Is it Possible to Reduce Taxable Income for a $0 Tax Bill?
Most people grow accustomed to the big chunk of federal income tax withheld in each paycheck. The more you make, the more the IRS withholds. As a tax specialist at Personal Capital, I often get the question: is it possible to reduce your taxable income to result in a $0 tax bill? Careful tax planning can slash your tax bill to almost nothing even if you have a fairly high income. Here’s how.
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How Much Does the Average American Pay in Taxes?
During the fiscal year 2017, the IRS collected more than $2.4 trillion dollars, processed more that 245 million tax returns, and issued more than 121 million individual income tax refunds totaling almost $437 billion. (source: IRS)
Most of the tax burden fell on the highest income earners. According to the IRS, the top half of taxpayers paid 97% of all individual federal income tax and the top 5% of taxpayers paid 58% of all the taxes in 2016. Taxpayers falling in the lower half of income earners paid only 3% of the total income tax burden despite earning roughly 11.6% 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.
The State of the Tax Code
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 types of income as well as deductions and credits available to taxpayers that plan carefully. Another layer of complexity arises when these deductions and credits phase out as incomes increase. The tax system is so complex for many reasons, from individuals who take advantage of loopholes in the code (prompting the creation of further rules), to government-driven initiatives and incentives. And the sweeping tax code changes that resulted from President Trump’s 2017 Tax Reform and Jobs Act make things even more confusing.
Taking Advantage of Tax Credits and Deductions: Is it Cheating the System?
Are taxpayers that take advantage of many deductions and credits to reduce their taxable income carrying their fair share of the tax burden? Or are they cheating the system by finding tax loopholes to avoid paying their fair-share of 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 with investment income over $100,000 could pay zero tax. Regardless of where you stand on the issues of fairness, it is financially prudent to take any available tax deductions and credits for which you qualify.
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How the Average American Can Reduce Their Taxable Income
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 Single Person, No Children|
|Adjusted Gross Income||$18,000|
|Retirement Savings Contributions C||-$600|
|Total 2019 Tax||$0|
For tax purposes, what started out as a $30,000 salary becomes $18,000 in adjusted gross income after subtracting the $12,000 John contributes to his 401k during the year. For tax year 2019, an individual taxpayer with no dependents will owe $600 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 $600. 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 $19,000. A reduced Saver’s Credit is available to individual taxpayers with adjusted gross incomes up to $31,500.
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 $600, the Saver’s Credit is limited to $600. 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.
John’s tax bill: $0
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.
|Married Couple, 40 Years Old, 2 Kids|
|401k Contributions (x2)||-$38,000|
|Traditional IRA Contributions (x2)||-$12,000|
|Healthcare Flexible Spending Account||-$2,000|
|Child Care Flexible Spending Account|
|Adjusted Gross Income (AGI)||$46,250|
|Childcare Tax Credit||-$2,289|
|Refundable Child Credit||-$1,711|
|Total 2019 Tax Refund||-$1,711|
After taking these deductions from their gross income, their $103,250 combined salaries are reduced to an adjusted gross income of $46,250. A married couple with two children will owe $2,289 income tax on a $46,250 adjusted gross income. The Smiths can take the child tax credit of $4,000 ($2,000 per kid). $2,289 of the credit is a non-refundable credit which offsets the income tax liability and they are also allowed to take $1,711 as a refundable credit.
Their tax credits totaling $2,289 completely offset the tax liability they would otherwise have on their $46,250 adjusted gross income. The Smiths will owe zero tax and receive a refundable tax credit. 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 several tax credits and deductions.
Mr. and Mrs. Smith’s Tax Bill: $0, and total tax refund of $1,711
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.
|Married Couple, 55 Years Old, No Kids|
|401k Contributions (x2)||-$50,000|
|Traditional IRA Contributions (x2)||-$14,000|
|Capital Loss Carryforward|
|Adjusted Gross Income (AGI)||$38,550|
|Retirement Savings Contribution Credit||-$1,455|
|Total 2019 Tax Bill||$0|
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 $6,000 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 $25,000 per year to a 401k and $7,000 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 $64,000 for 2019.
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 $8,000 to his Health Savings Account offered by his employer.
Most families can contribute a maximum of $7,000 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 $8,000. 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.
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 $38,550!
For a married couple with no additional dependents, the tax liability on $38,550 income (after the standard deduction) is $1,455. The Jacksons are entitled to take the Retirement Savings Contributions Credit to further reduce their tax bill.
At an adjusted gross income up to $38,550, 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 owed by the taxpayers, which is $1,455 for the Jacksons. The Jacksons take the $1,455 Retirement Savings Contributions Credit and reduce their tax bill to zero.
The Jackson’s Total Tax Bill: $0
The Miller’s: 30-Something Married Couple, 3 Young Children
The Miller’s, a couple in their 30’s with 3 young children will earn approximately $150,000 in 2019 between salaries and some moderate investment income.
In this table, their gross salaries are shown along with all the deductions from their salary for retirement savings, child care, flexible spending account, and health savings account, health insurance, and dental insurance. After all the deductions, their $141,000 combined gross salaries are reduced to a net of $75,900 (almost a 50% reduction):
|Salaries & Deductions||Husband||Wife|
|Health Savings Account (HSA)||-$7,000||$0|
|Remaining Gross Salaries||$27,900||$48,000|
In this second table, the earned income and investment income is shown along with another series of deductions including the capital losses from tax loss harvesting. Since the Millers have three children, they received $3,927 of child non-refundable tax credits. They also had $300 foreign tax withheld on their investment income, hereby generating a $300 foreign income tax credit. There was also a $2,073 refundable child tax credit.
Additionally, because their taxable income was less than $77,200, the 15% capital gains bracket, their qualified dividends were taxed at zero percent.
In this situation because of both the non-refundable and refundable Child Tax Credit, they were not only able to zero out their tax liability, they received a refund of $2,073. While nobody can argue paying no taxes is “fair”, it is certainly allowed by the tax code.
|2019 Taxes, 30-Something Married Couple, 3 Children|
|Dividends ($6,500 qualified dividends)||$7,500|
|Current year long-term capital gains||$25,000|
|Capital loss carryover|
|Net capital loss||-$25,000|
|Capital loss limitation and carried forward to the next year||$22,000|
|Allowable capital loss for current year|
|IRA Contribution (x2)|
|Adjusted Gross Income||$68,900|
|Child Tax Credit||-$3,927|
|Foreign Income Tax Credit||-$300|
|Refundable Child Tax Credit|
|Total tax credits||-$6,300|
|Total Tax Refund||-$2,073|
|Effective Tax Rate||0%|
|Tax on $6,500 of qualified dividends||$0.00|
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 despite earning six figure salaries.
How did these taxpayers reach a zero dollar tax bill and how can you do the same?
- Contribute significant amounts to retirement savings plans
- Participate in employer sponsored savings accounts for child care and healthcare
- Pay attention to tax credits like the child tax credit and the retirement savings contributions credit
- Tax-loss harvest investments
The reality is clear – careful tax planning can slash your tax bill to almost nothing even if you have a fairly high income.
*Disclaimer: The information and content provided herein is general in nature and is for informational purposes only. All individual tax scenarios and outcomes depicted in this article are hypothetical in nature, and do not represent actual client experiences. This information is not intended and should not be construed as a specific recommendation, or legal, tax or investment advice, or a legal opinion. Individuals should contact their own professional tax advisors or other professional to help answer questions about specific situations or needs prior to taking action based on this information. Tax laws and authorities are subject to change, either prospectively or retroactively, and any subsequent change could have a material impact on your situation. To comply with U.S. Treasury Regulations, in particular IRS Circular 230, we also inform you that, unless expressly stated otherwise, the information contained in this communication is not intended to and cannot be used to avoid IRS penalties, and is provided to support the marketing of our services.
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