One of the most significant tax changes enacted recently and also one that received very little media attention was the turbo charging of 529 College Savings Accounts.
If you weren’t using one before, you definitely need to start now if you have kids!
In the Olden Days
529 plans allowed parents, grandparents, uncles, aunts, etc… to invest money in stocks, bonds, or money markets and then pull that money out to pay for college expenses without paying taxes on the investment gains. If that weren’t sweet enough of a deal, most states won’t charge their income tax rate on any contributions. Essentially, you win on both the front end and back end. You get a tax break on the state level by putting money in and shielding it from state taxation AND you get a win on the backside by pulling money out and not getting a tax bill from Uncle Federal Sam on the 100-300% appreciation that you’ve likely made ($100 invested for 18 years compounded @ 6% yearly growth would be worth $285.43).
Now, you can pull the money out of a 529 to pay for K-12 private school tuition. This is YUUGEE. As an example, let’s consider a family of four living in the great state of Illinois.
Illinois income tax rate is a flat 4.95%. For this hypothetical, let’s pretend that private school tuition is $6,500 year per pupil. That would be 2 kids x 13 x $6,500 = $169,000 in tuition payments.
But if the parents were savvy, they would use a 529 plan to shield money from state taxes. They could be risk averse and simply choose a stable money market fund that won’t sway with the broader stock market, in which case they’d simply contribute money every year and withdraw it as needed to save 4.95% on tuition. $8,365 saved!
Obviously, the higher the state’s income tax the more beneficial this becomes. There is a cap of $10,000 a year of withdrawals for K-12 expenses so it cannot be over abused.
It would probably be a good idea to open two 529 accounts per child. One for K-12 expenses and another for post secondary education expenses.
More Reading… http://www.savingforcollege.com/articles/coming-soon-big-changes-to-529-plans
I am a bit disappointed in the results, Shae is more positive, and we both feel that the investment is in a much better position now than when we originally bought.
There were two deciding factors in the lackluster first year performance.
1. Large Periods of Vacancies
Vacancies kill your cashflow. The building has 4 units, so there are 48 rent checks to collect in a year. Sounds easy right?! We collected 34/48. At an average rental rate of $560, the uncollected rent due to either vacancy or squatters cost us $7,840 in lost revenues.
While the late, but paid with late fee might seem like a nice bonus to the bottom line, the amount of stress induced comes no where close to the monetary benefit of collecting an additional late fee (usually in the range of $25-50). In almost all cases, a late payment preceded a no payment and no payment means eviction.
Which brings me to the next bit. We had such high vacancies because we turned over 3/4 units. Two of those tenants we asked/insisted that they leave after they failed to pay and had fallen behind so far that it would take a miracle to catch up. Believe me, I take no satisfaction in kicking out a tenant. It is a major headache. You have to serve notice, usually to someone who is angry, then make sure that you have a copy of that notice notarized so the courts won’t throw your case out, then you have to hope that it doesn’t go to court and incur more expenses. It all takes time. Lots and lots of time where you are wondering if your place is getting trashed and destroyed. The onus to play by the legal rules is squarely on the landlord.
Could this have been avoided? Yes, Yes, and YES! I fully blame the previous property manager for not doing proper screening of tenants before signing leases. We have a very simple screening process, tools, and minimum requirements. It takes maybe an hour or two to go through the entire process of checking credit history, searching for past evictions, doing background checks, and verifying employment income. If a prospective tenant has a past eviction (or two or three as might be the case), DO NOT RENT TO THEM. If a prospective tenant has a crap credit score, and I am talking about well below 600, DO NOT RENT TO THEM. This is not rocket science folks. A teensy bit of work upfront can save you mountains of headache later.
While I make it sound like all doom and gloom, we did have one tenant leave of their own accord. They did everything right and we were sad to see them go. So being a landlord isn’t all horror stories.
2. Expensive Capital Improvements
We spent around $12,000 in capital improvements and repairs in the past twelve months. Some of that we had planned for and were expecting when we bought the building, such as the $1500 back stairs replacement and the $600 in vinyl repair work. Other expenditures caught us off guard like the $900 chain link fence we erected to slow down the flow of trespassers using our property as a shortcut and the $3,200 furnace/AC replacement that we thought we could kick down the road a few more years.
Each of those three apartment turnovers cost us approximately $2,000. It wasn’t that we did anything terribly fancy renovation wise, they were just so run down and beaten up that in order to attract a decent tenant we had to spend a large amount of money just to get them presentable. We’ve laid about 1500 sqft of click lock laminate flooring, spread about 20 gallons of paint, and hung up more mini blinds and closet doors than I’d care to thing about.
Slowing down the turnovers were the long overdue maintenance items that needed to be addressed in different apartments, such as leaky washer outlet boxes, dryer vents that terminated in bad places, and ancient garbage disposals that needed to come out.
I anticipate that moving forward, apartment turnovers will require a fraction of the labor and money because we have ‘a’ screening process in place and many of the longstanding defects have been corrected.
A few more numbers and observations to put a wrap on this roundup. The tenants paid off about $2,000 worth of equity by making mortgage payments for us. That 2k is factored into our $0 profit/loss for the first twelve months, so really we are at about -$2,000 liquidity. In the next 12 months, the amount of equity earned will accelerate to $2,300. Hurray for a fixed rate mortgage! We managed to increase monthly rental income for the building entirety by at least $95. That translates to an additional $1,140/year in revenue. In capital improvements, we still have 3 x $3,200 HVAC replacements lurking in the woods. We’ll take care of those as they become issues. We also have about $2,500 in concrete work that needs to be done probably in 2018. I put in the paperwork to appeal the property tax assessment value. If things go my way, and I am confident that they will, our 2019 (and onwards) property tax payment will be almost $500 less.
As a short term investment, real estate sucks. We could have easily done better by sticking to index funds.
Tis the season to file tax returns for 2016. This is the first year we paid someone else to do it.
Taxes are the largest financial burden that you will shoulder throughout your life, even more so than buying a house or car. You get the same amount of government services as your neighbor does regardless of who pays more, so I am in the firm mindset of paying as little as legally possible.
My tax idol is the Root Of Good blogger. He had a great write up a couple of years ago about paying $150 of income tax on a $150,000 income. I’ve linked to it before, but here it is again because it is a must read for anyone looking to downsize their tax burden.
2016 was the first year that we were able to ‘max out’ all of our tax sheltered retirement accounts. I ran the numbers and thanks to that saver mindset we managed to avoid an enormous tax bill.
So how exactly did we do it?
Let’s run through the approximate numbers. Our combined gross income from day jobs was about $133,000. Shae contributed the employee maximum ($18,000) to her 401k plan. I also contributed the maximum to my employee 401k plan. As an added perk to being self employed, I also get to put on the hat of the employer and contributed another $8,000 to my 401k plan.
Shae has good benefits, and one of those is a flexible spending account for dependent care. She was able to tuck away $5,000 into that account tax free. Health and dental insurance also come out of the paycheck before taxes are applied, so that was another $3,100 and $350 respectively.
With all of those pre-tax deductions in place, our taxable salaries shrunk down to $80,550. From there, we have to start adding back some side income. We made $1600 of taxable interest by churning bank account bonuses. Our brokerage account kicked off $800 worth of dividends from VTSAX (Vanguard Total Stock Market Mutual Fund). $750 of those are qualified dividends and depending on your income level don’t get taxed. We also had rental income for the first time thanks to the addition of our first apartment building. We only owned it for 2.5 months in 2016, so it is just a glimpse. While on paper the $150 profit seems paltry, that comes after the magic of depreciation write offs. We were able to write off around $900 worth of depreciation for the building because in the eyes of the IRS, all buildings will be worth exactly $0 in 27.5 years. The secondary ‘hidden’ profit that has not been realized yet is the $400 of mortgage principal that was paid off in 2016.
Rounding out the additions and subtractions, we had $2300 in long term capital gains from selling off a chunk of our VTSAX investment to put a down payment on the apartment building. Like qualified dividends, if you can stay in the 15% tax bracket, you don’t have to pay taxes on LTCGs. We also fully funded each of our IRA accounts, so that is another $5500 x 2. Finally, I was able to deduct a portion of my self employment tax. It sounds like a sweet deal, but self employed people still get royally screwed in taxes. Normally you as the employee pay half of your Medicare and Social Security taxes and your employer pays the other half. Self employed folks get to wear both hats and foot both bills so this deduction is a little way to partially offset that.
In the end we finally get to the Adjusted Gross Income, AGI, of about $71,400.
From there, we get to deduct the Standard Deduction and 3 Personal Exemptions. With the addition of Frugal Girl in 2017 we should pay even less next year!
Taxable income comes in at $45,900 and the tax is about $5,600. We get one last hurrah before the cash register dings and that is in the form of a $1,000 child tax credit. Apparently the government wants us to have kids.
There you have it, $4,600 of income taxes on $133,000 gross income.
Now, the important question and why I bother getting onto this soapbox to ramble on about tax sheltering your hard earned money – How much would we have had to pay in taxes if we didn’t contribute to 401ks, IRAs, and Dependent Care accounts? Let’s run the numbers again with those key differences highlighted.
The gross salaries stay the same, but now the 401k’s and dependent care go unfunded. We really enjoy that big fat paycheck, but it isn’t as rosy as it may seem. The tax man cometh.
In the hypothetical, we also ignore setting up and contributing to IRAs. Our adjusted gross income has ballooned from $71,400 to $131,400. This is bad. We just moved from the nirvana 15% tax bracket where Uncle Sam is willing to give us a break to the 25% bracket where we need to ‘pay our share’. Suddenly qualified dividends and long term capital gains are now taxable. Working down the numbers we eventually come to the conclusion that the unsheltered strategy leaves us with a tax bill of $21,700. By using tax advantaged accounts, we saved $17,100 in federal income taxes. The effective tax rate jumps from 3.5% to 16%. OUCH!
It is practically a “max out one 401k and get one free” kind of deal. BOGOs on retirement plans. I’ll take 7 please!
Even with our usage of tax sheltered accounts we still paid boatloads in Social Security and Medicare taxes. At least with those you’ll likely see anywhere from 60-80% of it returned to you unless you die early. I also like to pretend that those payments go directly to our parents. It makes it a little easier to stomach when you think it is going to someone you know.
It took us years of concentrated effort to get to the point of maxing out retirement accounts, so don’t get discouraged if it seems a long way off or impossible. Even contributing an extra 1 or 2% of your paycheck is a big help and often times the easiest way to ramp up is to tuck away any bonus or promotion money.
Anyway, I just wanted to show a real life example of the power of putting away money into tax advantaged retirement accounts. We made a lot of mistakes on our way here and there is still a lot for us to learn. I hope it is useful for someone and if you have any tax tips that I should have mentioned please leave a comment!
This morning, Shae and I opened a kid’s savings account for Frugal Boy. We were able to do the entire process online in about 10 minutes including the initial funding requirement of $25. Later on, when the bank was open, Grandpa and I took Frugal Boy to a brick and mortar branch to deposit his very full doggy and piggy bank.
He looked ready to ride his money all the way to the bank.
The grand total of his little banks was $41.10. Thankfully, he was not sad about emptying out his little banks. In fact, he was kind of the opposite. When we got back to the house, he went up to Grandma and asked her for more money to fill up his now empty banks. Umm, we still have a lot of parenting work ahead of us.
In the future, any cash gifts Frugal Boy receives will go into his savings account. Any checks will continue to go into his 529 College Fund unless otherwise requested. In another year or two when he better understands the concept of money, we will probably switch all of his gifts towards his savings account.
Thank you to everyone that has gifted Frugal Boy with money over the years. We are trying to teach him how to be frugal and know the value of a dollar.
One interesting thought experiment when planning for retirement is thinking about your coast number. What is a coast number you ask?
Let’s take an imaginary man, Frank, for our little thought experiment. Frank is diligently saving 20% of his income into a 401K or IRA that is mostly invested in equities. For arguments sake, the retirement vehicle will produce 7% returns every year. Frank wants to retire at the age of 65, when he can pull social security benefits. If Frank front loads his retirement savings, there may come a threshold when he can stop saving 20% of his income because the investments will grow enough on their own to secure his retirement at age 65.
That threshold, is what I am calling the Coast number.
To calculate the coast number, we need 3 inputs. We need to know or guesstimate the Rate of Return that the investment vehicle will kick off every year. We need to know the goal amount to be saved and we need to know how much is currently saved towards the goal.
The continuous compounding formula is A = Pert where A is the goal amount, P is the starting amount, r is the rate of return, and t is the time it takes to get there.
Say Frank wants $25,000 a year from just his retirement savings after he turns 65. According to the 4% safe withdrawal rule, he would need a total amount of $625,000 in retirement savings to do that. If he has already saved $75,000 then we can calculate his coast number.
(1/r) * ln(A/P) = t
(1/.07) * ln (625000/75000) = t
Subtract 30.29 years from his planned retirement age of 65 and we can see that he can stop contributing to his retirement accounts and coast on the savings a little before his 35th birthday.
Of course, for the majority of the population, the coast number would be somewhere in our past. The whole point of this exercise is to see if you front loaded your retirement savings to take advantage of compounding interest, when could you theoretically stop saving for retirement.
You can use the calculator below for your own hypotheticals. They don’t have to be retirement related. Perhaps you are saving up for a house down payment or other large expenditure.