FIRE Taxes – On Cash Flow

I have said it before and I will say it again “I love taxes” oh but what I mean by that is: “I love legally avoiding paying taxes.” I have developed a scenario of a hypothetical couple with no kids that file jointly, and they take the standard deduction. This couple is very passionate about achieving financial independence and retiring early (FIRE). They live frugally enough to pay $0 in federal income taxes. In this scenario, the couple’s creative frugal ways and fierce determination to become financially independent allow them to pay $0 in federal income taxes in 2019. If you are on the path to financial independence, and your situation is similar to this couple then you too could pay $0 in federal taxes in 2019. The first step is estimating gross income. The second is calculating adjusted gross income (AGI) by subtracting traditional 401K contributions and traditional individual retirement account (IRA) contributions. After figuring out adjusted gross income, utilizing the retirement saver's credit will bring the federal income tax bill to $0. Gross Income This hypothetical couple has no kids and they are a dual-income household. In 2019 they have earned an annual combined gross income of $94,300. This is actually a pretty high household income depending on where you live. With such a high gross income, it is hard to imagine this couple paying $0 in federal taxes, but it is very easy for those seeking financial independence. Just for fun, if we were to divide that annual gross income by 52 weeks in a year, then that would put our couple’s weekly gross income at $1,813.46 per week before deductions. Furthermore, if we were to turn that weekly income into per hour pay based on two 40 hour work weeks then our hypothetical couple would be making about $22.67 per hour each if they made the exact same amount, which they do not need to. Keep in mind that this couple’s gross income not only includes wages from employment, but it also considers any interest, dividends, and other reportable income earned throughout the year. Their gross income does not yet take into account many different withholdings from their paychecks. Also keep in mind that this couple is highly driven to reach financial independence as soon as possible, and so they live a very optimized frugal lifestyle and invest a huge portion of their income because of it. Traditional 401k And IRA Contributions Since day one of 2019, our hypothetical couple has been rigorously contributing to tax-advantaged retirement accounts. They know that in order to not pay any federal taxes at the end of the year, they must vastly reduce their taxable income. For the 2019 tax year, each employee may elect to withhold and contribute up to $19,000 to an employer-sponsored 401k. This is exactly what our couple did: each of them withheld $19,000 from their paychecks. After the total deduction of $38,000 to their income, they know that it means that $38,000 of their income is not eligible to be taxed for federal income taxes. So as it stands, their taxable income now looks like it is $56,300. In addition to the 401k deduction, our couple is able to contribute to their traditional IRAs. For the 2019 tax year, each individual may elect to contribute up to $6,000 into a traditional IRA. As a married couple, each spouse is allowed to contribute their earned income on behalf of the other spouse. For example, if one spouse withheld the $19,000 for the 401k but that was all that they earned, the other spouse that made much more can use their earnings to contribute the $6,000 to their own IRA and $6,000 for their spouse’s IRA. As you guessed it, this is exactly what our couple did and so they lowered their taxable income by another $12,000, and now their taxable income looks like $44,300. Adjusted Gross Income The $44,300 of taxable income is known as adjusted gross income or AGI. There are other things that can reduce AGI further, but our hypothetical couple does not have any other deductions for simplicity sake. It is important to note that our couple’s disposable income has been slashed down by $50,000. This is over half of their income and some would say impossible to live on. Through various ways of optimizing their lifestyle, our couple easily “survives” off of this amount of spending because they are fierce in their determination of financial independence. They also are lucky (or smart) enough to live in a lower cost of living area. Retirement Saver's Credit As a result of contributing so much money into traditional retirement accounts, our happy couple now has a very low AGI. Their new AGI is $44,300 and this makes them eligible for the Retirement Saver’s Credit. This credit is offered as an incentive for low-middle income Americans to contribute to their retirement. The credit makes our couple’s contributions eligible for a 10% match up to $1,000 each or $2,000 total. Being that it is a credit and not a deduction it is so much more useful. Our couple qualifies for the maximum credit of $2,000 off of their tax bill. If there was not a $2,000 limit, then our couple’s credit would be $5,000 because they contributed $50,000 into tax-advantaged retirement accounts and would be eligible for a 10% match. $2,000 is just what our couple needed, but that's not all, our couple also takes the standard deduction. Standard Deduction AGI is now $44,300, in 2019 the standard deduction for married filing jointly is $24,400. Subtracting that deduction from our AGI leaves our couple with only $19,900 in taxable income. So they went from a gross income of $94,300 all the way down to a taxable income of only $19,900 and that is amazing. The tax structure in 2019 is a laddered tax meaning that income is taxed in brackets. The first $19,400 of the income is taxed at 10% which leads to a tax of $1,940. The next $500 that is left is taxed at 12% which leads to a tax of $60. In total the two tax brackets add up to $2,000 even. This is where we bring in our retirement saver’s credit that wipes out the tax bill, leaving it to be $0. Other Things To Keep In Mind The $94,300 was not chosen as the gross income by accident. It was the maximum amount that would lead to a $0 tax bill in 2019 for our couple assuming they were seeking to invest $50,000 of it. It also assumed that they had no other deductions that they could have taken. There are however other deductions that can be taken while still utilizing the standard deduction. Some examples include: Student interest loan deductionHealth savings account contributionsSelf-employment deductionsEarly withdrawal interest penaltiesHealth insurance withheldDental insurance withheldLife insurance withheld The moral of the story is that you can earn more than $94,300 as a married couple filing jointly with no kids taking the standard deduction and still end up not paying any money in federal taxes in 2019. If that sounds good to you, go forth and legally not pay any taxes in 2019!