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Prioritizing Tax Benefits

Two kinds of clients scare me most. The first ask me as they pick up their tax return what they can do to lower their tax bill. The other requires a pry bar to get complete information out of them during the year.

Each of these clients scares me because I can’t give them a good answer. The first client is really asking what they could have done better last year when the answer makes no difference and the second client gives me reasonably accurate information (if I’m lucky) meaning my advice is only “reasonably” accurate.

The worst part is some tax breaks aren’t gentle phase-outs, but cliffs. One additional dollar of income can cost $500 of tax savings! Clients receiving the healthcare credit face several cliffs as their income crosses mile markers of the federal poverty level (100%, 200%, 300% and 400%). A small amount of additional income can result is a significant reduction in the credit causing a seriously higher tax bill.

Compounding the problem is where you take a deduction. A good example here is Health Savings Account contributions. You can pay the money yourself and take a deduction on Page 1 of Form 1040 or have your employer withhold from your paycheck and deposit the funds. The second way is usually better.

HSA contributions are an adjustment to gross income when you make the contribution yourself. When handled through a payroll deduction it reduces the W-2 and hence, total income. The further up the page a deduction is taken, the better. As you move down Form 1040 options for certain credits and deductions are reduced.

Prioritizing Your Tax Planning

Money is limited so you have to pick and choose which tax benefits to focus on. We will use a hypothetical client named Fawn to illustrate how prioritizing tax options can yield massive results.

Fawn is a single mother with a son approaching the age of majority. She works full-time and earns in the low to mid 30’s with overtime.

Fawn has several issues to consider. We will assume healthcare is covered at work or she doesn’t have a health plan from the site. We do this to simplify our illustration and to focus on three potential tax planning options: Earned Income Credit, Saver’s Credit and the Student Loan Interest Deduction.

HSA contributions can affect different areas of the return.

The Earned Income Credit is on a sliding scale. It starts low, maxes out around $10,000 to $20,000 (depending on how many children you have), and hovers around this maximum plateau for a while before starting a slow decline as income climbs. Fawn’s EIC is slightly under $1,000.

Earning more money will reduce her credit. But, there is a way to earn more and still get a larger EIC. If Fawn has a retirement plan at work she can divert money to this fund so it never shows up on her personal tax return. An HSA run through payroll will have a similar effect.

EIC is generally calculated off Adjusted Gross Income (AGI) and earned income with some modifications. We will not go into all the possible issues affects Fawn’s return. What I want to make clear is the advantages of reducing income on certain areas of the tax return without giving up income. In short, I want you to have your cake and eat it too.

Choices are almost always available to reduce taxes and increase a refund if plan in advance. We can pick this apart deeper, but today’s point is concept. I want you to understand a simple concept. You don’t have to earn less to avoid the loss of credits.

When higher income increases taxes due and reduces or eliminates credits at a rate near or greater than your additional income it makes sense to stop earning unless you can break through to the next level where income goes up while taxes are muted. Or you follow my plan.

Bringing Together Disparate Pieces

Every action can have multiple effects! Diverting more money into a 401(k) can do more than just reduce your reported income on the W-2. Lower income means lower tax. It also means you might qualify for a Saver’s Credit! Think of that for a moment. The very act of saving might actually reduce your income enough to qualify you for a Saver’s Credit. Isn’t the tax code great!

There is still one more problem Fawn can’t figure out how to solve. She has student loans that just came out of deferment. The payments are small and will all go to interest for a while.

The new tax law working through Congress might eliminate the student loan interest deduction after this year so she wants to pay at least $2,500 to max out this year’s deduction. Unfortunately, all this retirement saving to maximize the EIC and Saver’s Credit has reduced her take-home pay to the minimum level she needs to cover basic bills.

The student loan interest deduction might also reduce state income taxes. This is an important deduction and since it might go away, Fawn wants to max out the benefit this year.

She can’t reduce her income more without keeping food on the table. Here is where tax planning leaves the comfort of Form 1040 and heads for the real world. Fawn needs $2,500 to pay at least the full amount of the interest deduction. (Remember, all payments will go to interest first and she has at least $2,500 of accumulated interest.)

Since Fawn started making token payments earlier in the year (let’s say $500) she has some of the deduction covered already. It would probably make sense to borrow money short-term to max out the student loan deduction. Her top dollar will probably be in the 15% tax bracket so the student loan deduction will benefit her $300 if she can come up with the remaining $2,000 to maximize the deduction.

Credit card is probably a bad idea here, but a car loan or help from family or a friend makes sense. Fawn could also approach her employer and ask him for a loan. If she explained her situation nicely, the employer might buy into the idea since it helps a valued member of his team and really costs him nothing more than a temporary loss of use of a small amount of money.

The Good Game

Gaming the system is one of America’s great pastimes. It can be very rewarding as long as you keep it legal.

The above example has plenty of holes and I took some liberty with the facts. I was careful not to get hung up on exact numbers. No matter what numbers I use, your situation will be somewhat different. I understand increasing her 401(k) investment helps the Saver’s Credit limits. It might also increase the credit from10% to 20% (or more) of the first $2,000. The student loan interest deduction could improve situations all around the tax return.

The point today is to look at your tax situation and examine it for un- or under-utilized deductions and credits and then start thinking outside the box.

There are many opportunities to manipulate your tax results legally! Adjusting your 401(k) contributions higher doesn’t reduce your take-home pay as much as the additional contribution due to lower taxes and potentially higher credits.

Normal people can do this; not just the self-employed or rich! HSA and 401(k) contributions are not a drain on the budget; they are necessary parts of a vibrant financial plan.

I focused on lower income earners this post. I get plenty of complaints I spend too much time on ideas reducing taxes for the self-employed and high incomers. Every income category has opportunities.

Whether you are a good client or one who wants to know how the past could have been better or only coughs up all the information needed during tax season, you can plan with purpose.

Fawn is not a hypothetical client (though her name was changed to protect the guilty); she is a living, breathing human being I’ve helped for a few years now. I modified her factset slightly for this post and because she reads this blog and is sure to remind me when she gets around to reading this post.

We ran the numbers and it paid to borrow money to take advantage of the student loan interest deduction. She can pay the loan in full (which her awesome employer did lend to her) by April 1st. Her increased refund will kill most of the loan.

The best part is she keeps the money, the added tax savings, no matter what happens in the future.

And if we get a new tax code we get to play the game with a few different rules. So hand me the dice; it’s my turn to roll.


Thursday 14th of December 2017

Here's a quick (relatively) high income screw up from 2012. I'm going to ballpark the story so you have even numbers to consider.

I'm self employed, and in 2011 I set up an SEP to start saving 25% of my income (~50K max). 2012 was my first to break 200K, and I made around 250K or so. I did not manage my savings properly and long story short, put NOTHING into my SEP in 2012. My CPA asked if I was going to fund my SEP, and I told him I simply didn't have the money. What I didn't consider was HOW MUCH I was was giving the government so I could NOT SAVE money. It was really dumb, and in hindsight, I would have been better to borrow the money, than to pay 33% tax at the top end for not saving (that "last" 50K of income is taxed at highest rate since it's not deducted for saving it).

I had to pay an extra $15,000 in taxes, which gave me a net benefit of only $35,000 on the 50K (and it gets much worse). Because I process credit cards with PayPal, they have a pretty sweet loan deal where they pull a percentage out of sales for loan paybacks, but the interest is low/fair (like 4%). I could have gotten a 50K loan to fund my SEP! 4% is WAY LESS than 33%. That would have been MUCH SMARTER than paying the 15K in taxes. And I don't have to tell you that funding 50K in the stock market in 2012 would have DOUBLED by now in 2017. So I could have paid $2000 (4% on 50K) to make/save $100,000. Instead I paid $15K and lost another 85K. And further life long math say over the next 20 years, that "lost" 100K would turn into 400K. And in 30 years 800K. Financial mistakes compound forever.

Since that time I have never missed maxing out my SEP, and I do not depend on my CPA to be my financial advisor. I was quite disappointed he did not push me harder to find a way to fund my SEP. Since that time, I've been working super hard to grasp taxes and learn this stuff. It's super important.

These tax tricks Keith is trying to show everyone are real... at all income levels.


Thursday 14th of December 2017

Hey Keith - my mom is a business owner and I have some doubts about how good her accountant is. Example: I had to tell her about contributing to a retirement plan to reduce her earned income so that she could qualify for a health insurance subsidy. Uh, really? Anywho...

What you were saying above about the HSA contribution, would that be of benefit to her? She has a high-deductible plan, but technically her business at this point (another bone I have to pick with the accountant, because it's becoming larger and more profitable) is taxed as a sole proprietorship, so does it make any difference in her case if the business deposits the money directly or she deposits it herself later?

Keith Schroeder

Thursday 14th of December 2017

Rachel, you don't pay yourself a W-2 wage as a sole prop so you can only pay it on your own and deduct as an adjustment to income at the bottom of Page 1 of Form 1040.


Wednesday 13th of December 2017

Keith, you have any plans to release articles about activity grouping. More specifically regarding section 469?

Keith Schroeder

Wednesday 13th of December 2017

Only seasoned accountants ask questions like this, M-Bomb! I have written on grouping issues before as it relates to cost segregation studies:

Section 469 is a pain in the tail. The rules are vague at best and can cause litigation issues. My post covers some of the mechanics. Review Revenue Procedure 2010-13 for the best source material on interpreting Section 469. I haven't written on the issue in greater detail is because readers with a heart condition would face serious medical risks. In truth, there is serious disagreement between tax professionals and the IRS on Section 469. One final note: grouping activities MUST be reported to the IRS; any changes to the group MUST be reported to the IRS. The tax profession does NOT agree with some issues surrounding grouping; ie. stranded properties treated as a group of one.

That said, one day in the distant future, after a large quantity of consumed whisky, I may start typing on the topic. Even I'm excited over what I might come up with.


Wednesday 13th of December 2017

I am trying to lower our EARNED INCOME (box 1) to max out EITC. We earn around 50k, fully fund a 403b (18k) and pay about 2k a year for health insurance, which gets us down to 30k . My understanding is that getting it down to about $23,700 (2 adults & 2 kids under 17) would maximize this credit. So my question is.....Do pre-tax HSA contributions made through employee payroll lower that (earned income/box 1) number? We also do a spousal IRA for 2k a year.

Thank you for writing such an informative blog....I subscribed months ago and it has really helped me a lot!

Keith Schroeder

Wednesday 13th of December 2017

Ryan, you want to make the HSA contribution through payroll deduction. The Income never hits your personal tax return (just a note on your W-2) so it should help with the EITC.

Thanks for subscribing.


Wednesday 13th of December 2017

Good article. I had not heard anything about the student loan interest deduction going away with the new tax plan. I contacted my senators asking why the government hasn't increased the interest deduction with all the news about the student loan bubble. Neither replied.

Keith Schroeder

Wednesday 13th of December 2017

The student loan interest deduction is still on the chopping block last heard unless is was stripped out in reconciliation.