I want to introduce you to some friends of mine. They are comfortable, middle-class professionals with a decent income, yet they pay zero federal income tax. There's no need to call the IRS, though. What they're doing is completely legitimate because they take advantage of enough tax deductions and credits to get their income to a level that results in zero taxes. Here's how to pay less taxes.
A Real-Life Case Study
You might have friends with jobs just like my friends'. Amy is an engineer, and Jason is a teacher. They live in an adorable (paid-off) house that started off as a starter home and grew into a forever home.
Even after their first child arrived, they didn't feel a need to leave their quiet little corner of the neighborhood behind in search of something bigger (and more expensive).
They worked hard to pay off their house, and the idea of a new mortgage payment didn't seem appealing at all!
Let's Take a Look at Their Financials
Amy earns $65,000 per year at an engineering firm, and Jason earns $45,000 per year teaching third grade at a rural public elementary school in North Carolina. Their combined salary of $110,000 is much higher than the median household income for their community, yet they tend to live just like everyone else around them.
They are really focused on paying as little tax as possible right now, and they take advantage of every opportunity to reduce their taxable income. Amy's job offers a 401(k), and she puts the maximum of $18,000 into her account each year.
Amy also contributes $1,000 to her employer-sponsored healthcare flexible spending account (FSA) to cover their typical medical and dental bills for the year. To cover childcare costs for their toddler, Amy funds her childcare flexible spending account with $5,000 to cover most of the costs during the school year (Jason turns into a stay-at-home dad during his summer breaks from school).
Jason's government job offers a 401(k) and a 457 plan. It's a little-known secret that you can contribute the maximum amount ($18,000 in 2017) to both a 401(k) AND a 457 account. Jason defers $36,000 into his 401(k) and 457 plan, making his paychecks embarrassingly small. Thank goodness for Amy's more robust take-home pay!
On top of all their other savings, Amy and Jason each fund a deductible traditional IRA with the maximum amounts ($5,500 each in 2017).
Here's the breakdown of their financial situation and proof that they pay $0 income taxes.
- By participating in all of the tax-deferred savings options available to them, Amy and Jason manage to reduce their income by $71,000! Their income shrinks from $110,000 to $39,000.
- After subtracting their standard deduction ($12,600) and three personal exemptions ($12,000 total), they are left with a taxable income of just $14,400. This leaves the couple in the 10% tax bracket with a tax bill of $1,440 before applying for any tax credits.
- At Amy and Jason's income level, the Retirement Savings Contributions Credit amounts to $800. With one child, they are entitled to a $1,000 Child Tax Credit (taken as a $640 Child Tax Credit and a $360 refundable Additional Child Tax Credit).
- Together, these tax credits completely wipe out the couple's tax liability and result in getting a refund of $360 (plus any federal income tax withheld during the year). That's better than $0 tax!
No Kids? You Can Still Pay $0 in Taxes
It's no doubt that having kids is a great way to lower your taxes. But Amy and Jason could still earn a six-figure salary and pay zero taxes without that cute little tax deduction chasing them around the house.
Here's another variation of the above scenario, if Amy and Jason didn't have kids.
Let's give the couple a slight pay cut to a combined salary of $102,000 and remove the $5,000 deduction for the childcare FSA contribution (no kids = no childcare).
In this case, the couple is left with a net income of $36,000 and a $1,540 tax liability before tax credits. The Retirement Savings Contribution Credit would wipe out the entire tax liability, leaving Amy and Jason with a $0 tax bill.
The Retirement Savings Contributions Credit could be as high as $2,000 for Amy and Jason; however, it's limited by the actual tax liability ($1,540 in this case).
The Cost of Spending vs. Saving
You might object to the level of income that Amy and Jason take home each month. In the first example (with one kid), their income after deductions is only $36,000. That might be plenty in rural North Carolina where Amy and Jason live, but won't be enough to survive in higher cost of living areas like New York City or Silicon Valley. That's a valid criticism.
What if Amy and Jason didn't take advantage of any options to lower their taxable income? Their taxable income would be $85,400 (after standard deduction and personal exemptions). The couple would owe almost $12,000 in taxes at that income level.
In other words, Amy and Jason can save $12,000 on their taxes by maxing out their tax-deferred savings accounts and participating in flexible spending accounts.
Paying $0 Taxes on a Six-Figure Income
So how do you pay $0 taxes when you make six figures? The net result of clever tax moves has been proven. Here's the exact method to follow:
- Max out tax-deferred savings plans such as 401(k)s, 457s and IRAs
- Funnel medical and childcare expenses through HSAs or FSAs
- Don't miss out on common tax credits like the child tax credit and retirement savings contributions credit
Want to make sure you're taking advantage of all the tax benefits you can and paying as little taxes as possible? Get your accounts reviewed by a licensed professional like Personal Capital
Want to learn more about how to save on your taxes, even if you don't have a six-figure income? Check out Cofield's Concepts, an educational site from financial advisor Carter Cofield. In his tax course, you'll learn everything you need to know about how to take advantage of deductions and how taxes on investments work.
Further Reading: Our Cofield's Concepts review