Empowering Wealth: Let’s Play a Game

Many assume that taxes and retirement are menial labor that can be dealt with at another time. They are confusing; there are a lot of rules and exceptions to those rules. Our tax preparers and HR managers don't even know them all. How are we, regular individuals, supposed to know the nitty gritty details of taxes and retirement plans? But what if our approach to how we view them is incorrect? What if not engaging in retirement planning and tax preparation early on costs us more money than we wish to admit?

We are taught that trivial things make the most significant changes throughout life. Some statistics say that reading 5 pages a day on anything accumulates to up to 5 long books and expands our grasp of any topic, including days of breaks. Spend a few minutes with a desired language; by the end of a year, we speak it broken but understandable. Life is funny and cruel at times. The mundane obligations we neglect build into huge problems or the small habits we partake in that allow us to move mountains. Unfortunately, Taxes and retirement are no different; I want to share in this paper how sacrificing a month a year can drastically increase our current disposable income and build our future wealth.?

Taxes. If there are inevitables in this world, it is that we are born, we die, and we must pay our taxes. In the US and each state, the taxes are set by a progressive tax rate set by arbitrary income brackets. We pay a specific tax rate for every dollar within that income bracket if we make a certain income. Simply put. If we have a progressive tax rate of 2, $0 to $50,000 at 10% and $50,000 to $100,000 at 20%, any dollar we make under $50,000 is taxed at 10%, and any dollar above $50,000 up to $100,000 is taxed at 20%. Thus, the tax paid is the sum of the two separate taxes based on how much we earn; that's how we get effective tax rates. If you are interested in more details, unfortunately, we do not have time to go deeper on this paper; other resources are available, such as IRS.org or a previous article included in this newsletter.

Why does this matter? I believe it matters because we can use our retirement to minimize taxes paid while maximizing how much discretionary income we keep. A quick definition to understand why I will use the phrase "discretionary income" and not money, cash, or income to describe tax returns. Discretionary income is the amount of money an individual or household has left over after paying for necessities, such as housing, food, and transportation (DI = Total Income – Taxes – Necessities).??

We have heard about 401k, Roth, and traditional IRAs but have yet to decide which to pick. This paper will explore the tax-deductible vehicles to maximize our tax returns and discretionary income, including the 401k our jobs offer and the Traditional IRA. Regarding investments, as this is not financial advice but a plan you can take to your CPA, tax preparer, or financial planner, I will not comment on which strategy is better. The goal of this paper is not to convince you to do what I do but to get excited about tax and retirement planning every year. If you do not know which plan best works for you, please see a financial planner, financial advisor, local banker, or CPA.?

Let's look at an example of income. The income I am choosing is entirely arbitrary and only for education. The exact percentages will differ depending on where you live and your local tax jurisdictions.?

Let's assume earnings of 55,000 a year. Total taxes are as follows: considering the US federal tax rates of 2023 and the California tax rates of 2022, State taxes are $2,119.95, and Federal taxes are $6,394.50. There are other taxes of 4,400 (CDI, SSD, etc.,) but we will not address those, only accounting for the loss, as these taxes are not refundable.?

That is a total of $12,914.45. Using our Discretionary Income (DI) formula, DI = $55,000 – 12,914.45 – Necessities. Assuming (0) for easy numbers, DI equals $42,085.55. That is a lot that is taken from our check 12,000 dollars!

So, let's look at how our tax deductible-eligible accounts help us increase our discretionary income. The Traditional IRA has a new contribution limit of $6,500 for most of the population. This first decrease our discretionary income down from $42,085.55 down to 35,585.55. This is a lot, but we will use the max contribution to the Traditional IRA. What does the contribution gain us? First, it forces us to save $6,500 for our retirement. It is a net 0 change to our discretionary, but it is less than we have to spend on necessities or other wanted items. But, by contributing $6,500 to our Traditional IRA, our taxable income drops from $55,000 to 48,500. Unfortunately, the "other" taxes are not affected, but our federal and state taxes are. With a contribution of $6,500, our federal tax liability decreases from $6,394.50 to $5,614.5, and our state taxes reduces from $2,119.95 to $1,729.95. It doesn't seem like a lot. You are locking away $6,500 to get a measly $1,170. But, again, don't think in terms of "how much I have to spend." Think in terms of how much wealth was able to be preserved. You could keep your $6,500 in a retirement account and increase your DI by $1,170. That increases your DI to $43,255.55

Let's try adding to our 401k. And let's match the contribution of only $6,500. This initially drops our available discretionary income from $35,58.55 to $29,085.55. With our initial tax retention of $1,170, we increased our retained taxes to $2,511.56 while putting up to $13,000 into our savings account. Money to spend drops to $29,085.55, but our discretionary income increases to $45,767.11. From the initial tax reduction from $55,000 to $42,085.55, we rose it to $44,597.11.

Let's experiment and contribute your max into your 401k of $16,000. Let's see what happens. You first increase your yearly retirement contributions up to $23,000. Second, your usable cash drops down to $19,085.55. This is very low and not very feasible. But if we can, this drops our pretax income to 32,000 and increases our tax retention from $2,511.56 to $$4,762.54, increasing our discretionary income to $46,848.09.

Every person must plan how much they need every month and how much they can contribute to their retirement to increase tax retention. If you do this ahead of time, you don't have to scramble to get things done; you can do them promptly and with attainable goals. Some can only do 3 thousand and 3 thousand, but any amount decreases your tax expense and increases your discretionary income in the present and future.?

For those who read up here want to know a secret? You don't have to put in your tax forms how much you earn. You can put how much you expect to report as earnable income. What do I mean? You make $55,000. But what if you write down $32,000 as income in our taxes? In terms of breaking a rule, if you make more, you must pay the difference at the end of the year. So why even bother if you have to pay the difference? If you report $32,000 and contribute max to 401k and Traditional IRA, you retain one more tax type, the "other" category (CDI, SSD, etc.). What does this mean? This means your total taxes are $6,602.54, your retentions increase to $6,602.54, and your discretionary income rises to $48.688.09, as you now retain the "other" taxes. This is hinged on your promise to contribute your max. Otherwise, you will be subject to paying those taxes.?