Some people have nothing to look forward to after the holiday season. But lucky for us, we do: tax season! Taxes are pretty simple when your finances are in order and definitely not a burden when you know how not to pay very much of them. So, I have two fun tax examples for you today. A Christmas present from me to you! We’ll do a couple more of these in the future too.
The Tax Table
For simplicity I’m going to give examples of a person who is single today, but for married people filing jointly the principles are the same–just use the corresponding tax table.
Tax Example 1: The Basics
Jimbo is a graduate student in an MD/PhD program. He gets paid a stipend of $30,000 per year. Unlike many other less fortunate graduate students, he gets a W2. Because of this, he can contribute to an IRA. If, like many of his peers, Jimbo didn’t get a W2, his income would simply be “other income” instead of “earned income”, and he could not contribute to an IRA. Anyway, Jimbo maxes out his Traditional IRA in 2018 — $5,500. So, his gross income was $30,000, but his adjusted gross income is $24,500. His low adjusted gross income qualifies him for this free TurboTax software. Score! To get his taxable income, he subtracts his deductions from his adjusted gross income. Deductions can be itemized or you can take the standard deduction of $12,000. Since Jimbo rents an affordable apartment he doesn’t have property tax or mortgage interest, and his charitable donations aren’t quite at spectacular levels yet. So he will take the standard deduction. Subtracting $12,000 from $24,500 gives a taxable income of $12,500. Using our handy tax table, he owes $952.50 + 0.12*(12,500-9,525) = $1,309.50. Note that though Jimbo’s marginal tax rate is 12%, his effective tax rate1There are actually different definitions of this term. Mine is total tax/gross income. Some people use it to mean total tax/taxable income. is 1,309.50/30,000 = 4.4%. Not bad!
A couple quick things: Jimbo likely had all of this withheld from his paychecks anyway. However, if he didn’t get a W2, he’d need to pay quarterly taxes throughout the year. If you owe more than $1k and haven’t paid quarterly, you’ll be hit with a small fine. Also, Jimbo doesn’t pay payroll taxes (social security and medicare) as a graduate student. In virtually every other case you have to pay these, but grad school is weird. And we’re ignoring state taxes for the purposes of today’s examples.
Tax Example 2: Using your tax knowledge to profit
Fast forward to the future. It’s 2019 and the contribution limits for IRAs are up to $6,000 and 401ks are up to $19,000/year2This is actually happening. . Also, Jimbo is graduating this year and in July will start a residency program that pays $51,000/year. They also offer a 401k and an HSA. But he will have to pay payroll taxes. So in the first half of the year he will earn $15,000, and in the second half of the year he will earn $25,500 in gross income.
Before we dive in, let’s learn a little bit more about Jimbo. Jimbo knows how to play Defense. He only needs about $20k to live a perfectly happy life. Thus, even after maxing out his Traditional IRA every single year in grad school, he’s got a nice stash of $20,000 invested in a regular brokerage account. This money is invested in a total stock market index fund, and most of it has been held for well over one year.
Jimbo makes it through the first half of the year and manages to be just slightly more frugal than he usually is, maxing out his Traditional IRA–$6,000–by the time he starts residency. In the second half of the year, Jimbo does a few interesting things. First, he maxes out his HSA at $3,500. This reduces his taxable income AND is exempt from payroll taxes. Then, he decides to completely max out his 401k–$19,000. This leaves him with only $3,000 in income for the second half of the year. How does he survive? He sells $8,000 of stock in his taxable brokerage account. Let’s assume that half of this, $4,000, is long term capital gains and the other half is principle3Only the gains count as income, since that’s the money you “made” from your investment. Principle is just what you put in. .
Ok, let’s step back and summarize Jimbo’s year:
- Total income: $40,500 from grad school + residency and $4,000 in long term capital gains. Let’s keep those two separate for now.
- Taxable income: 40.5k – 6k (IRA) – 19k (401k) – 3.5k (HSA) – 12k (standard deduction) = $0. Plus $4,000 in LTCG.
I hope your jaw is already starting to drop. Let’s keep going by calculating how much tax Jimbo owes:
- Income tax: Nothing! Turns out if you don’t have taxable income, you don’t have to pay income tax.
- Long term capital gains tax: This is determined by tax bracket. Jimbo is in the bottom bracket. His capital gains are taxed at $0.
- Payroll (social security and medicare) taxes: This is 7.85% of gross income. For Jimbo, this only applies to his residency income. The only thing you can deduct for payroll taxes is an HSA. So Jimbo pays 7.85% of 25.5k – 3.5k. Or 0.0785*(22k) = $1,727.
- Effective tax rate: $1727/44.5k = 3.9%
Note that in 2019 Jimbo made more money, had to pay additional types of taxes, but somehow managed to pay a lower effective tax rate than in 2018!
This stuff matters
It’s already quite clear that Jimbo has done very well for himself. But let’s quantify just how amazing he’s done. In 2018, Jimbo saved $660 in taxes by contributing to a traditional IRA. Not a huge sum, but it will compound into much more money in a few decades. Plus he’s been doing this every year, putting himself leagues ahead of his colleagues.
In 2019, things got a little more serious. Assume Jimbo’s average classmate/co-resident did not contribute to an IRA, 401k, or HSA. Their gross income would be $40.5k. That results in $4,849.50 in income tax plus $2,001.75 in payroll tax, or $6,851.25. So Jimbo is instantly more than 5 THOUSAND DOLLARS richer than many of his colleagues, simply because he understands some tax basics. Of course, this year was kind of unique for Jimbo since he was transitioning between jobs which gave him access to a 401k while he still had a lower income on average thanks to the first half the year. Still, his tax savings in future years will still be just as high if he continues to max out his 401k, IRA, and HSA4And since his income will be higher for the entire year, he may not need to supplement it with long term capital gains any longer. .
Anyway, here’s the main point. This stuff is not super complicated, and a small time investment now will literally save you hundreds of thousands over your lifetime.
And of course, we’re always here to help. Just contact us or post your comments/questions below! Happy almost tax season :).