• Taxes & Insurance

How Can The Average American Pay No Taxes?

February 21, 2014 | Justin McCurry

Most people grow accustomed to the big chunk of federal income tax withheld in each paycheck. The more you make, the more they take.

Americans paid over $1.3 trillion dollars in federal income tax during 2012. Most of the tax burden fell on the highest income earners. According to the IRS, the top half of taxpayers paid 98% of all federal income tax with the top 5% of taxpayers paid 59% of the all taxes. Those taxpayers falling in the lower half of the income distribution paid only 2% of the total income tax burden despite earning roughly 13% of all income.

Every election season, the equity and fairness of our tax structure is a hotly debated topic. Some say we pay too much tax, period. Others say the hardest working, most productive members of society are unfairly burdened with a disproportionate share of the total tax bill. A third group says the middle class suffers from excessive taxation. Where you stand on the question of taxes often depends on how much you make and how much you pay.

Regardless of one’s opinion on the fairness of our tax structure, we can all agree that the tax code is complicated. However, the basic framework is simple. Your tax rate gets progressively higher as your income increases. The complexity arises from the various deductions and credits available to taxpayers that plan carefully. Another layer of complexity arises when these deductions and credits phase out as incomes increase.

Are taxpayers that take advantage of many deductions and credits carrying their fair share of the tax burden? Or are they cheating the system by finding tax loopholes to weasel out of their tax liabilities? The tax system we have doesn’t always seem fair, and the best way to make it fair is to lobby our elected representatives for true tax reform to ensure the tax burden is shared equitably among all taxpayers.

Some taxpayers can earn over $100,000 and still manage to pay zero tax. Ignoring issues of fairness, it is financially prudent to take any available tax deductions and credits for which you qualify.

In this edition of the Daily Capital, we present four examples of ordinary people with decent salaries that manage to keep the tax man at bay.

John: 23 Year Old Recent College Grad

In the first example we have John, a 23 year old who wants to keep his tax bill at zero. John just finished college and recently started full time employment at an entry level salary of $30,000. John managed to live frugally while in school and is willing to maintain the college student lifestyle for a few more years. John studied finance in college and knows the power of compounding investment returns. He knows that investment contributions made while he is in his twenties will grow for decades to come, thereby securing a safe retirement.

Since John has roommates that split the rent and utilities, John feels comfortable living on $1,300 per month total out of his $2,500 monthly paycheck. John participates in his employer’s 401k plan by contributing $1,000 per month. This leaves $200 from each paycheck to cover Social Security and Medicare tax withholding.

23 year old

For tax purposes, what started out as a $30,000 salary becomes $18,000 in income after subtracting the $12,000 John contributes to his 401k during the year. For tax year 2014, an individual taxpayer with no dependents will owe $785 on $18,000 income. Since John funds his 401k account throughout the year, he is entitled to take the “Retirement Savings Contributions Credit”. John’s Retirement Savings Contributions Credit will be $785. This credit will reduce his tax bill to zero.

The Retirement Savings Contributions Credit, or Saver’s Credit, offers taxpayers a credit of 10% to 50% of contributions to retirement savings accounts such as a 401k or an IRA. Individuals may take the credit on up to $2,000 of contributions, while married couples may take the credit on up to $4,000 of contributions. The maximum credit for individuals is 50% of $2,000 (or $1,000) with an adjusted gross income up to $18,000. A reduced Saver’s Credit is available to individual taxpayers with adjusted gross incomes up to $30,000.

The amount of the credit is limited to the total tax owed by the taxpayer. In John’s case, he qualifies to receive up to $1,000 for the Saver’s Credit. Since his tax bill without the Saver’s Credit is only $785, the Saver’s Credit is limited to $785. Unlike some credits (such as the Earned Income Credit and the Additional Child Tax Credit), the Saver’s Credit is not refundable if the credit exceeds the taxpayer’s tax liability.

John can keep his tax bill at zero even if he gets a raise. If he increases his 401k contributions by the amount of his raise each year, his adjusted gross income will remain at $18,000 and he will continue to receive the Retirement Savings Contributions Credit.

The Smiths: Married Couple, 40 Years Old With Two Kids

The Smith family is our second example of a household that pays zero federal income tax. Mr. and Mrs. Smith are both 40 years old and they have two kids in elementary school. Together, the Smiths earn $103,250 per year from their full time jobs.

The Smiths put a strong emphasis on retirement savings by contributing the maximum to their 401ks ($17,500 each) and traditional IRAs ($5,500 each). In total, they contribute $46,000 to their retirement accounts.

Since the Smiths have two children in elementary school, they have to pay for after school care during the school year and some child care during the summer months. The total child care costs amount to $5,000 per year. The Smiths contribute $5,000 to their childcare flexible spending account provided by Mrs. Smith’s employer, and this amount is taken out of her paycheck pre-tax.

Similarly, Mrs. Smith contributes $2,000 per year to her healthcare flexible spending account, which is also deducted from her paycheck pre-tax. With the family’s typical medical and dental expenses, they are certain to use the $2,000 each year.


After taking these deductions from their gross income, their $103,250 combined salaries are reduced to an adjusted gross income of $50,250. A married couple with two children will owe $2,400 income tax on a $50,250 adjusted gross income. The Smiths are able to take the child tax credit of $2,000 ($1,000 per kid) and the Retirement Savings Contributions Credit of $400.

Married taxpayers with an adjusted gross income between $39,001 and $60,000 are entitled to take a Saver’s Credit equal to 10% of up to $4,000 in retirement contributions. The Smiths’ adjusted gross income of $50,250 means their Retirement Savings Contributions Credit is $400 (10% of $4,000).

Their tax credits totaling $2,400 completely offset the tax liability they would otherwise have on their $50,250 adjusted gross income.  The Smiths will owe zero tax.

Even though the Smiths enjoy a six figure gross income, they still manage to bring their federal income tax bill down to zero by taking advantage of a number of tax credits and deductions.

The Jacksons: Married Couple, 55 years Old, Empty Nesters

The Jackson family will serve as our third example of how ordinary households can avoid paying federal income tax. The Jacksons’ total annual salaries sum to $105,550.

Mr. and Mrs. Jackson raised two wonderful children and are now looking forward to retirement within five years. The two Jackson children have finished college and are no longer dependents on their 55 year old parents. The Jacksons are also proud of recently paying off their 30 year mortgage on the house they bought when they were newlyweds.

With the kids out of the house and the house paid off, the Jacksons find themselves with lots of disposable income. Since Mr. and Mrs. Jackson are nearing retirement age, they want to put the disposable income to work for themselves by turbocharging their retirement savings.


The Jacksons are in luck because IRS rules allow taxpayers age 50 or over to make “catch up” contributions to their 401k’s and IRAs. An individual age 50 or over can make an additional $5,500 catch up contribution to their 401k, and an additional $1,000 catch up contribution to their IRA. This means taxpayers age 50 or over can contribute a total of $23,000 per year to a 401k and $6,500 to an IRA. Spouses age 50 or over are also entitled to make these catch up contributions. The Jacksons contribute the maximum (including catch up contributions) to their 401ks and their traditional IRAs, which amounts to $59,000 for 2014.

Mr. and Mrs. Jackson don’t have any significant health issues right now, but they want to ensure they have adequate savings to pay for healthcare expenses in retirement. Mr. Jackson contributes the maximum of $7,550 to his Health Savings Account offered by his employer.

Most families can contribute a maximum of $6,550 to a Health Savings Account (or HSA). However, the catch up provisions for taxpayers age 55 or over allow an additional $1,000 contribution for a total maximum contribution of $7,550. Amounts contributed to an HSA remain in the account year after year if they are not spent (in contrast to flexible spending accounts whose remaining balances are mostly forfeited at the end of the year).

The Jacksons have some investments in a brokerage account that they manage on their own. Mrs. Jackson enjoys overseeing the individual holdings and she “tax loss harvests” at least $3,000 per year from these taxable investments.

Tax loss harvesting is a method of selling securities that have decreased in value in order to recognize a capital loss.  Somewhat similar (but not “substantially similar” per IRS definitions) investments can be purchased to replace the sold investments. The advantage of tax loss harvesting is that up to $3,000 per year of capital losses can be written off against ordinary income. The Jacksons do exactly that. They deduct the $3,000 capital loss generated from tax loss harvesting, further reducing their adjusted gross income.

After deducting the 401k and IRA contributions, the health savings account contributions, and the capital loss deduction, the Jacksons manage to reduce their $105,550 earned income down to an adjusted gross income of $36,000!

For a married couple with no additional dependents, the tax liability on $36,000 income (after the standard deduction and personal exemptions) is $1,570.  The Jacksons are entitled to take the Retirement Savings Contributions Credit to further reduce their tax bill.

At an adjusted gross income up to $36,000, married couples can take a credit of 50% of up to $4,000 of retirement contributions. This would allow the Jacksons a $2,000 tax credit. The credit is limited to the tax actually owed by the taxpayers, which is $1,570 for the Jacksons. The Jacksons take the $1,570 Retirement Savings Contributions Credit and reduce their tax bill to zero.

The McCurry’s:  30-Something Married Couple, 3 Young Children

For the final example, I will share my own tax situation.  In 2013, my wife and I earned approximately $150,000 between salaries and some moderate investment income. We have three young children.


In the first table, our gross salaries are shown along with all the deductions from our salary for retirement savings, child care flexible spending account, health savings account, health insurance, and dental insurance. After all the deductions, our $141,000 combined gross salaries are reduced to a net of $71,750 (almost a 50% reduction).


In this second table, our earned income and investment income is shown along with another series of deductions including the capital losses from tax loss harvesting and the student loan interest deduction.  Since we have three children, we received $3,000 of child tax credits.  We also had $300 foreign tax withheld on our investment income, thereby generating a $300 foreign income tax credit.

Although we didn’t manage to get our tax liability to zero, our final tax bill was whittled down to $150, or 0.1% of our $150,000 gross income. I can’t argue the tax I paid is “fair”, but it is certainly allowed by the tax code.


With some level of planning, it isn’t impossible to file a 1040 that shows zero tax liability. The four examples highlighted in this article show various taxpayers at different stages of life that manage to dodge the tax man. Three of the example households reduced their tax bill to zero (or near zero in my case) in spite of earning six figure salaries.

How did these taxpayers reach a zero dollar tax bill and how can you do the same?

The reality is clear – careful tax planning can slash your tax bill to almost nothing even if you have a fairly high income.

Minimize your taxes by staying on top of your finances with Personal Capital today.

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photo credit: tolworthy at flickr under creative commons license

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