A Middle-Class American Works 3 Months Each Year for Income Tax

What if Americans worked as hard for their tax rate reduction as they do for their annual bonus?

Photo Credit: Walt Disney’s 1973 version of “Robin Hood”

Tax rate reduction was one of my first inroads into my FIRE walk. About five years ago I was working for a company whose overall performance was lackluster in that particular year. I was working for the specialty department of that company. Our small department was innovative, doing very well, and growing rapidly. I was working hard and we were crushing all of our department goals. Because the overall performance of the company was not great, the company decided to cut the annual bonus in half. As you can imagine that made me upset. I was working really hard and my department was growing quickly in part because of the hard work I was investing along with the rest of my small team.


How Cutting My Bonus Check Saved Me Tens of Thousands of Dollars

Suddenly, the incentive for all that hard work was capped at half what I earned the year before. I think it was capped around $5,000 or so. Now I wondered if it was even worth it to go for the performance bonus. I started to think about how much extra effort I put in to earn my bonus. I looked at my goals and all that I would have to accomplish above and beyond my daily work to earn the maximum bonus.

I started doing some math. I estimated how many hours it would take me to accomplish those five goals and I divided that amongst the business days available in the year. I worked out that I had to work approximately one hour per business day to accomplish those five goals and earn the full bonus amount.

Once I had figured that out I leaned back in my chair and pondered. I started to think it wasn’t really the best application of my time. I had a young son at home that I could be spending my time with. I started to think about what else I could do with one hour a day or five hours a week that would yield more than just $5000 a year. This was one of my first insights into the gravity of entrepreneurship and my FIRE walk.


Unplugging from the Matrix

Instead of my mind being totally dedicated to being exceptional at my daily work, now my mind was wandering through ideas that would yield more dollars for the same amount of time I was investing towards my bonus. I started thinking about side hustles, and how I could better use that time. I started thinking about how I was spending my money and what I could do to be more effective with the money I already earned.

Photo credit: Neo from the movie “The Matrix” as he learns to use the rules of the matrix to his advantage.

At the time, I was in the 41% marginal tax bracket. That felt terrible! I didn’t yet understand the difference between effective tax rate and marginal tax rate but the marginal tax rate of 41% felt like I was working almost half of the year for government and only a fraction of the year for myself.

I reasoned that if I could get my tax rate down I could probably save a lot more money than I earned in my regular annual bonus. I estimated that this would take even less time than trying to earn the bonus and it could potentially have residual rewards year after year. I was aware that my tax situation would change a bit from year-to-year but I reasoned that if it did, with a little more research, I could compensate for the difference in a tax rate increase.


A Middle-Class American Donates 3 months of Work Each Year to Government Income Tax

Let’s assume Middle-Class Melany is single and head of her household. She lives in the sunny state of South Carolina (which has an average state income tax rate) and makes $73,646.40 annual salary. Let’s also assume that she has some average tax deductions, and tax credits that bring her Modified Adjusted Gross Income (MAGI) down to $61,372.

If you are a Skeptical Sam like me here is the math. If you are a who Cares Henry skip to the summary of results, the third table down.

Results

Now how would you like to take just under three months of vacation every year and still earn the same amount of income?

That is what I am talking about here! That is what the entirety of the tax article boils down to. First, you have to be aware of where your money goes. Then you might just be motivated to do something about it! If you make above the median American income (higher tax bracket) your situation gets even worse I’m afraid. You quickly work your way towards working four months of the year for income taxes.

I started researching tax law and how to reduce your tax rate. I started implementing some of the strategies that I was reading about and I kept reading more the more I read the more excited I got to find another strategy to implement by the time taxes were due I had reduced my federal tax rate from 25% down to 9%. This felt like a huge win and I had reduced my effective tax rate significantly. I had achieved my goal! I had saved much more income tax than the maximum bonus that I could have earned and with less time. By the way, I still earned most of the bonus that year 😉 even though I had not invested nearly the time that I was prepared to.

This was extremely motivating for me to continue to learn a few more tax hacks the year after and get my federal tax rate down to almost nothing. I felt like a champion! I now was able to keep more money on my side of the ledger felt much more work this was a huge return to the time that I had invested. I wondered how else I could invest this money. 🤔


Savings Rate considerations

Consider for a minute what keeping those taxes does for your savings rate. Going from 25% to 9% is a 16% boost in savings rate! You didn’t have to cancel your Netflix, change your diet to beans and rice or turn your heat down seven degrees in the winter for that savings. I argue that it is one of the easiest areas to boost savings rate because it has no felt impact on quality of life.


That’s When I Got Audited

When I dropped from the marginal 41% bracket (25% federal bracket) to the 9% federal tax bracket and 3.5% state tax rate, I actually got audited. I guess that is not an ordinary move for a middle-class guy ¯\_(ツ)_/¯ and I got flagged for it. Perhaps, I was randomly selected for an audit but I suspect I got flagged because of the significant drop. The IRS required additional paperwork that I had to produce to substantiate some of my tax claims I made when I filed. Luckily, I kept good documentation and this was not that difficult.

Of the tens of thousands of dollars that was at play in the tax calculation, the IRS found that I was within $362* of their calculated number. They found that I had not falsely reported or exaggerated any of my income or expense numbers. And I was eligible for all of the tax credits and tax deductions I claimed. I was off in my calculation so I did owe  $362 plus additional penalties and interest of $12.10*.


The IRS could see that it was a calculation error and concluded that there were no fraudulent intentions. The audit ended I filed an amendment and life went on. Had they found anything intentionally fraudulent they would have looked into additional years of tax returns. In the case of intentional fraudulence, one would be faced with much steeper penalties and repercussions.

To be honest, although I made a mistake I felt vindicated in my tax optimization plan. I did make a calculation error but only had to pay what I owed anyways plus an additional $12.10* fees and interest. That is on the order of the cost of a lunch for the savings of a car! Considering the thousands of dollars at play and the fact that I drastically cut my tax rate, chalk that up to a serious win!


Tax Law Change for 2019

In 2019 there is only a 5% – 10% chance that Americans will itemize. With the Trump tax cuts in full force 90% to 95% of Americans will claim the standard deduction. I did it! I itemized this year. Technically, I would have been in the 9% federal tax bracket but I received enough tax credits to cover my federal and state liability and I get a sweet credit that the government paid me above and beyond that for being so awesome at tax optimization. I am curious to hear how you did this year. If you had a tax win please shout out in the comments below.

Now where will I invest all that sweet American tender? 🤔 I feel like 2019 should be the year of real estate investment?!


Pro Tips:

  1. Use a professional tax advisor they are bound by law to correctly advise you and check your math. It is a good thing to have a professional double-check your numbers. They also act as a legal buffer between you and the IRS. If they get something wrong they are liable and pay a penalty that is far worse than anything you or I would see.

  2. Rotate to a new tax advisor every year. You will learn all the tips and tricks they know and then you can move on to another advisor and learn a few new ones and keep adding to your tactical tax tool belt. Keep detailed notes each year in case your new advisor does not know of some of the eligible reductions a former advisor knew. Keeping good notes is critical. It is difficult to remember all of the reductions for the other 364 days of the year when I highly doubt you are thinking about income tax filing.

  3. Be honest on your taxes! There are so many legal deductions available to us there is no need to stretch your numbers.

Until next time, keep the FIRE burning my friends.


Related Articles:
Taxes Oh Man, Boring! Why should I Care?
Pillar I: Tax Optimization

*note: I have previously been interviewed on a Podcast and quoted the figures of “$300 miscalculation and $7 fees and interest.” Hopefully, you can forgive me for not being as precise as possible.

For the sake of this article, I went back through the audit letter (pictured above) to grab the exact figures. That is a luxury bloggers have over podcast interviewees. When you are in an interview you can be asked about any number in your entire financial history. That is a lifetime of data that you may be put on the spot for. I wonder how many people could get every number in their history precise and correct?

So angry commenters and fact-checkers beware. You got nothin’ this time! Confirming values is not something I have the luxury of doing in a podcast interview. So I use my best recollection when put on the spot. I am more exact on the blog because I can take the time to do the research and fact-checking. My intentions are always to give you the most accurate numbers so you can make the best financial decisions for your life.


Disclaimer:  This site is for informational and entertainment purposes only and shall not be construed as investment, tax or legal advice nor recommendations. Because of the nature of the interactive dialogue inherent in the format of this site, it is important for readers and listeners to understand that not all comments made will apply to them specifically. Nothing said shall be taken to be investment, tax or legal advice, nor shall statements on this site be considered an offer to buy or sell securities. Such advice is rendered solely on an individual basis and at times will require that the investor review a prospectus. You should seek advice for your specific situation from a certified financial advisor, a certified tax advisor, and/or a licensed attorney. I don’t claim to be an expert. Most days, I don’t even claim to be an adult. I just want more friends to drink out of coconuts with me on the beach.

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7 Responses

  1. Mr. Refiend says:

    I include FICA because I have to pay it and there is no guarantee it will be there in 30 years when I become eligible.

    I agree with you figure of 70% for the millennial generation but I would say it is more like a best case scenario. Think about that for a minute. Every dollar you put into a social security investment you only get back 70 cents. This is why I like individual retirements accounts over government managed accounts, I get 100% back (actually much more since it compounds) not just 70%.

    If you are open to it, there are several countries that have a single payer (government run) healthcare. If you don’t mind that additional tax you could retire in one of those countries today if that is the only thing holding you back. Just remember with government run plans for every dollar you pay you might only get 70 cent of healthcare in return.

  2. Matthew says:

    This is a good overview, and I listened to you ChooseFI interview, but do you have an article that goes in depth into what strategies you used to reduce your tax burden besides 401K, Traditional ROTH (if eligible), and an HSA (if eligible)?

  3. Jetsey says:

    No quibble w misremembering your audit amounts. But I would like you to clarify your statement of “When I dropped from the marginal 41% bracket (25% federal bracket) to the 9% federal tax bracket I actually got audited.”

    Can you show me how anyone in the 25% fed bracket will ever pay 41% marginal?

    • Mr. Refiend says:

      Happy to my friend. 25% Federal + 6% State + 2% local + 7.65% FICA = 40.65% or if rounded to the nearest percent that is the 41% total combined marginal income bracket. (That rate was before the recent Trump tax break.) I hope that adds clarity.

      • Mark says:

        I don’t think you should include FICA. There are certain things that government does (e.g. Social Security – and worst case scenario we will see 70% of our expected benefits) that are a form of insurance or benefit, and they equal or exceed what is provided to you by the private market. Similarly, if we went to a single payer health system that cost should not be in the calculation. Personally, if that happened, I would retire tomorrow, and happily pay the increased taxes on our investments.

        • Mr. Refiend says:

          I include FICA because I have to pay it and there is no guarantee it will be there in 30 years when I become eligible.

          I agree with you figure of 70% for the millennial generation but I would say it is more like a best case scenario. Think about that for a minute. Every dollar you put into a social security investment you only get back 70 cents. This is why I like individual retirements accounts over government managed accounts, I get 100% back (actually much more since it compounds) not just 70%.

          If you are open to it, there are several countries that have a single payer (government run) healthcare. If you don’t mind that additional tax you could retire in one of those countries today if that is the only thing holding you back. Just remember with government run plans for every dollar you pay you might only get 70 cent of healthcare in return.

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