EITC Guest Post on GoCurryCracker

Tomorrow, you’ll find my EITC-hacking guest post on GoCurryCracker’s website (link). It’s quite an honor to write a guest post on my favorite blogger’s website. Thanks Jeremy!

To the curious CrackerHead arriving to this website, welcome! To me, the great irony of personal finance is that there isn’t really much to say about it. You should be frugal to save money, be smart with taxes, and invest the savings wisely. I summarize these steps here. To me, it’s analogous to giving advice on how to be healthy. Everyone knows that we should sleep more, work out more, eat less ice cream, and eat more kale, yet few of us do this. We fail because working out is difficult, ice cream tastes great, and kale is disgusting. I don’t have the charisma to try to motivate you to do what you know you already should be doing financially, but I can provide some technical expertise to those hoping to be smarter on the tax and investment dimensions. Blogs like Mr. Money Mustache can provide the much needed kick-in-the-pants on the frugality dimension. He’ll convince you that financial kale tastes great.

I post our family’s financial statement every month (balance sheet, income statement, investment allocation), along with whatever random thoughts I had during the month. I’ve been tracking our family’s finances like this since the blog was born a couple of months ago, and I highly recommend it to anyone looking to take control of their finances. It takes me about 5 min/month to update thanks to Mint/Yodlee. There is no better method for understanding how your family’s wealth is generated than by actually programming it into a spreadsheet and seeing the gory details. In my sheet, I track every penny of income (including my employer’s 401k match), payroll withholdings (federal tax, state tax, medicare, social security, and healthcare premiums), and expenditures (including mortgage interest). Further, I show how the savings (net income – total expenditures) are allocated. It’s such a simple concept, but I think it’s incredibly powerful to see in action.

Below is the more technical version of the guest post if you’re interested. In this version, I highlight the importance that everyone know what their effective marginal tax rate is, not just those trying to hack the EITC. I’m being hit with AMT this year (quite the contrast from last year) and am facing an effective marginal tax rate of 45% when combining federal plus state taxes. Hopefully this uncut version of the post can help illustrate the importance of this concept to all those interested in a more detailed understanding of the tax code.

 

=======================================

Greetings CrackerHeads! I’ve spent a considerable amount of time over the past decade trying to understand the U.S. tax code. It seems that readers of GCC’s blog are a perfect target audience to share some lessons learned. I refer to a spreadsheet in this post, which is downloadable here.

 

First, a Brief Bio

By way of introduction, I’m the Frugal Professor. 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.

I spent 5 years studying engineering during undergrad, then 4 years doing engineering in cubicle hell at a Fortune 25 MegaCorp. After a few years of dreading going to work I realized that I had to change my life to avoid ending up like my miserable 65-year-old colleagues who had been doing the same thing their entire lives. So I had a quarter-life crisis, quit work with $100k in the bank during my late 20s, and pursued an MBA followed by a PhD.

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 from the U.S. tax code really sparked an interested 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. The picture below is essentially the three scenarios I ran in TaxCaster. Each scenario has $30k of income and 5 kids (all of which are <= 16 years old). 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. You can verify this scenario yourself in TaxCaster. The reason why is because the Earned Income Tax Credit (ETIC) requires investment income less than $3,400. (More on the EITC to come later in the post).

To say the obvious, I ended up purchasing the minivan by realizing less than $3,400 in capital gains that year.

But it was this experience that caused something inside of me to snap, and thus my obsession with the U.S. tax code was born. Through my ignorance of the tax code, I had almost flushed away $4,239 in free money. Admittedly, this was a very archaic rule that no reasonable person should have known, but it taught me two things. First, it is almost costless to run tax scenarios in TaxCaster. It takes a couple minutes of your time and you can potentially save thousands of dollars in the process. Second, 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 modelling 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 modelling the tax code.

 

First Off, Some Terminology

Your statutory federal marginal tax rate is simply the tax bracket in which your last dollar is earned.

However, your effective federal marginal tax rate is the actual tax rate, after taking into consideration your statutory marginal tax plus phasing ins and outs of all the credits in the tax code (ETIC, CTC, ACTC, AMT, etc). Your effective federal marginal tax rate represents the taxes on the last dollar of income you earn in a year (or conversely, the reduction in taxes by sheltering one more dollar in a 401k).

If you want to understand the actual economics of the tax code, it’s your effective marginal tax rate that matters – not your statutory marginal tax rate. The problem is, there is nowhere in the world to turn to in order to find this elusive number known as the effective marginal tax rate. TurboTax and TaxCaster, for example, only provide you with your statutory marginal rate.

Here’s a simple illustration showing the stark contrast between statutory and effective marginal tax rates for relatively high earners. This is the scenario I ran in TaxCaster: Married filing jointly, 5 kids (all under 17), $0 federal withholdings in either example, $185k in income in left portion of figure, $186k in income in right portion of figure. Note that TaxCaster provides the correct statutory marginal tax rate of 25% in both scenarios. However, we need to perform an additional calculation to determine the effective marginal tax rate on this extra $1,000 of income. It’s calculated as the change in taxes divided by the change in income, or ($27,081-$26,706)/($1,000) = 37.5%. Why is the effective marginal tax rate 12.5% higher than the statutory marginal tax rate of 25%? In this example it’s because of AMT. How much tax savings would a person in this scenario realize by sheltering an extra $1,000 in a 401k? The answer is $375, not $250. This is because it’s the effective marginal tax rate that matters, yet this elusive number which should govern prudent financial decision making is nowhere to be found. The statutory marginal tax rate that TaxCaster (and other software providers) spit out are completely useless numbers. Again, this is where I can help.

 

Earned Income Tax Credit (EITC)

(If you don’t have kids or are a very high earner, skip the EITC sections)

In order to induce low income families to work, the U.S. government introduced the Earned Income Tax Credit (EITC) years ago. 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 because they are facing high effective marginal tax rates, despite low statutory marginal tax rates. Even though one’s statutory marginal tax rate may be 10%, one’s effective marginal tax rate could be 31.06% (10% + 21.06% mentioned above) for low- to moderate-income households 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). As shown, the effective marginal tax rate of 31.06% experienced by a family of 3 kids from $33k-$54k in income is as high of an effective marginal tax rate experienced by the same family until they hit $220,000 in income. The green line is the effective marginal tax rate, which is equivalent to the slope of the tax liability (the blue line).

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 (link). 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 paystub:

  • 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 (link). However, the link clarifies that retirement income as well as investment income does not count as earned income.

 

How I Hacked the EITC Last Year

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… by the way, this is a HUGE tax hack available to many public university employees). As a result, I was able to reduce my taxable income by roughly $40k. In calendar year 2016 my gross income was $80k but I sheltered half of that in retirement accounts, so my taxable income was $40k, resulting in a tax refund of $8k despite the fact that I hadn’t withheld a penny of federal taxes throughout the year. To reiterate, 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.

 

Cliff Notes Version of EITC Hacking:

I used my spreadsheet to determine the optimal EITC incomes for various family sizes. The below table is the summary. I’m assuming married filing jointly for all scenarios. With 4 and 5 kids I have two entries for each. The first is the EITC maximizing point, while the second is another great kink point to be at, to the left of which there is only a 6% effective MTR.  It is this kink-point which I almost hit last year (I would have loved to have hit since there was a 21% effective MTR to the right of this kink point).

 

Frugal Professor that’s neat and dandy but what the hell do I do with this information?

Thanks for asking. The point of my years of obsession is that 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.

The other key takeaway is that the amount of taxes you pay (as well as your effective marginal tax rate) are to a large extent in your control, particularly for low- to moderate-income families. Like I did last year, such households can shelter a huge fraction of their total income.

You can download my spreadsheet here.

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.

 

How does this fit into the GCC wealth accrual method?

If you have been following GCC’s blog carefully, you’ll know that the GCC patented recipe for success is:

  • Be frugal.
  • Defer the crap out of your income while working.
  • Invest any left-over in taxable accounts. Avoid selling these stocks to avoid capital gains while working.
  • Retire early.
  • Then convert 401k to Roths (via a TIRA roll-over) to fund consumption during early retirement (since you can eat the converted principal) or simply convert to exploit the 0% or very low tax rate that you will be in during retirement.
  • Harvest capital gains in the 0% region (i.e. up to the 25% marginal bracket).

GCC chooses what his tax rate is in retirement. Given his Roth conversion strategy, he chooses to pay no taxes. He does so by converting all that he can tax free every year (standard deduction + personal exemptions = $12,650+3*$4,050 = $24,800) without paying a penny of taxes. If he wanted to convert more at the 10% or 15% brackets, he could chose to do so.

Using the GCC method, each $1 of income deferral will reduce today’s tax bill by $1*effective marginal tax without any subsequent increase in tax liability down the road. Why? Because the GCC method eventually converts pre-tax to post-tax money without ever paying a penny in taxes.

In 2017 my effective federal marginal tax rate is 37.5% due to AMT, which when combined with my state income tax, put me close to 45% effective total marginal tax rate. Needless to say, my strategy of sheltering the hell out of my income persists this calendar year as well, though the benefits to doing so are even more pronounced (given my higher effective marginal tax rate this year).

 

Parting Words

If you liked what you saw above, I wrote a high-level overview of the U.S. tax code here. 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.

You’ll also find our path to FI documented on the blog, with all of the gory details (link). Unlike many other bloggers who are already there, I’m still early in the accrual stage.

 

Disclaimer:
This site is for entertainment purposes only, as disclosed here: https://www.frugalprofessor.com/disclaimers/

2 thoughts on “EITC Guest Post on GoCurryCracker

  1. Brilliant post. I look forward to more posts on managing taxes for high earners in the accumulation stage (especially strategies related to the AMT).

    • Scott, great to hear from you. I wish I could save the day with AMT hacks, but AMT is notoriously impossible to exploit. There’s practically nothing you can do to avoid it. I suppose I’ll be tax-loss-harvesting to the amount of $3k/year (saving me roughly $1500/year in taxes). But other than maxing out retirement and jacking up charitable contributions, you and I are stuck. I enjoyed this recent discussion on Bogleheads forum: https://www.bogleheads.org/forum/viewtopic.php?f=2&t=215699. I imagine that this forum has the highest concentration of millionaires than any other forum on the internet. I learn so much every time I hop over to that website.

Leave a Comment