It was this time of year about seven years ago when we found ourselves in our mid-thirties with a beautiful young daughter, a small amount of retirement savings and a surprisingly large end-of-year tax bill.
A couple years prior was the first year of filings taxes after our daughter was born at which time I recall having the true realization of the word dependent. Over the first couple years of having a dependent, we determined it was best for us to include zero dependents in our employer’s W-4 to avoid owing excess taxes come April. We thought we had finally found the balance of owing just a small amount of taxes at the end of the year but when the next April came around we were shocked to receive a $7,500 end-of-year tax bill!!!
Why Were our Taxes So High?
I’ve always been a proponent of owing some taxes at the end of the year, as this strategy avoids the scenario where Uncle Sam is earning interest on your money instead of you. But, owing $7,500 was a wake up call that it was time we figure out how to lower our tax burden.
First, we needed to assess our situation to determine the cause of our high taxes. We were making decent money but not as much as Uncle Sam seemed to think we could afford. We both checked with our employers to ensure taxes were being withheld correctly from our pay-checks, which they were. We then looked into our end-of-year tax filings to ensure they were completed correctly, which they were. In the end we came to the conclusion that there were two main drivers of our higher taxes:
- Over the previous year I changed jobs from a non-profit back into the private sector, which came with a decent salary increase. This salary increase bumped us into a higher tax bracket.
- We were only taking standard deductions in our tax filings, as we did not own a home, have enough qualifying business expenses or make enough donations to allow for itemized deductions.
We realized we had achieved a level of income such that the tax system assumes you would be itemizing your deductions either by owning a home of having enough business expenses. If you can’t write off taxes in those ways you appear “cash rich”, which we certainly were not. We pay rent that is higher than many mortgages (not in our area though!), but rent is not recognized in the tax code. The tax system favors home-ownership.
Tax Reduction Strategy
Now that we had a better understanding of our tax situation, we set out to find the best way to lower our taxes. After researching the topic we went through the following process of considering key tax shelter strategies for our situation:
- The big-ticket item for tax deductions is interest on a mortgage. After careful consideration we decided the added tax savings were not enough to change course from our chosen lifestyle that includes renting in a location where we could not afford to buy. We also decided we were not yet ready to invest in a rental property, which is another way to access some good tax-shelters as well as generate passive income.
- We were already participating in our employers Flexible Spending Accounts (FSAs) and contributing the maximum allowed to both the dependent care and health care accounts. So, we did not have any tax benefits to gain in this area.
- We didn’t have any plans for a side-business at the time. Even if it’s not your primary income, a side business, which supplements the income you receive from you day job, offers some great tax shelter opportunities.
- We were already fully funding our two Roth IRA accounts, but this was not providing any tax shelter, as the contributions are in after-tax dollars.
- Because we were fully funding our Roth IRAs we did not qualify for tax deductions from contributions to a Traditional IRA.
- We were contributing enough to our employer’s 401(k) plans to qualify for the entire company match, but no more. DING DING DING… we found a winner!
We decided it was still best to fully find our two Roth IRAs going forward, so the center of our short-term tax reduction strategy ended up being to contribute as much as we could afford to our employer 401(k) accounts. Before the big tax-bill we hadn’t realized we could afford to save much more in our 401K’s than we already were, but discovering we were going to lose the money entirely if we didn’t come up with a new plan was quite motivating.
Financial Freedom Here We Come
The magic of saving is once you start you naturally seek to do more of it. On one hand, we were fortunate to begin ramping up our savings after the 2008 financial crisis had passed; as it was nice to see our investments grow at a steady pace. While, on the other hand, we were in our mid-thirties and we realized we had missed out on many years of savings growth potential. We were both fortunate our careers were progressing nicely and our salaries were increasing. We were living comfortably so, we consciously chose to retain our same standard of living while increasing our savings rate along with our salary increases.
We have always lived well within our means with one of our primary goals being to avoid debt. When our earning potential really began to increase we seized the opportunity to set ourselves on the path to financial freedom by living beneath our means and saving as much of our earnings as we could.
Once we zoomed out to include the remainder of our lives in our financial plans, I set out to create a suite of spreadsheet tools to support our plans. Some of the key features of our planning tools include budget planning, projections of savings, rate of return, retirement expenses, retirement income, and the effects of inflation. Our tools have provided us with a sense of control, clarity and confidence in our ability to achieve our goals. We’re no where near the point of breaking free, but we’re well on the path and we have a plan for how we’re going to get there. Financial freedom here we come!