sure ones income sits exactly at the top end of the 15% tax bracket sure seems like a lot or work to me! I think we're well into the nitpicking area now. I imagine this will be even more difficult for young CH as he continues to make more and more money, invest well and advance in his career. One day - probably sooner than later - he won't find himself in the 15% bracket - and I can promise you that it won't be anything to sulk about!

This reminds me of some of my fancypants acquaintances who told me I was silly for paying off my mortgage because I'd have too much income and miss out on that $2,500 reduction in my taxes from mortgage interest. I know it sounds silly, but I'd rather pocket the $18,000 annually than take the deduction.

My original post was one of admiration - I was congratulating CH on some damn, fine work. I merely made a casual observation that he could pocket a little more money by maxing out his 401k. I will still stand by that advice, I think CH agrees that is factual - he just chooses not to have that $ tied up for 30 years in the 401k and is fine with forgoing the additional $1,500 he could pocket annually.

I have no problem with that. There are a lot of people that would agree with him. Kudos again to him. Best to CH, and to you, too, Apex....

@EAS,

My post obviously fell on deaf ears here at least with respect to the larger point I was making. The post was intended to provide general information to a broader audience so that is fine.

However, I will state the crux of it one more time. This is not just about having access to the money now versus having more money for later as you seem to think it breaks down to. The point of the detailed post was to point out how certain activities that defer taxable income can actually cause you to pay higher taxes later and thus give you even less money in the future than if you just pay the tax now.

Instead of address that you simply restate your position and argue that:

1. It's a lot of work.
2. It's nit picky.
3. My point reminds you of people who you consider to be fancy pants.
4. Your point is factual and CH agrees.

There is not much I can say to that list now is there?

@EAS,

If you have a good idea of what your income and deductions will be for the year it's not a lot of work. For 2013, I want my income after deductions to be at $72,500. It takes me about 10 minutes in January to calculate how much I should allocate to a regualar 401K and how much I should allocate to a Roth 401K to hit this target. My calculation is usually within a few hundred dollars of the 15% cutoff. I think most people would agree a Roth is better for someone who is young and in the 15% tax bracket, like CH.

Although APEX nailed the explanation of this strategy, this is probably a good topic for FMF to explore.

Apex & JW: In the interest of not extending this disagreement, I'll defer to your expertise. You both have fine points. Also, I retract the fancy pants comment....:) Best...

Wow, Apex, kudos -- you nailed it again. Great explanation! I've really been irked about this "mistake" people (including me) were making regarding their tax myth that deferring the most tax now is the best strategy. When I explained to them why they would actually save less (lose more) in the long run in certain circumstances (i.e. 15% bracket), most of them never really got my point. However, now if I showed them your post hopefully they'd understand it better. But obviously, you can teach calculus to anybody, but not everyone will get it. :)

@Gus,

Thanks for the comment. If my explanation can shed any light on it for others that would be great. It is a complicated topic and a bit counter intuitive. It also feels wrong. How can paying more money in taxes save me money. Just feels so wrong. So there are some walls that need to be broken down before people can open up and at least consider the points.

It's great that you are self-sufficient and manage a lot of auto and house maintenance yourself . I have different rationale in my case. I hire services from different folks and service centers. I would save a bundle surely if I apply myself and of course it would add to my net worth as well as free up more $ for charity. But I feel I contribute better by providing work to so many people. I help the economy and it is better than charity. It frees up my time where I can spend more time improving my skills, doing overtime and overall be better at what I do. By doing everything yourself you are getting rich but you are not contributing to economy. That's my take on it. Of course it may not be perfect and I would to hear what readers think about it.

Aks: I'm here to support my family and do what's best for them, not the "economy". I'd argue my additional savings/investments helps it more anyways. If someone desires to supply me with a service, the burden is on them to generate enough demand from me to pay for it.

Apex: for your analysis to be complete, you need to allow for the time value of money. This is the chief reason to delay recognition of income. In this particular case, I suspect your analysis is correct, but you can't discuss the problem in general terms without taking that into account.

@Sarah,

You are correct. The topic is already a bit complicated so adding time value of money really muddies the waters. But in fact that is exactly why some farmers do this in the extreme. Every extra dollar they save in taxes now regardless of the tax bracket is one less dollar they have to borrow to fund their operations for the year.

So you are correct that it is a little less clear cut than just comparing brackets. However the issues that businesses face with needing to borrow money to fund operations are different than what most W2 employees face. The time value of money benefits for a business are greater than for a W2 employee even though there are still benefits for the W2 employee as well.

An example with real numbers would add clarity and would probably be instructive. I am not going to do that right now but any discussion that explores this in greater detail should include real number examples.

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