TL; DR: This is the fourth in a series of posts for Colorado teachers that looks at the tax code and discusses how you can optimize your financial decisions to take advantage of it. Hint: most people don’t take full advantage of the tax code.
Part 1 in this series describes the “what” and the “why” of Financial Independence. Part 2 discusses the process of “how.” Part 3 looked at the possible “what its” and “yeah, buts” objections to accomplishing FI. This post builds on part 2 and discusses how knowing the rules around taxes can allow you to optimize your finances and help you achieve Financial Independence.
Taxes are an interesting thing. Most folks will begrudgingly admit that they are necessary, but then often go on to complain about how much they have to pay or how unfair the system is for X reason. While there are certainly good arguments that can be made about the fairness of the system and how it could be improved, there are also ways that you can make decisions to address how much taxes you pay. To be clear, this is not cheating on your taxes, this is simply knowing the rules and making decisions to take advantage of those rules. If people would take the time to learn the rules and then adjust their decisions, they might not complain about how much they pay (or, more realistically, complain a bit less).
I am not a tax expert, nor can we go in-depth on all the various aspects of the tax code in this post. But there is some pretty basic information that you can use to your advantage, and some specific aspects that apply just to teachers, both of which you can use to optimize your finances. Spending just a little bit of time learning about the rules and then adjusting your decisions can have a big impact over time.
First, a quick reminder about how Federal taxes work (very simplified, but helpful for our purposes). You have a certain amount of income, some of it earned (your paycheck) and some of it is not (interest, dividends, capital gains, etc.). Some of that earned income you can “shelter” from taxes by investing in tax-deferred accounts, and some if it is automatically sheltered from taxes (your PERA contribution, your insurance premiums if you choose to take them pre-tax, your HSA contributions if you have them, dependent care expenses, etc.).
You then have some deductions to your income which, for the vast majority of taxpayers now, is going to be the standard deduction, with a few other deductions that might apply (for example, teachers also have the $250 teacher expenses deduction they can take).
You then end up with your taxable income, which is taxed using a progressive tax rate (that is adjusted for inflation each year), which means some of your taxable income is taxed at one rate, some of it at another, and perhaps some of it at yet other rates if you have a large taxable income. (Note that some of your unearned income, like qualified dividends and long-term capital gains are treated differently. This is important and we’ll talk about this eventually.) For example, in 2019 for a married couple, the first $19,400 in taxable income is taxed at 10% and any amount over $19,400 and up to $78,950 is then taxed at 12%. If you have taxable income above $78,950 but below $168,400, it gets taxed at 22% (and it continues above that, but most teachers won’t need to worry about that).
Many folks don’t completely understand how this progressive system works and think that all of their taxable income is taxed at whatever tax bracket they are currently in, which can lead not only to misunderstandings about tax policy, but sometimes some poor decisions around your taxes. For example, if your taxable income is $75,000, then the tax you would owe would be $8,612, which is an effective tax rate of 11.48%, not the 12% that many people think that $75,000 would be taxed at. ($19,400 at 10% is $1,940, the remaining $55,600 to get us up to $75,000 is taxed at 12%, which is $6,672 in taxes, for a total of $8,612.)
But it gets even better, because many people don’t actually owe that amount because they also get tax credits. Tax credits are different than tax deductions. Tax deductions get subtracted from your income to then determine your taxable income, but tax credits are dollar-for-dollar offsets to the tax you owe. The most common one for many people is the child tax credit, which is currently $2,000 per child (with up to $1,400 of that refundable). So, for the example above, if they had one child they would owe $6,612 in taxes, not $8,612. There are many other tax credits that could apply, so it’s important to investigate those based on your situation.
State taxes in Colorado are much simpler, as they take your federal taxable income, perhaps make a few adjustments, and then calculate your state tax at a flat (not progressive) rate of 4.63%. This means that all the ways you can lower your federal taxable income (deductions, tax-sheltering, etc.) also lowers your Colorado state tax owed, and then there are a few Colorado-specific tax credits you might be able to utilize (one of the most common is contributions to the Colorado 529 college savings plan are exempt from Colorado state taxes). Also, a quick plug (pun intended) for the Colorado Alternate Fuel Tax Credit, which is a $5,000 tax credit for an electric vehicle (and that’s refundable), which means if you have at least $7,500 in federal tax liability, then you can take a whopping $12,500 in total tax credits if you buy an electric vehicle (subject to phase out limits – Tesla and soon Chevrolet will begin ratcheting down).
Sorry if that was more (or less) than you needed, but we needed to set the stage for the next part of our discussion, which is about how best to take advantage of those rules on your path to financial independence. We’re going to focus on four areas: tax-sheltered accounts, Section 125 deductions, HSA contributions, and possibly optimizing to get the Savers Tax Credit.
Tax-sheltered accounts come in two main variants – pre-tax and post-tax. Pre-tax accounts are things like 401k/403b/457/Regular IRA accounts, where the money you contribute does not get taxed in the current year, but then gets taxed when you withdraw it during retirement (hopefully). Post-tax are the Roth variants of those, where the money you contribute is post-tax, meaning you do pay taxes on that money in the current year, but then any investment earnings you receive do not get taxed, so when you withdraw during retirement there is no tax liability.
For many folks, particularly if you are on the road to Financial Independence and will be considering retiring (work optional phase) early, the pre-tax accounts are the ones you want to focus on. (This post will not be able to go in-depth on why this is probably preferable to using Roths, but there are many resources on the web that discuss this.) This lowers your taxable income (both Federal and State, and often keeps you in the lower tax brackets), allows your investments to grow tax free, and sometimes helps you qualify for the Savers Tax Credit (more on that in a minute).
Every public school teacher in Colorado has access to PERA’s 401k plan (which is a good one). Most teachers then also have access to a 403b and a 457 plan. The 403b is going to be through a vendor other than PERA, but the 457 could be through PERA or that other vendor. Having access to that 457 is a huge advantage for teachers (and most public employees), because it not only allows you to shelter additional money, but also allows you to access that money when you are younger with no penalties (which is huge if you are planning on retiring/work optional at a younger age). (If your district does not offer you a 457 plan, talk to your Human Resources department ASAP. Even if they don’t want to deal with an outside vendor, setting it up with PERA is very easy for your district to do since they already are setup for the 401k.)
In 2019 you can contribute up to $19,000 to your 401k or your 403b – the limit applies to the combined amounts you can put into one or both of those accounts. (If you are over 50 you can contribute an additional $6,000, so up to $25,000). Note that this is per person, so if you are married your spouse can also contribute up to $19,000 (or $25,000 if over 50). But an important point to understand, particularly as your income increases as you grow older, is that you can also contribute up to $19,000 (or $25,000 if over 50) to your 457 plan. That’s in addition to the 401k/403b contribution. Essentially, public employees have double the amount they are able to shelter. (And, in fact, the 457 plan even has an additional “last-three-years” catch-up provision that can effectively allow you to contribute twice as much – $38,000 currently – each year for the last three years you are with with that employer.)
And the 457 is even better than the 401k/403b, because it’s considered “deferred compensation”, which means that you can access that money as soon as you leave that employer. This is different than a 401k/403b, where if you access the money before age 59.5 you may have to pay a penalty. (Note, there are ways to access a 401k/403b before age 59.5 without a penalty, but a 457 is so much easier if you have that option.) This means that if you do achieve Financial Independence and enter the “work optional” stage by quitting your teaching job, you can immediately access any money in your 457 to use as living expenses, even if you are way short of 59.5.
When we get to the case study posts (starting with part 5), we will go more in-depth on how to use this in the best possible way, but here are the two most important points to remember:
- Invest as much as you can in your 457 plan and increase it every year until you max it out.
- Once you max out the 457, invest as much additional as you can in the 401k/403b.
Many folks look at that and say, “That’s great, but I need money to live on.” That is certainly true, but keep in mind that since these contributions are coming out pre-tax, they don’t actually reduce your net pay by your total contribution. For example, if you contribute $19,000 in a year to your 457, and you normally would be in the 22% federal tax bracket (plus 4.63% Colorado tax bracket), your net pay “only” decreases by $13,940. Now, that’s still a fair amount of money, but it’s a lot less than $19,000. (And, as we’ll see, it might actually be even less than that if you can qualify for the Savers Tax Credit). As you’ll see in the case studies, if you can rein in your lifestyle expenses, most folks can actually save more than they think.
The second area to be aware of is Section 125 Plans. This refers to the part of the tax code that allows you to receive part of your income pre-tax if it is used for particular expenses. The added benefit for teachers is that it comes out pre-PERA contribution (although that will be changing for new hires hired after July 1, 2019). What are these particular expenses? They include insurance premiums (health, dental, vision, etc.), dependent care expenses (child care), and flexible spending account contributions (unless you have a high-deductible health plan, which we’ll discuss below).
All of these end up being expenses you can pay with pre-tax dollars (and pre-PERA dollars for current PERA employees), which can save you a significant amount of money. Again, if you were going to be in the 22% federal tax bracket, plus the 4.63% Colorado tax, you would save 26.63% of the total you spend on these areas. Plus, if you’re a PERA employee hired before July 1, 2019, you save an additional 8% on your PERA contribution (and that will be increasing over the next few years to at least 10% as part of the legislation passed in 2018). (Note that if it is coming out pre-PERA, you want to stop doing this in your last 3-5 years of employment in order to maximize your Highest Average Salary calculation. The amount you “lose” in tax savings during those years is more than made up for in pension income over time.)
If you have access to a High Deductible Health Plan (and most teachers do), then you also have the ability to contribute to a Health Savings Account (HSA). Employers also often kick in a small amount to your HSA in order to encourage you to sign up for the plan. Your contributions do not come out pre-PERA, but they do come out pre-tax and pre-FICA. HSA’s are known as “triple-tax-advantaged” accounts, because they are the only accounts that allow you to contribute pre-tax, earn pre-tax, and withdraw pre-tax. Basically, you never pay tax on this money (as long as you use it for medical expenses). And unlike an FSA, you don’t have to “use it or lose it” each year, can can carry over any balance for as long as you want.
You also have the option to invest this money, which can help it grow even more. From an FI perspective, this is an amazing account, especially if you can afford to not withdraw any money for medical expenses along the way and just let it grow tax free. As long as you save your receipts, you can always withdraw the money in the future when you need it, or you’ll likely have future medical expenses anyway. If you never have medical expenses (unlikely, but it could happen), then you can still withdraw it after age 65 and simply pay taxes on the withdrawals (but no penalty).
If you do have a High Deductible Plan, you can’t also contribute to an FSA (the HSA takes its place). But many district will have a Limited Purpose FSA that you can contribute to, and that money can be used for dental and vision expenses, but not health expenses. While this is “use it or lose it”, if you can estimate your out-of-pocket dental and vision expenses for the year, this is an extra tax strategy you should take advantage of.
Finally, as promised, we’ll talk about the Savers Tax Credit. In order to encourage folks to save for retirement, the Federal Tax code will actually give you money to help save, as long as your income is below a certain threshold. Because all of the previously discussed items (401k/403b/457/HSA/FSA/Section 125 plans) reduce your income threshold, if you can take advantage of enough of them you might also qualify for at least some of the Savers Credit. For example, in 2019 if you’re married and your adjusted gross income is below $64,000, you can claim 10% of your contributions to 401k/403b/457 plans as a tax credit, up to a total of $4,000. So, in our previous example where we discussed that contributing $19,000 to your 401k only reduced your net pay by $13,940, it may actually only reduce your net pay by $12,040, because you might get $1,900 from the Savers Tax Credit (assuming your income is adjusted gross income is low enough to qualify for the 10% Savers Credit). For many teachers, this is possible in your first few years of teaching, as you’ll see in the case studies posts.
There are more tax strategies we could consider, and we certainly will when we discuss the withdrawal stage of Financial Independence, but this gives you the overall approach. By understanding the tax rules and adjusting some of your decisions based on them, most folks can actually save (and invest) much more than they thought. While you can still complain about your taxes, you’ll have actively made some moves to reduce what those taxes were, which will help you on your path to Financial Independence.
- Part 1: The Concept
- Part 2: The Process
- Part 3: The “What Ifs?” and the “Yeah, Buts”
- Part 5: Case Study: Teacher Married to Another Teacher
- Part 6: Case Study: Teacher Married to a Non-Teacher
- Part 7: Single Teacher