28 October 2015

I am very fortunate that I had a living Grandmother for so much of my life, but she passed away last week. She was withered and frail at the end, but her mind was still keen. She was widely revered in my family for her wit and wisdom. I am sure if I had ever asked her if she thought she was wise she would not admit to it. She would probably say she just had common sense. (Something that seems altogether less common in our society these days.)

I have been thinking of the things she used to do and say. Whatever you want to call it she taught me many life lessons, and one of them is to not be wasteful. She and my grandfather (who passed last year) lived comfortably on very little money. They knew how to stretch every nickel, and I learned from them how to do the same.

A penny saved is a penny earned is an old adage that I often heard growing up. I don't hear it as often these days, but I think it is just as valid as it ever was. Given the estimates on retirement savings rates I read about, it might be time to revive a penny saved is a penny earned. Saving & investing needs to be taught and encouraged with every generation of Americans.

Remarkably, some of my Grandmother's wisdom seems to have made it's way into the tax code. In some circumstances a penny saved can immediately be turned into more than a penny earned. To encourage individuals to save for retirement the government provides tax incentives. Certain types of saving can reduce your tax bill, resulting in an immediate gain on the amount you save.

Imagine that your top marginal rate is 25%. If you put $200/month into the retirement plan at work (or a traditional IRA) you would have $2400 saved at the end of one year. Since money put into an IRA comes off your taxes as an adjustment to income, you would also have reduced your tax bill by $600 (25% of $2400). That means it only cost you $1800 to save $2400. 180,000 pennies saved, 240,000 pennies earned. The guaranteed rate of return on your savings in that scenario is so incredibly high it boggles the mind. If an investment advisor promised you a 25% return on your investment I'd say run away as fast as you can, but in this case it's a certainty.

Let's not forget about state income taxes. In Virginia the top marginal rate is 5.75%. That saves you (if you're a Virginia resident) another $138 in taxes. That means it only cost you $1662 ($1800 - $138) to save $2400. Add to that total any matching contributions offered by your employer and you are in the investment return stratosphere right out of the gate.

To sweeten things even more for people at the lower end of the wage scale there is also a Saver's Credit. The Saver's Credit provides an additional retirement saving incentive in the form of a non-refundable tax credit of up to 50% of the amount saved. Income limitations and filing status impact the amount of the credit according to the table below. 

virginia beach tax preparation savers credit

Military members serving in a combat zone will often have an unusually low AGI because of the combat zone tax exclusion. What a great year to save that can be!

The federal government provides more incentives for paying for college than saving for college, but there are still some college savings tax benefits. These are found primarily in 529 college savings plans. 529 plans are sponsored by the various states and there is no federal tax benefits for your contributions to a 529 account. Most states, however, allow a state income tax deduction for your contributions. The Virginia 529 allows up to $4,000 to be deducted per account per year from your Virginia state income taxes. At a top marginal rate of 5.75% that is an immediate tax savings of $230 per $4,000 contributed. Or as I like to say, it only cost me $3,770 to save $4,000. 

Money in a 529 plan grows tax free and is exempt from both state and federal taxes if it is used to pay for a qualifying higher education expense (QHEE). If you saved $166.67/month for 15 years ($2,000/year) and it grew at a reasonable 0.5% compounded monthly (6.168% APY) you would have invested $30,000 and have $48,470.75. The tax benefit of having that $18,470.75 (the growth on your $30,000 investment) growing tax free is $5,679.76 (marginal rate of 25% federal and 5.75% Virginia). $5,679.76 will buy you a semester of tuition at James Madison University. (I know, I just paid for one!)

The bottom line to all of this is that my Grandmother was right. A penny saved is a penny earned. And if your saving also gets you additional tax benefits your saved penny turns into pennies very quickly. If you want to explore ways to increase your tax savings, please contact me.