Sometimes we’ve been asked to help friends and family file taxes. While we’re not tax advisors in any sense, we do relish the opportunity to help others learn to do it yourself (DIY) taxes – but only when the tax scenario is simple. Not only does DIY taxes save money upfront, but it also shows you just how the government incentivizes saving.
For this post, we’re using TurboTax Home & Business 2016. In the vast majority of cases, this software is overkill. The IRS itself offers free eFiling for filers with under $64k of income. TurboTax has less pricey versions that might fit your personal situation. And there’s a plethora of other options out there. Shop around.
Let’s look at an example of playing with the numbers.
Joe Teacher-Assistant is just starting out his professional life and made $21k in 2016 as a single filer. Unfortunately, Joe failed to calculate his W4 withholding properly and ended up with a meager $200 sent to the IRS during the 2016 calendar year. Uncle Sam isn’t happy, and Turbo Tax shows his displeasure with a prominent red $938 due. Youch.
Let’s make one small change to Joe’s taxes. Although he doesn’t have much income, he did manage to scrounge $1,200 during the year. Instead of keeping that in checking, he opts to move it into a Roth IRA. Joe has until April 17th, 2017 to make this contribution for the 2016 tax year. His decision to put money into a Roth IRA is wise, because the Roth IRA allows you to withdraw all contributions tax-free at any time for any reason, giving Joe flexibility. In all likelihood, he would be better off paying taxes now, at his low teacher’s assistant rate and withdrawing the compounded balance tax-free in retirement. We’ll dig into Roth vs Traditional in a later post, but for now, let’s assume that Joe is making the right choice.
TurboTax requires a couple more questions before it will recalculate the amount owed. In this case, Joe needs to review the section for “Retirement Savings Contribution Credit,” and TurboTax helpfully marks that section as “Needs review.”
A few easy questions later, Joe’s tax problems just got a little bit better:
OK, so $120 isn’t going to make a huge dent. Joe closes out and goes to sleep. He visits his parents the next day and discusses the dilemma. Joe’s parents are generous, and they tell him they can help him out. They offer to give Joe a full $6,000! But there’s one condition – Joe must max out his IRA. For tax purposes, the money contributed to an IRA must come from earned income, and because Joe earned more than $5,500 during 2016, he can legally and ethically state that the $6,000 gift from his parents went to living expenses and he saved the $5,500 from employment to go to the account. He goes back to TurboTax and updates his numbers.
Instantly, TurboTax has adjusted the amount due down to $738. Joe has $500 leftover from his parents plus $1,200 that he had planned to set aside anyway. We’d advise Joe to pay the remainder of his tax bill out of pocket, but wait, there’s another alternative. Instead of making a Roth IRA contribution (the better choice in the long run), Joe can make a Traditional IRA contribution that will immediately wipe out his tax bill. It’s a short term gain for long term loss, ill-advised, but still much better than doing neither and sending a $938 check to the IRS! Let’s see what happens when we try the alternative option.
VOILA! Look at that vibrant green number. This definitely isn’t the best choice, but it’s not a bad one either. We’d explain that plenty of downsides should dampen Joe’s excitement. Joe’s Traditional IRA contribution will be more difficult and more costly to access should he need the money pre-retirement. Because Joe is so young, his $5,500 could compound at 8% for 35 years and morph into over $80,000! That’s a lot of money to pay tax against, especially if Joe retires at a higher tax bracket. This demonstrates why we would strongly recommend contributing to the Roth IRA in this scenario. Regardless, it’s a wonderful exercise to play with the tax software and see for yourself how saving for retirement can put money in your pocket, not just for your future self, also right here right now.