Reducing tax bracket

[hopefulfirefly]

Please be patient...I'm still learning

It has never occurred to me that I could reduce the tax bracket I'm in by contributing more to my 401K, or otherwise reducing my taxable income. (I've understood that doing so reduces your taxable income but never realized that I should find other ways to do so for the purpose of staying in a lower tax bracket). So, I'm trying to strategically think through this to see if it's possible to get in the 15% bracket.

Dh has made the excel spreadsheet & now we just need to fill it with numbers. What "things" reduce our taxable income & thus dictate our tax bracket? 401K, mortgage interest, 529 contributions....what else? What other data should I be gathering to figure out what my taxable income is & how I can reduce it?

Is it literally dollar for dollar (If I'm contributing 10K into my 401K per year, does that reduce my taxable income by exactly 10K?) in every category?

Also, we have 1 child and we adopted him so we will be able to claim the federal adoption tax credit next year. Does that 'credit' work like a deduction to reduce our taxable income?

What other things should I consider while trying to do this?

[snshijuptr]

The first thing you should understand is that you are already "in" the 15% tax bracket. The way bracketing works is that your first $16,750 of taxable income are taxed at 10% (so $1675) then the next $51,250 (= $68,000 - 16750) is taxed at 15% (so $7,687.5) and so on. By increasing your 401k contributions, you will still see less money NOW, but you are betting that you will not be earning over the 15% bracket when you retire. Many people think that by falling over the bracket line (over $68000 in taxable income) means that you are suddenly taxed 25% on everything.

With that cleared up...

1. 401k contributions do reduce your taxable income dollar for dollar.
2. Deductions also reduce your taxable income. These include mortgage payment, standard deduction, work expenses, etc.
3. Your exemptions also reduce your taxable income.
4. Credits DO NOT reduce your taxable income. They reduce your taxes owed. They rock like that.

The easiest thing to do is look at your 1040 from last year. Line 43 on a regular 1040 is your taxable income. Line 40a and 42 are your deductions and exemptions. Line 36 also reduces your taxable income. the stuff that creates the numbers here are the factors you should consider.

[jIM_Ohio]

Please be patient...I'm still learning

It has never occurred to me that I could reduce the tax bracket I'm in by contributing more to my 401K, or otherwise reducing my taxable income. (I've understood that doing so reduces your taxable income but never realized that I should find other ways to do so for the purpose of staying in a lower tax bracket). So, I'm trying to strategically think through this to see if it's possible to get in the 15% bracket.

Dh has made the excel spreadsheet & now we just need to fill it with numbers. What "things" reduce our taxable income & thus dictate our tax bracket? 401K, mortgage interest, 529 contributions....what else? What other data should I be gathering to figure out what my taxable income is & how I can reduce it?

Is it literally dollar for dollar (If I'm contributing 10K into my 401K per year, does that reduce my taxable income by exactly 10K?) in every category?

Also, we have 1 child and we adopted him so we will be able to claim the federal adoption tax credit next year. Does that 'credit' work like a deduction to reduce our taxable income?

What other things should I consider while trying to do this?

the best tax deductions to lower tax rate are

1) 401k/ deductible IRA contributions
2) HSAs (Health savings accounts)

to a lesser degree the following helps
3) Student loan interest

to an even lesser degree the following helps
4) schedule A deductions such as mortgage interest

529 plans DO NOT reduce FEDERAL income taxes (unless you know something I do not)

The best way to calculate projected tax bracket...

Gross income

minus (sum of all the following)
standard deduction
minus exemptions (one for self, one for spouse, one for each qualifying child)
401k deposits
HSA contributions
student loan interest paid

Reference Room
For example if you know gross income
std deduction for 2010 is 11,400
exemptions are $3650
so a married couple has $11,400+$3650+$3650=$18,700 come off the top
plus any 401k and HSA deductions.

Using link above, goal for a married couple would be to get taxable income UNDER $68,000 (the $68001 dollar is taxed at 25% (the first 68k is taxed at 15% with a small portion of that taxed at 10%).

[kork13]

You should look at the items that can be deducted on the Schedule A. Charitable contributions is an easy one to overlook if you make alot of donations to charity. Non-reimbursed employment expenses (travel/moving, for example), tax preparation fees, and many others. A separate idea, you can be more tax-conscious with your investments -- some bonds are exempt from local/state/federal taxes, and some mutual funds/ETF's are designed around receiving fewer taxable distributions.

If you're really serious about reducing your taxable income, you need to either a) read up and become very familiar with the 1040 and its associated instructions/forms/schedules; or b) hire a CPA to sit down and do some tax planning with you. They often can be hired on an hourly fee, and they'll just work through your tax picture and figure out where you can be more efficient.

[jpg7n16]

Please be patient...I'm still learning

It has never occurred to me that I could reduce the tax bracket I'm in by contributing more to my 401K, or otherwise reducing my taxable income. (I've understood that doing so reduces your taxable income but never realized that I should find other ways to do so for the purpose of staying in a lower tax bracket). So, I'm trying to strategically think through this to see if it's possible to get in the 15% bracket.

How much do you make combined?

Dh has made the excel spreadsheet & now we just need to fill it with numbers. What "things" reduce our taxable income & thus dictate our tax bracket? 401K, mortgage interest, 529 contributions....what else? What other data should I be gathering to figure out what my taxable income is & how I can reduce it?

Oh good lord all sorts of things! here's a list of a umm... few: Tax Credits and Deductions

Kork's suggestion to just read the schedule A is probably good. I had courses on taxation and still don't know them all.


But 529 plan contributions do not lower your current income. They are allowed tax free withdrawals but there are no income tax deductions for contributing to them.

Is it literally dollar for dollar (If I'm contributing 10K into my 401K per year, does that reduce my taxable income by exactly 10K?) in every category?

Sorry what do you mean "every category"??

If your gross income was $100k and you contribute 10k to your 401k, then your Adjusted Gross Income (AGI) would be $90k. Then you start deducting your personal exemptions and other deductions to get to your taxable income. Since some of those deductions are based on a percentage of AGI, it may reduce your taxable income by a little bit more than 10k.

Also, we have 1 child and we adopted him so we will be able to claim the federal adoption tax credit next year. Does that 'credit' work like a deduction to reduce our taxable income?

Umm... not exactly. It's better than that.

Adoption Tax Credit - How to Claim the Adoption Credit

Things that lower your income, lower taxable income. So say your income after all deductions and what-not was $90k. Then you would figure out how much tax that income means you owe. (you pay tax of like $20k or so)

The credit doesn't lower your income dollar for dollar, it lowers your tax bill dollar for dollar.

Credits are awesome.

What other things should I consider while trying to do this?

Filing status (MFJ)
Standard Deduction (11,400) or total of all acceptible itemized deductions (whichever is greater)
Personal and Dependency exemptions (3650 for each of you, unless you are over 65 and/or blind) and $950 for any dependents)


Here's the formula:

Total Income
minus deductions to Gross Income (401k, student interest, HSA contributions, traditional IRA, alimony paid, etc.)
equals Adjusted Gross Income

AGI
minus the greater of: standard deduction -or- the sum of all itemized deductions
minus personal and dependency exemptions
equals taxable income

Then you use the charts to find out the tax owed.

[Slug]

Lots of good advice here. One thing on the 529 plans is that in certain states you CAN write off contributions up to a limit, but this only effects your state taxes, not your federal.

[jIM_Ohio]

How much do you make combined?




Kork's suggestion to just read the schedule A is probably good. I had courses on taxation and still don't know them all.


But 529 plan contributions do not lower your current income. They are allowed tax free withdrawals but there are no income tax deductions for contributing to them.

Two points of clarification

Reading schedule A would be good for deductions, but you will only get 15% or 25% of those expenses back (depends on your tax bracket). Look on front page of 1040- the best deductions are really adjustments to income before AGI is calculated (AGI is calculated before you enter schedule A as schedule A is phased out for high AGI)

401k and HSA and student loan interest are adjustments to income- they are better than schedule A deductions.

Second- 529 plans offer no federal deductions to income. Depending on your STATE you might get a state tax deduction on your contribution.

In Ohio my state tax bracket is 5.5%. That means for every $1000 I put into my kids 529, I save $55 in state taxes. Its not the greatest deduction in the world, but it is something.

[jIM_Ohio]

Please be patient...I'm still learning

It has never occurred to me that I could reduce the tax bracket I'm in by contributing more to my 401K, or otherwise reducing my taxable income. (I've understood that doing so reduces your taxable income but never realized that I should find other ways to do so for the purpose of staying in a lower tax bracket). So, I'm trying to strategically think through this to see if it's possible to get in the 15% bracket.

Dh has made the excel spreadsheet & now we just need to fill it with numbers. What "things" reduce our taxable income & thus dictate our tax bracket? 401K, mortgage interest, 529 contributions....what else? What other data should I be gathering to figure out what my taxable income is & how I can reduce it?

Is it literally dollar for dollar (If I'm contributing 10K into my 401K per year, does that reduce my taxable income by exactly 10K?) in every category?

Also, we have 1 child and we adopted him so we will be able to claim the federal adoption tax credit next year. Does that 'credit' work like a deduction to reduce our taxable income?

What other things should I consider while trying to do this?

Here are the basics of taxes (the really simple basics)

I am doing all this from memory... do your own work or rely on others to correct me if I mis type...

1) you calculate your income
this is first section of any tax form (1040-1040a-1040EZ)
what makes one form different from the other is what types of income you have (for example certain types of income require the 1040, or cannot be put in the EZ)

2) Calculate adjustments to income
these adjustments usually reduce income dollar for dollar (its usually straight subtraction)
examples here are 401k, deductible IRA (traditional IRA deposits which are tax deductible), HSA and student loan interest

**edit to add** 401ks are not actually entered on the tax forms- but it has same effect. If you put money into a 401k it is subtracted from income, and a lower income is reported in step 1, the 401k is not added to tax form in step 2) **end edit**

If income added up to 30,000 and you have $6000 worth of adjustments, your result is $24,000 gets passed on.

When you subtract adjustments from income you get
Adjusted Gross Income

Then if you use the 1040 long form, you move on to a section called deductions

3) Deductions
Most of us use schedule A and those are deductions. Things like mortgage interest and health care expenses and charitable contributions.
Different deductions have different tests- for example there is a 7.5% AGI floor on health care expenses- this means if AGI was $24,000, 7.5% of that is $1800- meaning first $1800 of medical expenses are not deducted, and anything above $1801 is. This means for an income of $30,000 which has an AGI of $24k and health expenses of $1900, only $100 of that is deducted, and you get 15% of that back (because $24k is probably in 15% tax bracket if single). So the $100 deduction on $1900 spent for medical expenses gets you $15 back on tax return.

If your income was $69,000 and you have an AGI of $57,000, then your 7.5% floor is $4275. This means the first $4275 of your medical expenses are on you, and $4276 or higher is deductible, but again you only deduct a percentage (57k is in 15% tax bracket for married, so its 15% of the expenses above $4275).

Mortgage interest is a percentage deduction. If you pay $1000 in mortgage interest, in 15% tax bracket that saves you $150 on your taxes.


Once deductions are calculated, they are subtracted from AGI

This gives you TAXABLE INCOME
this is the income which you are taxed on

4) Taxable income/ Calculate tax
I use this website
Reference Room

It takes the taxable income (which is income minus adjustments minus deductions) and calculates a tiered tax
the first portion of your income is taxed at 10%
if you are married this means first $16750 is taxed at 10%
the next portion is taxed at 15%
if you are married this means any income between $16751 and $68,000 is taxed at 15%
the next portion (if it exists) is taxed at 25%
if you are married this means any income between $68,001 and $137,300 is taxed at 25%

and so on for 28%, 33% and 35% (I believe Obama has increased the 35% rate to 39.5%, but it has not kicked in yet)


Once the tax is calculated, the tax code compares what you owed (your tax liability) to what you paid (what was withheld from paychecks)

5) Once you calculate a tax credits are factored in.
there are 2 ways to do this- refundable credits and non refundable credits

Refundable credits allow your tax to be negative- this means the government owes you money. For example if you have an income of 12k and a tax of $1200 from the table, its possible refundable credits make that $1200 a negative number and says for earning $12k the government OWES you another $800 for working ($1200 tax, $2000 of refundable credits. $1200-$2000=$-800. Political rants aside, hopefully I explained this simple enough. If you paid $1200 in tax this means your refund would be $3200... all $1200 you paid in, plus the $2000 tax credits.

Non refundable credits drive the tax owed to zero, but will not allow tax to go negative.


You should be able to tell which credits are refundable and which ones are not by looking at the back of the 1040 form (where the credits are) and non refundable (I believe) are listed first, then refundable are listed second.

Some tax credits carry over (adoption might be one of them) so if you have an unused non refundable credit one year, you can use it up the next year.


This is the basics- knowing which deductions have floors on schedule A, how dividends and interest (different schedule) and small businesses (different schedule) factor in still follows the above process (income, adjustments, deductions, tax, credits).

[hopefulfirefly]

Jim,

Thank you. That's a very helpful chunk of information to digest. Thank you for taking the time to explain that so clearly!