GCC: Tax Day is just around the corner, so what better time to showcase someone who has gone head-to-head with the US tax code and come out the victor.
Today’s guest post is by the Frugal Professor, and he is here to highlight how the Earned Income Tax Credit has accelerated his family’s path to Financial Independence.
Frugal Professor
Greetings CrackerHeads!
I’m the Frugal Professor. I’m still early in the accrual stage on the path to Financial Independence, which we document with all of the gory details.
I have 5 kids, all of which are under the age of 10. I wanted 2 kids and my wife wanted 5, so we compromised.
A lot of people think kids are expensive and make it difficult to save. But our children are actually helping us become financially independent sooner.
Learning to Love the Tax Code
During my 7 years in graduate school, our total household income was no more than $30k/year. However, when we did our taxes I noticed generous Uncle Sam rewarding me for being poor. I would get checks on the order of $7k-$9.5k every time I filed my taxes. To be clear, this was not simply a refund from the excessive withholdings. This was cold hard cash from the government, no strings attached, after withholding $0 in federal taxes during the year. The opaqueness, complexity, and recently found windfalls really sparked an interest in learning more about the tax code. However, the following story transformed my interest in the tax code into an obsession.
During my PhD (where children 4 and 5 were born), I bought a new $30k minivan with cash. In order to do so, I was planning on liquidating some of my taxable brokerage account. However, I did some tax planning before selling to understand the tax implications. Below are essentially the three scenarios I ran in TaxCaster. Each scenario has $30k in labor income and 5 kids (all of which are <= 16). Scenario 1 (the left-most picture below) has $0 in long term capital gains (LTCG), Scenario 2 (the middle picture below) has $3,399 in LTCG, and Scenario 3 (the right-most picture below) has $3,400 in LTCG. It turns out that the $1 extra dollar going from $3,399 to $3,400 carries a tax burden of $4,239. Let me repeat that, $1 extra dollar of capital gains would have cost me $4,239 in free money (=$8,289-$4,050). That’s an effective marginal tax rate of 423,900% on that $3,400th dollar of capital gains earned, which I’m pretty sure is the highest effective marginal tax rate you will find in the entire U.S. tax code.
To say the obvious, I purchased the car by realizing less than $3,400 in capital gains that year. (The Earned Income Tax Credit (ETIC) requires investment income less than $3,400.)
I left this experience with a firm desire not only to understand, but to model the U.S. tax code in spreadsheet form. Our fifth child was born during tax season, and I reverse-engineered then modeled many of the gory details of the U.S. tax code in a spreadsheet during the labor (I took a few minutes off from modeling for the actual delivery…after 4 kids, the labor of the 5th kid is a boring affair).
I think fellow CrackerHeads could benefit from what I’ve learned in the process of modeling the tax code.
Earned Income Tax Credit
In order to induce low income families to work, the U.S. government introduced the Earned Income Tax Credit (EITC.) The way it works is pretty simple and is best described with the below chart (source). Take the example of a family with three children. Every dollar for the first $14,040 in income earned will be matched with a $0.45 (45%) subsidy from the federal government. As shown in the figure below, the EITC plateaus at $6,318 ($14,040*0.45). Then there is a plateau until $18,340. After which there is a 21.06% removal of the subsidy until the household income is $48,340. What this means to a household is that the effective marginal tax rate (due to the EITC alone) on the first $14,040 of income is -45% (that’s right, NEGATIVE 45%), followed by 0%, followed by 21.06%.
The EITC is refundable, meaning that even if you have no tax liability you can receive a check from the government for $6,318 (if you have >= 3 kids).
Where this gets interesting for the GoCurryCracker crowd is that low to moderate income households with several kids have a huge incentive to shelter income. Even though one’s marginal tax rate may be 10%, one’s effective tax rate could be 31.06% (10% + 21.06% mentioned above) as households come down the ETIC ramp. The below chart illustrates how a family’s effective marginal tax rate can change significantly in the moderate income region (<$60k).
This is truly an asinine part of the tax code, but it makes sense. If you give free money to poor people it will eventually have to be taken away, resulting in high effective marginal tax rates.
Naturally, the EITC is a quite lucrative source of free money, and thus it is ripe for fraud. A common scheme is for an unemployed household to over-report self-employment income to max out free money. Another scheme is to steal social security numbers, file a fraudulent tax return, and pocket the ETIC. It is for this reason that tax returns to EITC recipients were delayed this tax season.
However, a legal way of maxing out the EITC is to be mindful of the breakpoints in the figure above and strategically lower one’s earned income. Management of earned income is lucrative not only in the setting of EITC, but also for ACA subsides and public service loan forgiveness plans. I haven’t personally managed earned income for either of these reasons, but a buddy of mine has done the latter and it’s worked out beautifully for him.
The levers available to lower one’s earned income are anything that reduces your federal taxable wages on your pay stub:
- 401k/401a/457/403b contributions
- Pre-tax payroll deductions for FSA, HSA, insurance premiums, etc.
The levers unavailable to you for EITC maximization:
- Traditional IRA contributions
- HSA contributions for plans purchased on open market
Perhaps not surprisingly, the IRS’s commentary on what levers you have available are not particularly helpful. However, the link clarifies that retirement income as well as investment income don’t count. The income has to be “earned.”
How I Hacked the EITC
I used the above knowledge in 2016 to actively shelter money to (almost) max out the ETIC.
I work for a university where I’m given the opportunity to shelter retirement money in a 401a as well as supplemental retirement accounts ($18k in 403b + $18k in 457… a HUGE tax hack available to many public university employees). My family made $80k in 2016; I sheltered half of that into tax-deferred accounts and got paid $8k for doing so.
All low- to moderate-income households need to realize that they are facing very high effective marginal tax rates and can substantially increase their tax refund (and thus their wealth) simply by sheltering more money.
By knowing my effective marginal tax rate I could determine the precise amount of taxable income to get maximum subsidy.
Summary
Particularly for low to moderate income families, the amount of taxes you pay are to a large extent in your control in large part due to the Earned Income Tax Credit. However, everyone should know their effective marginal tax rate. This is the most important number in the tax code, since it is a person’s tax on the next dollar earned or the tax break on the next dollar of sheltering.
To determine the effective marginal tax rate for your situation, you are welcome to use my spreadsheet. The exercise of determining how much to shelter can (and should) be done in conjunction with TaxCaster or TaxAct’s calculator, but my spreadsheet should be a lot simpler to visually interpret.
GCC chooses what his tax rate is. You should too.
If you liked what you saw above, I wrote a high-level overview of the U.S. tax code. Further, I’ll post an updated version of the spreadsheet (with improvements along the way) to reflect changes in the tax code. If any readers care to improve upon what I’ve done, I would love for this spreadsheet to be crowdsourced to be the definitive tax planning tool for CrackerHeads like myself.
Love these stories about hacking the tax code! Please keep them coming.Super interesting to hear how people are finding strategies to take advantage of the mess of a tax code we have in the U.S.
If you’ve got any hacks for those of us still earning lots of W2 income – let’s hear them!
In 2017 my income is well above EITC territory. I’m doing the standard stuff to lower my tax bill. 1.) Max out 401a + 18k 457 + 18k 403b. 2.) Max out HSA. 3.) Back-Door Roths. 4.) 529 up to state max. 5.) Tax loss harvest. 6.) Perhaps open up a UGMA for each child as described here: https://www.bogleheads.org/forum/viewtopic.php?t=135851#p2005687. Other than that, I’m about out of ideas. I recently came across this thread at Bogleheads that you might also find interesting: https://www.bogleheads.org/forum/viewtopic.php?f=2&t=215699
I am on the same line here. I am a high W2 earner and I have been maxing out the 401K (plus matching), Roth IRAs, HSAs (limited FSAs), 529s, and even opened 4 UTMAs (4 children) to gift shares that have capital gains. I am still paying a good amount of taxes. Is there anything else I can do to shelter my income?
Is it possible to have solo 401Ks or something similar? Maybe having a small LLC? Anybody doing something like it?
Are you being hit with AMT? If so, it seems to me that your sheltering options are extremely limited.
If you have self-employment income then the solo-401k would make a ton of sense. I don’t have any such income. Otherwise I would. And I’d take advantage of the home office deduction as well.
Not many people know about UGMA/UTGA accounts. How much do you have in each child’s account? $100k w/ 2% dividend yield would kick out $2k/year tax free in dividends. Times 5 kids in my case would kick off $10k/year tax-free in dividends. Seems like a good strategy to me.
A solo 401k won’t help you very much if you already have a 401k at your day job. The allowed contribution is for all 401ks. If you have a side biz, you might be able to profit share some bucks into the solo. The only ways left to reduce your taxes are–and they maybe should be first on your list, not last are:
1. quit your w2 job and start your own biz, or at least have a side job where you can write off biz expenses such as home office, computer, cell phone, internet, possibly a car, etc
2. buy cash flowing rental ppty and get the depreciation.
Are you sure you can use a Roth IRA? You don’t qualify for that at all once you make over $120k!
@ Antonio: https://www.bogleheads.org/wiki/Backdoor_Roth_IRA
Thank you Antonio. I file married and the limit goes from 186K to 196K: http://www.rothira.com/2017-roth-ira-limits-announced
Very informative. As someone who will be entering in to ER within the next 4 years or so, learning the tax implications is something I need to start doing. Look forward to checking out your site!
Glad you found it interesting. The EITC is certainly an interesting topic that most people know very little about.
As a married couple with no kids making around $110k a year, will this work in our favor?
Married w/ no kids = no ETIC hacking for you. However, see my comment to Freedom 40 Plan for a list of things I’m doing this year that would certainly help you. At your level of income you won’t need to bother with backdoor Roths and can instead max out TIRA contributions x 2 = $11k, further reducing your taxable income. If both of you max out 401k, that’s an additional $36k/year of sheltering. Max out an HSA, even better. You can substantially lower your tax bill by sheltering today. Use every tax-qualified plan that you can and be mindful of deadlines. IRA + HSA can be funded until mid-April of following year. 401k, etc may not. If you’re sitting on idle cash you can still fund last year’s TIRAs.
Thank you! My wife doesn’t’ work much, I’m the primary breadwinner. I bring in about 110k a year and I do some per diem work as well, so it ends up being around 130k a year after a little per diem work and my wife’s part time job. Can we still shelter for both of us out of MY income in a TIRA? (is TIRA taxable IRA?-so a roth? or employer matched plan?) Should I max out the HSA as well that my employer has?
If your wife doesn’t work outside of the home (mine doesn’t either), your wife can contribute to a Trad IRA / Roth IRA as part of what’s known as a “spousal IRA” contribution, so long as you’re married filing jointly: http://www.investopedia.com/articles/retirement/03/021903.asp. This is what my wife and I have done for over a decade now. Sorry TIRA is an abbreviation for Trad IRA. Back of the envelop calculations say that your taxable income should be $130k – $12.6k standard deduction – $8.1k personal exemption (=$4.05k*2) – $11k Trad IRA contributions (=$5,500×2) – $6,750 hsa = $91.55. Your marginal tax rate is 25% in that region.
I’d look hard to see whether you could qualify for a “mega backdoor roth” through your employer. If so, exploit the hell out of this. Google it and see what GCC, Madfientist, Bogleheads, and White Coat Investor say about it. Incredible loophole right there that jacks up the size of your Roth contributions in a given year from $5,500 by almost an order of magnitude. The one caveat is that few people qualify for this. It requires that your employer allows for after-tax contributions into the 401k. To really exploit the strategy, it further requires that your employer allow for “in-service distributions”. Even though it’s a long shot, you should try to learn more there.
Is the EITC really only a big deal if you have children? We’re doing our taxes this year and my fiance, who is currently in a residency paying her $4k per year, was eligible for $365 of EITC (her income after standard deduction was negative for 2016). I was curious and looked it up and saw the max for a family with no children is around $500.
Financial Panther. I replied yesterday but mistakenly misplaced it elsewhere in the comment thread.
You’re correct. The EITC is primarily a subsidy for low-income households with young children. The more children you have (up to 3) the better, as illustrated in the Tax Policy Center’s chart I pasted above. What I didn’t discuss in this post is that the additional child tax credit (ACTC) is another source of free money to parents. My spreadsheet, alongside TaxCaster, properly computes the total amount of the subsidy arising from both the ACTC and EITC. The two combined max out at $4,373 for 1 kid, $7,572 for 2 kids, $9,269 for 3 kids, $9,376 for 4 or more kids.
Glad it works for you! I retired at 52! Now we are empty nesters collecting pensions. Income sheltering becomes impossible.
I only wish I had your problem! Congrats on receiving a nice pension! That’s a relic of the past that us younger pups will never have the luxury of drawing. We’re completely on our own to choose how much to invest as well has where. As a result, many of us will fail horribly. I’m fascinated to see such little mention of this impending doom in the news.
In your situation, the only thing you can and should do is tax loss harvest as well as strategic Roth conversions to avoid RMD’s down the road and exploit favorable marginal tax rates today in the 10% and 15% buckets. You may find this recent thread interesting in which an old-timer (carolinaman) expresses regret for not converting to Roth sooner: https://www.bogleheads.org/forum/viewtopic.php?f=2&t=215699
You’re correct. The EITC is primarily a subsidy for low-income households with young children. The more children you have (up to 3) the better, as illustrated in the Tax Policy Center’s chart I pasted above. What I didn’t discuss in this post is that the additional child tax credit (ACTC) is another source of free money to parents. My spreadsheet, alongside TaxCaster, properly computes the total amount of the subsidy arising from both the ACTC and EITC. The two combined max out at $4,373 for 1 kid, $7,572 for 2 kids, $9,269 for 3 kids, $9,376 for 4 or more kids.
Great write up. The U.S. tax code is an amazingly bizarre thing. Who would imagine that you’re actually paid for having additional kids. :)
That said, I wonder if tax opportunities like the EITC will actually survive the current administration … along with other benefit plans that help low income families like the ACA.
I suspect that the EITC will be maintained indefinitely. It has the support of many policymakers and academics because it incentivises people to work instead of getting a free handout (food stamps, etc). The problem with this logic is that nobody on the planet – particularly those in that income range – understand the mechanics of the EITC. As a result, the behavioral reasons for having the EITC (to promote people to work) are a complete failure in practice. If anything, the EITC promotes fraud through over-reporting self-employment income. It succeeds, however, in redistributing wealth which is one of its intended outcomes.
Big picture, I think a progressive tax system makes sense, but what’s the least distortionary way of implementing it? Progressive tax brackets make sense to me. The EITC is essentially a negative tax on the first bracket for those who qualify (those with kids primarily). The problem of the EITC as it’s designed today, in my mind, are the very high effective marginal rates as you go down the EITC ramp.
Hopefully the current administration will prove me wrong, throw out the mess of the US tax code, and start fresh.
I believe your comment regarding “redistributing wealth” is the real reason for why the EITC exists. I am sure it was promoted by the Democratic Party when first implemented, so it is not a leap of faith to believe wealth redistribution was their primary focus. The points around incentivizing people to work, etc, were all a smoke screen. Regardless, great article.
Great job lowering your taxes. Everyone should max out their 401k to reduce their taxes. We saved $50K+ per year in our 401k and Roth IRA. They are great accounts to help build wealth.
I’m curious about your plan for the kids’ education? Would they have some kind of education benefit because you are a professor? How would they pay for college?
We’re not exactly sure about kids education. I’ll fund 529 up to state max every year (pretty low amount). I’m also entertaining the idea of UGMA for each child as discussed brilliantly here: https://www.bogleheads.org/forum/viewtopic.php?t=135851#p2005687.
At some universities (i.e. private ones like Notre Dame and U Chicago), faculty get insane tuition benefits for kids. Notre Dame, for example, pays 50% of Notre Dame’s tutition anywhere in the country, which is pretty much a full ride anywhere. And this tuition benefit is untaxed!!! With 5 kids I’d entertain moving to a school like that down the road if the opportunity presented itself.
Aside from that, I’m optimistic for merit-based scholarships. Our kids, though young, are doing very well in school. I hope they keep it up. If they don’t get merit-based scholarships, I’ll recommend that my kids do the cheap in-state route followed by grad school (hopefully fully funded) at a top tier school.
Can the EITC and Savers Credit be hacked in tandem?
I’m not an expert on the Saver’s Credit, but the gaming that I do in terms of lowering taxable income definitely pays dividends across many dimensions. In the coming year I’ll update my spreadsheet to include the effects of the saver’s credit as well.
The Saver’s Tax Credit is non-refundable. At the income levels needed to hit the EITC, I don’t think there would be any way that you would end up owing any tax to utilize it.
Thanks for the clarification Kyle!
Thank you Frugal Professor. This was a very informative article for me since we have three children and I am also employed at a university where I have access to both 457 and 403b options. I have hesitated opening these other accounts due to a number of reasons. My question to you is how did you set up your W4? Are you claiming all your children as dependents? I would like to start making contributions to either a 457 and 403b account but have to figure out first how much that would impact my net income.
Cynthia, glad to see your comment. You’re in a very unique position to hack the EITC like I did last year. The 403b + 457 will enable you to shelter up to $36k more in income. If you’re married filing jointly, if you can get your taxable income down to $23.7k, your tax refund would be $9.3k. Play around with my spreadsheet and Taxcaster to verify for yourself. http://www.frugalprofessor.com/updated-tax-calculator/
As far as W4 withholdings go, you are correct in that the $36k extra of sheltering will influence your taxes. If you project no tax liability this year after maxing these out (like I did last year), you can claim exempt from withholdings (like I did last year). If you don’t want to do that, leave your withholdings as is and enjoy a huge fat refund.
One thing to consider is that the $36k must be sheltered by the end of the calendar year. So the sooner you start contributing, the better.
It really is amazing when you consider how much you can shelter and the impacts thereof. We are nowhere near the ability to hit EITC but we’ve qualified in various years for several credits solely by sheltering in various accounts (401K *2, HSA, Dependent care FSA). It really is a head scratcher. Then again it’s almost like a stealth incentive to save.
FTF, I totally agree. From now on, I’m well out of EITC territory as well. In fact, I’m in AMT territory and facing effective marginal tax rates of 37.5%. As a result, the benefits to sheltering are even more important now than they were last calendar year for me. Like you, I’m sheltering every penny I can and the tax savings are astounding. In 2017, by deferring in 401a, 457, 403b, and HSA will save me on the order of $25k/year in taxes. If I then slowly convert to Roths tax-free as GCC does, this will essentially be a $25k/year windfall. My rule of thumb these days is to defer every penny I can. Future tax rates are irrelevant by doing the GCC method of converting up to standard deduction + personal exemptions * number of people in house. The power of deferral cannot be understated, particularly for high earners.
I am trying to figure that number where we are tax free. You mentioned the normal ones above. What about another 10K per child for the child tax credit and 10k for families with students who qualify for American Opportunity credit if the family is in the 10% bracket? Are there others besides 403b, 457 and TIRA that I need to remember? Do you know any good articles on how to figure this free money? Thx!
I had a blog reader (and now blogger – Finance Patriot) try to persuade me to eliminate my $10k in dividend income and interest so I could snag the EITC for my 3 kids and $30k-ish in self employment income from my blog. Very tempting but I’d have to turn my world upside down financially.
As it is, I LOVE the EITC and the way it’s structured. It gives lower income people a real injection of cash. Up to a point it incentivizes work and offsets the loss of public benefits/welfare the poorest experience as they start to earn some money. AND the EITC has an implicit asset means test via the investment income limit of $3400. So wealthy people (like me!) can’t get the benefit whereas lower income people, even lower income people who have saved a little bit, can get the benefit. It’s not perfect but it’s the closest I’ve seen to perfect in the “government giving out free money to people for welfare purposes” game. I’m a little sad I can’t have $6,000 free government dollars in my pocket (that is, after all, a considerable amount of money and think of all the tacos I could buy). But I’m very happy I can’t get the money along with all the other low income millionaires out there :)
Out of curiosity, what strategies would there be to reduce investment income to below the EITC threshold? The only one that comes to mind would be tax loss harvesting, but that seems to be working at cross-purposes the tax gain harvesting that GCC has taught us.
Also, I love the term “CrackerHead”! With your permission I’ll adopt it :-)
I just replied to ROG, but I checked TaxCaster and it appears that TLH won’t work. If I’m wrong, let me know. Crackerhead is all yours, buddy. Just piggy-backing on the brainiacs over at Bogleheads, of course.
ROG, glad to see your comment.
So here’s the deal. With 3 kids, you’d max out your refund at $9,269 at an income of $23,700. Download my spreadsheet or play around in TaxCaster to observe directly. By not hacking the EITC, you’re pissing away this money every year (until your kids are >= 17).
That’s a HUGE incentive to play the game. How do you get your taxable investment income below $3.4k is the only remaining question. As discussed here (https://www.bogleheads.org/forum/viewtopic.php?t=135851#p2005687), UGMA accounts would help, I think. Transfer apprciated shares to your kids. They get $2k/year tax free.
I just checked Taxcaster to see if you could do enough TLH could lower your investment income below $3,400, and it doesn’t appear to work. Bummer.
Alternatively, you could take a “big bath”, realize a ton of capital gains one calendar year, and reinvest in Berkshire Hathaway, which pays no dividends. Going forward, you’d have $0 in dividend income to screw things up.
I’m about to start populating my taxable brokerage accounts, and discussions like these are really informative for how I want to set up my strategy. As you and I know, the optimal holding period is near-infinite due to cap gains deferrals.
I made an overstatement here. North of $3,400 in investment income, you lose the EITC but preserve the ACTC. By having investment gains north of $3,400, the forfeiture of free money is on the order of the $4,239 quoted in the initial blog post.
Tell me about it. We tried to get the eitc for 2016. Ended up over the unearned dollar limit. We converted some Tira to Roth and sold and rebought some winners in taxable. Our changes should make 2017 work.
Also capital loses do not offset unearned gains for eitc purposes.
I thought about the big bath approach – sell it all, take the $1xx,000 cap gains and pay a little tax. Oldest 2 are 11 and 12 this year so I have 4-5 good years of EITC left (EITC drops bigly once I only have 1 kid on the payroll).
Taking EITC also prevents me from doing Roth conversions since those count against $3400 max investment income (treated as withdrawals from IRA).
In the end it’s a lot of hoop jumping, some non-negligible tax costs, and a shrinkage of my future Roth space, plus it’ll restrict my ability to tax gain harvest or sell appreciated assets for living expenses.
Sweet idea though! Wish I had set up the taxable account a bit differently to game this particular tax advantage a bit more.
Perfectly rational response, ROG. I wouldn’t expect anything less from you.
It’s a topic that I’ll have to give more thought to. I agree that forfeiture of tax-free GCC-style Roth Conversions in retirement (up to std deduction + personal exemptions) is a bummer, but so is giving up $4,239 of EITC hacking money. Not sure what the optimal solution is….
I’m not sure either. It’s hard to quantify. I’m also managing to a target AGI around $40-42k to maximize my roth conversions while keeping IBR loan payments at $0 and ACA subsidies close to 100% of premiums (paying $16/mo now). Dropping from $40k AGI to $23k is a lot of lost Roth space each year but it works out to roughly a 25% implicit tax (losing $4300 EITC but gaining 17000 roth value) IF I could otherwise take the EITC (which I can’t due to too much investment income!).
Hey ROG….can you suggest a good article that guides a person thru getting the most out of ACA as you mentioned above?
Thx
https://gocurrycracker.com/obamacare-optimization-early-retirement/
https://gocurrycracker.com/obamacare-optimization-vs-tax-minimization/
Check this one out: http://rootofgood.com/affordable-care-act-subsidy/
It doesn’t age out til 23 if they are in college full time.
Thanks, I see that now. Good to know! Makes it a little more favorable to try to snag the EITC after all.
I am very interested in this. As I am in the process of negotiating my severance and layoff, as I plan to retire early this year with a bang, next year could potentially be a very low income year. I have a bunch of tax loss carry forwards that I could use this year, in order to do some tax gain harvesting for next year.
I wonder if, should my blog not produce any significant income next year (a likely scenario), that I should invest in Berkshire B shares next year instead, as they never intent to pay a dividend. I have two kids, so even a small amount of earned income would likely be a windfall. My wife or I could get a seasonal job for fun, make just enough to maximize this credit, and fund the rest of the year with sales of taxable investments, which would have an increased tax basis.
Great article, as the youngest of five in my family, I know my parents got plenty of tax incentives, but the ones available today are even better for big families, particularly IF you know what you’re doing. (my parents didn’t really know what they were doing).
In addition, I plan to sign my family up for a Christian Health Sharing plan, which is exempt from ACA penalties, so our level of income is irrelevant for O-care subsidies. That part is not an issue for us.
See my response to root of good above. In order to hack the EITC, you’ll have to be awfully mindful of the $3,400 requirement. In my basic scenarios that I ran on TaxCaster, it appears that TLH can’t work to get you under the $3,400 threshold. If you are EITC hacking, then the optimal approach is to not do any capital gains harvesting.
Hi there, I’m hoping to get some advice regarding pre-tax deductions. My work doesn’t allow me to contribute to 401K and does not have the option to send pre-tax payments to IRA. Are there any other options for me to help with lowering my AGI?
Catherine, if your employer doesn’t offer a 401k, your best bet is to shelter via a traditional IRA. You won’t see the tax deduction on your paystub, but this doesn’t matter. It will be applied once you file your taxes the following April. Your tax savings would equal your effective marginal tax rate * the contribution amount (max of $5.5k if single, $11k if married). I’d also look into HSA contributions if your employer offers them.
Great article and timely for me. First year of low income for me; wife still works because she teaches at a private school my two kids attend. I think we could benefit from this but cash flow could be a problem as I was planning to liquidate some stocks and get the 0% capital gains rate. But this appears more lucrative. Couple questions: I will make a few thousand this year from my self-employment – will contribution to my Solo 401k shelter this money so it doesn’t count? If I take distributions from Coverdell IRAs for payment of my kids’ tuition, will that affect the EITC calculation? Thanks much for giving me such interesting fodder.
The money you put into the Coverdell is after-tax money, and the gain is tax deferred. But if you use the gain for “qualified education expenses,” then the gain is tax free. Therefore, neither the principal nor the gain add to your AGI so won’t effect your taxable income, if you follow the rules.
I used the IRS EITC calculator and I got a different result than I thought for my approximate situation. Unlike your scenarios above, it doesn’t seem to subtract out deductions and exemptions. As you can see below (copied and pasted from the IRS site), with an AGI of under 42k, the EITC is only $1774. Is this wrong?
Filing Status: Married Filing Jointly
Qualifying Children: Two
Earned Income: $40,000
Adjusted Gross Income: $41,750
Your Estimated EITC Amount for 2016: $1,774
2016 Estimated Income:
Edit
Wages, Salaries, and Tips: $35,000
Statutory Employee Gross Income: $0
Clergy Income: $0
Self-Employment or Business or Farm Income (or loss): $5,000
Taxable Interest: $0
Tax-Exempt Interest: $1,200
Ordinary Dividends: $1,500
Capital Gain (or loss): $0
Taxable Refunds: $600
Alimony Received: $0
Unemployment Compensation: $0
Nontaxable Combat Pay Election: $0
Other Income: $0
Estimated Adjustments to Income:
IRA Deduction: $0
Alimony Paid: $0
One Half of Self-Employment Tax: $350
Self-Employed Health Insurance Deduction: $0
Moving Expenses: $0
Penalty on Early Withdrawal of Savings: $0
Student Loan Interest Deduction: $0
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To Hack the EITC w/ only 2 kids (<=16 years old), your tabla income would ideally be in the neighborhood of $23.5k. Download my spreadsheet to observe this directly. At that level of taxable income, the EITC + ACTC give you a total refund of $7,572. North of there, you're facing effective federal MTRs of 21% and 31%.
To answer your initial questions about Solo 401k + Coverdell IRAs, I played around in the full version of TurboTax and it appears that the self-employment income is going to be problematic in that you can't fully shelter it up to $18k of income like you could a standard W2 income. That's a bummer to the self-employed looking to hack the EITC.
I'll stop short of further analysis on the Coverdell IRAs. It takes about 10 minutes to answer any question in Turbotax. One of my favorite tricks for learning the tax code is to do scenario analysis through the "amend return" feature in Turbotax if you've already filed for a given year. I can't yet amend this year's return, but I can amend last year's return. To do so, log into Turbotax, go to your tax timeline, and click amend 2015 return. It will prompt you to download the desktop version of Turbotax 2015 along with your .tax file. With this full version of Turbotax now on your computer, you can do scenario analysis to your heart's content. Obviously there is no harm in running scenario analyses if you aren't going to mail in the amended return.
If you do the above and find something different than what I found, let me know. For me, the self-employment income killed the thing at the "Earned Income Credit Worksheet Computation." No amount of solo 401k contribution could negate the self employment income, unlike a normal W2 income where any 401k contribution simply doesn't show up as earned income.
Happy hacking.
Just have to vent.
Costco special dividend just bumped us out of the EITC for 2017. $400 over.
Guess we will convert more Roth now.
Christine, you may be able to tax loss harvest $500 or so to get you under the threshold. Play around with a full version of TurboTax to verify for yourself. I don’t know the answer off the top of my head, but this sounds vaguely like something I’ve done in the past. It could be that my memory is failing me.
That would require losers in taxable. More first world problems since we don’t have any at the moment.
I haven’t thought this through completely… and I’m not an EITC expert, having never qualified myself, but an option may exist to reduce your investment income by gifting shares (pre ex-dividend) to either your children or a non-dependent family member. Or worst case, donating shares, assuming charitable donations are part of your plan anyway.
I like this idea a lot GCC. I think it could work very well.
I’ve been hacking the EITC and CTC for years. What’s extra useful is that my state matches EITC at 30% and CTC at 33% (this one only on kids over age 4 for some obscure reason). So I estimate that every $1 DH contributes to his 401k gets a return of 41.3% (21% federal EITC phaseout + 30% state match of phaseout (6.3%) + 10% fed tax + 4% state tax). For HSA contributions, add another 7.65% for total of 48.95%, at least on that portion of contributions.
When all 5 kids were at home, our refunds were enough to fund Roth IRAs for both DH and me. We are down to one CTC and 2 for the EITC right now, and can still fund about 2/3 of our Roth IRAs via refunds.
The biggest gotcha to watch out for (beyond the investment income limit) is that the EITC is tested on both line 7 wages AND AGI. Thus 401k is not equivalent to tIRA in this instance.
Sooo..stupid question. Is there a good way to reduce investment income other then selling all your dividend stocks and buying Berkshire or similar?
I recently came across the FI movement and have been reading a lot of various blogs. I am married with 2 kids, and have taken advantage of the EITC for the past couple years. I don’t have any investments/savings but want to start. I have been hesitant to start because I didn’t want to disqualify myself from getting the EITC. I’m not 100% clear on what is considered investment income. For example, if I have 50k in a Vanguard index fund, and it is worth 5k more at the end of the year, does that count as investment income?
In order to reach FI, I need 350k total (withdrawing 4% per year). I am self-employed and my wife is not currently working. What would my investing look like so that I can continue getting the EITC?
$350k*0.04=$14k/year. If you can live on that with two kids, props to you.
Investment income = dividends + realized capital gains. If you own $50k of Vanguard stocks, you will receive roughly a 2% dividend yield, or $1k/year in dividends. If the stock price goes up by 10%, your stock will now be worth $60k. But if you don’t sell it, you will have an UNREALIZED capital gain of $10k. It’s unrealized b/c you haven’t sold it yet. So long as you don’t sell it, it doesn’t effect your taxes at all. Moral of the story: try to avoid realizing capital gains (i.e. selling stocks that have appreciated) until you retire, then you can play the game that GCC does of capital gain harvesting. Google the term for more information.
Awesome, thanks for the answer. I figured it was something like that, but I couldn’t find it, probably because it is such a basic fact of investing.
Right now, our spending is $20k/year (we are somewhat frugal, and we own our house w/o a mortgage). I can definitely get it to 14k, since we have 2 leased cars, and will be getting rid of one this year, and then getting rid of the other in a year or two.
I just thought of another question, about bonds. How would I figure investment income from owning bonds? Or is getting bonds in the initial saving stage not good, because growth is slower?
David your best bet to start would be Roth before starting a taxable account. Once you accomplish funding two Roths than I would start thinking about taxable.
Yes, now that I know it is safe to invest in stocks and still get the EITC, I’m looking to fully fund TIRAs for me and my wife. However, I am still thinking through my situation. I am in semi-retirement (working ~10 hours per week), and I don’t plan on working more than that. Since I won’t be earning much more than 30k, do I really need a tax-advantaged retirement account? If I only need 14-16k per year, wouldn’t I be better off with a tax-advantaged account? I wouldn’t have to deal with the restrictions of an IRA, right?
I am not quite following you. Usually TIRA, Roths, and HSAs are called tax advantaged. Money in a brokerage account or stuffed in a mattress is taxable. IMO both are important for early retirement. What is more flexible depend on several things.
If you invest 10k dollars in 10 $100 shares at of ABC company in taxable and it goes to $200 in ten years it would be worth 20k. If you need 10k ten years from know you will have to sell five shares and have a capital gain of 5k and render yourself ineligible for the EITC.
If you put it in a Roth you have paid the taxes on it even if the taxes are zero. Take the above example out of a Roth and you have zero taxable capital gains and the same 5 shares left
Would I be eligible for EITC in the Roth scenario, or would the 5k in capital gains still count against me, even though I won’t be taxed on it.
With a family of 4, I can make up to ~28k before paying any tax. As long as I keep my income below 28k, then my investments won’t be taxed, whether IRA or taxable. And when I reach FI, I won’t need to withdraw more than that threshold, so I won’t be taxed either. In this scenario, would taxable accounts be better, since I don’t have to worry about IRA age/withdrawal restrictions?
Yes in the Roth scenario you could still be EITC eligible with the taxable you would not be. It kinda stinks to miss out on the EITC when your unearned income is just a few dollars over. Negative tax rate is better than zero tax rate.
So…realized capital gains from tax advantaged accounts don’t count as investment income? I thought all of it counted as investment income, the only difference being whether it is taxed or not.
Realized capital gains from tax advantaged accounts are irrelevant for EITC purposes, and for any other tax purposes for that matter. The IRS only cares about tax advantaged earnings once you withdraw from the accounts.
Yes, got it. This is very helpful.
My game plan: Invest 11k in Roth, then put the rest in taxable.
Good ! David your best bet to start would be Roth before starting a taxable account. Once you accomplish funding two Roths than I would start thinking about taxable.
We are just barely over the limit for the EIC, we max out an HSA, but it doesn’t help because we have obamacare. My husband has zero retirement options at work. I know a traditional IRA will not help us qualify for EIC. Is there anything we can do?
How do you factor in an EE pension amount?
Hi I’m filling a joint return & have 3 kids at home. 1 kid works so can’t claim him but one is age 20 & youngest age 18 & just turned 18 in December. I am self employed. How can I get the biggest return possible?
We recently moved and kept house we owned and rent it out now. Because our rental income is more than 3500 annually we now do not qualify for the EIC even though as a married filing jointly with 3 kids we only made 37000 this year!! It feels like this credit was for us, but because I kept the house for long term financial success I lost out on thousands now. Is there a way around this?
I commiserate as we have missed the EITC because of too much unearned income in 2015, 2016,and 2017. The miss in 2017 was just because we got a special dividend of $700 and went over the threshold by ~$200. We just filed 2018 yesterday. We made it.
I do think the credit is intentionally designed to not be conducive to having money in taxable or real estate that is not your primarily residence.
Is selling and then using any gains help fund larger 401k/403b contributions an answer?
Really hoping you can help. You and I are both in the zero tax category for long-term capital gains. Why, then, does the tax refund decrease when you enter in less than the $3500 threshold into Taxcaster? I’m really baffled and hope you can help. It’ll go down about $600 – $700 if you enter in about a $3000 long-term capital gain. How is that possible when we are in the zero percent bracket for such gains? If you have the answer I’ll be eternally grateful. I need to consider this for 2019 carefully. Thanks so much.
I would venture to guess it has to do with how the EITC phaseout works.
This article includes a graph depicting how the EITC phasesout
https://www.taxpolicycenter.org/briefing-book/what-earned-income-tax-credit
Can anyone help me? I am so very upset. My husband makes $38000/year. One income. We have four children living at home. We invested ten years ago a small inheritance into mutual funds. Some years we qualify for EITC/others not because of this. Six years ago we inherited mineral rights for an oil lease. So this year our mutual fund and oil (this only amounts to $80 and change) put us to $3547. $47 over…and we lost thousands. Is there any way around this? And if not for this year, how can I fix this in the future.
There really isn’t any way to “unearn” unearned income after the tax year is closed. Your situation stinks.
Selling your mutual fund and buying Berkshire Hathaway is an answer but that would likely incur capital gains (they are unearned income too) for 2019 and mess this year up too.
Maybe others have more ideals?
Thanks Christine. I questioned this when we invested the money and the FP said that the gains would be worth it. SO far, this is correct actually…but I’d really like the EITC to use for things like groceries. Ha! I’m wondering if the reason she chose not to put it in an IRA is because they don’t make as much as mutual funds? I’m unclear on that. It seems saving comes with a penalty of sorts. Same situation with the 529. We don’t qualify for any grants or tax credits for education because we unknowingly saved. We have twins in high school and they take college courses. We pay out of the 529 and I don’t believe we can take the tax credit because we utilize all 529 funds to pay. I really wish we’d gone on vacation instead. Honestly. It seems like my friends with kids that never save a penny are much better off than we are. Thanks for responding! There must be a silver lining somewhere!!!
Thank you for sharing your knowledge GCC! Quick question… I am inheriting my deceased great aunt’s IRA of unknown amount this year. I was planning to maximize the EITC of $5,828 in 2019 fully by utilizing my 403b and 457 this year to reduce income to the standard deduction amt for MFJ. Questions if you have a moment (I reviewed elsewhere but wanted to see your thoughts).
1. Will the RMDs or lump sum distibution count towards the $3,599 max interest income threshold to receive for eitc? If so then the EITC is lost.
2. Everything I see says a required ira rmd’s or lump sum distributions count as normal income. So as we pay 0% in federal taxes currently as long as I do not exceed the max AGI for MFJ with two children EITC threshold – I just need to fit in the inheritance under the AGI and Evaluate how much to take out each year right?
3. Current tax plan was based (not including non-spousal inherited ira of unknown value) around my details:
$49,100 pre tax income
Plus $3,599 interest income.
Minus $2,160 pre tax health care contributions.
Minus $19,000 457b contributions
Minus $19,000 403b contributions
Std deduct of $24,400. No state income tax.
Much obliged for any wisdom or thoughts that you have on the above.
It isn’t investment income, so I don’t think it impacts EITC as long as you are below AGI thresholds.
I’ve never done EITC forms or process myself, so there could be something I’m missing.
Going to run it through turbotax. Thank you for your thoughts!
I received some stock as a gift and talked to the broker about tax penalties before selling. The broker said we are well under the income to get taxed on capitol gains so we sold $13,000 in stock. As I filled out our return online I was confused why we lost about $5,000 in our return. After talking to three accountants who couldn’t figure it out either, one helped me reverse through the steps and realize that we lost the EITC because of the unearned income we received. I was hoping there was a way we could retroactively put money into Roths and College to reduce the unearned income, but there isn’t such an option. Now we know, that in order to keep our EITC we can’t sell more than $3,600 in stock.
Sorry that you received some bad advice :(
More correctly you cannot have more than $3,600 in investment income (2019), which includes capital gains, dividends, and interest (even from a savings account.)
As gifted stock, when selling your basis would be the gifter’s original cost basis.
If Biden wins – it will be interesting to see how the proposed elimination of retirement contribution deductions measures up to this current optimization process.
Kitces just shared an article about it but did not dive deep enough into this aspect: https://www.kitces.com/blog/biden-tax-plan-cuts-democrat-proposal-capital-gains-396-increase-estate-exemption-retirement-credit/
Retirement contribution deduction elimination ‘s impact would significantly depend upon whether the credit % is capped and what type of contributions count towards it – correct?
1. Elimination of retirement contribution deductions to income is a huge change for those who are reducing their earned income for taxes and earned income tax credit optimization.
If, for example – I earned $49,000 this year and contributed $24,000 to pre-tax 401k/403B/457 retirement. I would receive max EITC of $5,920 with two qualifying children + $1,200 x 2 (child tax credit refundable amount) = a tax refund of $8,320 in 2020. (Assumes 0 federal tax liability as std. deduction is $24,800) Assumes 0 state tax liability (true in my case).
However – under this new hint of law of no retirement deductions.- my income would not be reduced for federal taxation purposes and instead I would receive a flat $24,000 retirement contributions x 26% = $6,240 + child tax credits of (let’s be generic and just say $3,000 and $3,000) But we do not know how much of that child tax credit is refundable (currently only $1,400 out of the $2,000 is). So let’s say that $2,000 is refundable. That equals a tax refund of $10,240 – Federal tax liability.of $2,564 = $7,676. Because I can no longer reduce the earned income for EITC maximization – that credit falls down to $730 making the Biden hint of a plan total tax refund: $8,406
2. Which leads me to the question – for those of us that have multiple options to contribute to retirement: 401K + 403B + 457 defer comp + personal IRA’s – Exactly what DOES count and is there a limit other than the IRS max retirement contrib limit for said year in terms of what # is multiplied by the ( never detailed in Biden’s ‘plan’ ) 26% tax credit refund? Because I for example – contributed $40,000 to retirement this year between personal IRA and 403B/457 plans. Would I really get $10,400 in retirement tax credits? Or will they find a way to CAP the benefit to punish savers (they punish savers in every other way in our current economy so this is a valid question).
3. This is a shadow of a plan – lacking detail and clarity (which means that whatever comes out of it is unclear and likely not to benefit taxpayers.
Very interesting – but the details are necessary in full to come to a full decision.
I welcome comments on the above – I cannot be the only relatively lower income household that utilizes retirement contributions to maximize EITC and CTC tax credits.
>I cannot be the only relatively lower income household that utilizes retirement contributions to maximize EITC and CTC tax credits.
Sure. If you were, you wouldn’t be commenting on a post about somebody who utilized retirement contributions to maximize EITC, etc… ;)
By your math, it seems you get a bigger refund under the Biden plan? $8,406 vs $8,320?
You put the word plan in quotes a lot… which is appropriate – there is always lots of potential legislation. I usually only read it after it passes, after it has passed through the legislative sausage grinder.
Fair enough – we should all know that until we dive into the actual bill’s wording and interpretation of that bill that we do not know how the math will work out.
Correct – because there is precious little detail it is hard to know – I suspect that the CAP on 26% of retirement contributions is not going to allow joint $12,000 IRA contributions or people with 403B/401K and 457’s to claim all of their actual retirement contributions. Otherwise the tax credit opportunities are massive.
I just got a bit exciting thinking of the tax credit opportunities but your wise counsel reminds me that when anything looks too good to be true in politics – it normally is. I’ll stay tuned if legislation occurs.
Thank you for all that you do here with the blog – stay healthy over there!
The EITC investment income limit went up to $10,000. This is great news for a lot of people who might need to wash some gains or not manage their interest and dividend income so closely anymore. https://www.nytimes.com/live/2021/03/06/business/stimulus-check-plan-details#what-is-happening-with-the-earned-income-tax-credit
Yes! For only one year at present (2021.) The EITC was also expanded for younger and Senior households with no children.
Some details here: The American Rescue Plan Act of 2021
The investment income limitation increase is permanent (or as permanent as any tax change is). https://crsreports.congress.gov/product/pdf/R/R46680
Oh nice, thanks!