t1larg.tax-forms.t1largOops, I did it again.  Another year of nearly $100k in investment income, but with a very budget friendly income tax bill of $0

The same as last year, income was primarily from index fund and individual stock dividends, interest from a seller-financed mortgage on a property we sold a few years ago, and interest from our cash reserves and a municipal bond fund.

This year’s tax situation was a little more complex, since I violated Rule #1: Choose Leisure over Labor.  The blog made a small income, so I learned a thing or two about self employment taxes in the process

Let’s go through our actual 2014 tax return, to see how we kept taxes low this year, and took action to minimize taxes in the future

Income

Total real income for the year was $44,640, almost enough to cover our base cost of living for 2014.

All of this income was real, with checks or deposits received from varying sources shown here with their respective line on the 1040 form

Interest (Line 8a): $7,410
Tax-free Municipal Bond Interest (Line 8b): $1,455
Qualified Dividends (Line 9b): $30,166
Non-qualified Dividends (Included on Line 9a): $3,622
Blog income (Line 12): $1,987
Total income: $44,640

We also had imaginary income of $52,469, as a result of a Roth IRA Conversion of $5,744 and harvesting long term capital gains of $46,725

I refer to this as imaginary income because it doesn’t really exist in the same way that a paycheck does.  I’ll explain more later in this post, but for now we include it in taxable income

All of these sources of income appear in the Income section on Page 1 of our 2014 1040, with Total Income = $95,644

GCC 2014 1040 Page 1xx
The only adjustment we have to income is the result of self-employment income from the blog.  1/2 of self-employment tax for Social Security and Medicare is a deduction shown on Line 27

Tax Due

Rewards Credit Cards

On Page 2 of the 1040, we calculate total tax due.  The first step is calculate taxable income by subtracting all possible deductions

As a married couple filing jointly, we have a Standard Deduction of $12,400 (Line 40.)  Since we are a family of 2, we have 2 Personal Exemptions of $3,950 each (Line 42.)  These deductions reduce our Taxable Income by a total of $20,300 to $75,213 (Line 43)

If you’ve ever done your taxes manually, you’ve probably used the Tax Tables.  According to the tax tables, total tax due on $75,213 of income is $10,519.

But look at Line 44.  Total tax due is only $212!  Why?

When you have income from Qualified Dividends or Capital Gains, the tax tables aren’t used.  Instead, we use the Qualified Dividends and Capital Gains Tax Worksheet, which I’ve included below.  (If you are super interested in the details, the 1040 instructions for Line 44 explain in depth)

GCC 2014 1040 Page 2xQualified Dividends and Capital Gain Tax Worksheet

This is where all the magic happens when determining total tax due.

The main point of interest is on Line 8, where is shows a value of $73,800 for Married Filing Jointly.  This is the amount of qualified dividends and long term capital gains we can have, tax free!  We had a bit more than this, so tax is calculated at a low tax rate of 15% on the difference (Line 20) resulting in total tax due of $212

GCC 2014 Sched D worksheetBut $212 still seems like a lot of money.  I want to pay $0.  This is where the Foreign Tax Credit comes in.  We paid over $500 in taxes to foreign governments through an index fund we own that invests in international stocks.

The IRS will give a credit for any foreign taxes paid, which appears on Line 48.  This completely wipes out any tax liability we have for the year, resulting in a total tax bill of $0 (Line 56 of Page 2 of 1040)

Imaginary Income

Earlier I referred to some income as imaginary.  This “income” appears on our 1040, but is really just the result of moving money around that we already have.  Today, there is no increase in net worth as a result, but it has a great impact to long term net worth since this income will be tax free forever

Roth IRA Conversion

We moved $5,744 from our Traditional IRA to a Roth IRA this year, which is known as a Conversion.  In effect, we choose to pay taxes on this money now in order to pay no taxes on it in the future, the key feature of a Roth IRA

Earlier we saw that the Standard Deduction and 2 Personal Exemptions totaled $20,300, which reducing our total taxable income.  We can think of this as first offsetting all non-dividend and long term capital gain income, which is taxed separately on the worksheet we reviewed above

This other income includes interest ($7,410), non-qualified dividends ($3,622), and blog income ($1,987), for a total of $13,019.  Since this is much less than $20,300 we create some imaginary income in the form of the Roth IRA Conversion

We could have transferred up to $7,281, but we didn’t have all of the information necessary before the end of 2014 so we had to estimate.  We estimated low, doing a Roth IRA Conversion of $5,744.

It is unfortunate, but we left $1,537 of tax free income on the table.  But we still win, because the $5,744 that we Converted into a Roth is tax free forever

Capital Gains Harvesting

We harvested long term capital gains of $46,725.  You can think of this as selling some stock that has increased in value and then immediately purchasing more stock.  This year I sold some individual dividend stocks and purchased more VTI.

From Line 8 of the Qualified Dividend and Capital Gain Tax Worksheet, we saw that we could have $73,800 of tax free qualified dividends and long term capital gains

Earlier we reported qualified dividend income of $30,166

If I do nothing, I leave $43k of tax free income on the table.  So I generate imaginary income by selling appreciated stock.

I estimated a little high this year, generating a gain of $46,725.  A few thousand of this is taxed at 15%, the maximum tax rate on long term capital gains.  This is the $212 tax bill shown on the 1040 and on the Dividend worksheet (which is then wiped out by the Foreign Tax Credit)

This gain is taxed at 0% today, and is now part of our basis in new stock.  That gain is locked in, which means it is tax free forever.  The higher basis also increases the opportunity to harvest capital losses in the future

Self Employment Income

It turns out, if you have self-employment income you have to pay self-employment Social Security and Medicare taxes at a rate of 2x that for an employee.  This year the bill was $281

I always knew this, but since this is my first year having self-employment income I made some beginner’s mistakes.

I at first assumed I could offset this with the Foreign Tax Credit.  Not so.  The self employment income only appears on the 1040 at Line 57, after the credit is applied.  This error caused me to leave $300 in tax credit on the table, while also losing some opportunity in the size of our Roth IRA Conversion.  I know better for next year

It’s not all bad though, I made an additional contribution to our Roth IRA equal to our total self employment income of $1,846 ($1,987 – 1/2 of self employment tax.)  Since our tax rate is effectively 0%, this is perfect use of a Roth IRA

Conclusions

Overall, 2014 was another great tax year for the Go Curry Cracker household.  We paid no tax on nearly $100k in investment income, increased the size of our Roth IRAs and increased our basis in our stock holdings which will minimize our future taxes

I also learned a lot about self-employment taxes.  Yes, I left money on the table through some beginner’s mistakes.  That is the price of tax education.  It is by making mistakes that we learn, and past mistakes learning is how we are able to pay no taxes today

Hopefully this was useful, and will help you also Never Pay Taxes Again

If you like what you read here, please consider sharing.  Everybody can benefit from learning how to minimize taxes

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As I do every year, I used TurboTax to process and e-file our taxes.  I think its worth the price to import everything directly from our brokerage without mistakes, versus the hours it would take to enter everything manually.  This year the bill was $59.99, which easily saved 3 hours of my time
TurboTax Premier helps you keep more money from your investments. Learn More.

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