Using Your 401k To Get an instant 65% Returns

First off I would like to admit that my post is a little misleading. I would like to clarify that this post is not about investing in penny stocks or other risky investments to make ridiculous returns in your 401k.

However, the money you set aside in your 401k can lower your tax liability and have the same effect as getting an instant return, sometimes returns as high as 65%.

In order to get this type of treatment you must be eligible for the Earned Income Credit, the retirement savings contribution credit, and have a 401k account you can contribute to (in some cases a traditional IRA account may suffice, but not always).

Here is a hypothetical scenario:

A couple Married Filing Jointly with one dependent makes $43,250. Lets say only one spouse goes to work, and is eligible to participate in a 401k plan with their employer.

with $0 contributions to their 401k plan, the tax due by April 15th would have been $2,456 (given the 2013 tax, exemption & standard deduction rates).

With the same situation $2,000 of contributions to their 401k plan, the tax due by April 15th would now be $847. Nothing has changed, except the family has deferred $2,000 of income to save $1,609 in tax ($2,456 tax in the prior example, less the $847). The only issue becomes, can the family afford to lock up the $391 in thier 401k account to take advantage of this gain.

Note that at first glance this example appears to have an 80% return. (1,609/2,000 = 80%). The reduction in tax attributable directly to the 401k account in my opinion is not a real "return" because this money will get taxed later when you withdraw the funds at retirement. The real return comes from the increase in credit you receive with your EIC credit (increased from $0 to $309) and the credits you receive from the Retirement Savings Contribution credit (increased from $0 to $1,000). The total of $1,309 you get by contributing $2,000 to your 401k is a 65% return.

This works because when you contribute money to your 401k account your W-2 Box 1 wages are reduced. This is the amount that gets reported on your tax return. Note had you contributed your money to a traditional IRA, you would not have the benefit of reducing box 1 wages, and instead get a "for AGI deduction"** which has the chance to screw up your EIC calculation (depending on your circumstances).

The reduction in wages lowers your income that is considered for the EIC and Retirement Savings credit, which is more beneficial for lower income earners.

If you can afford to take a hit on cash flow to increase your overall wealth, I think that it would be well worth the investment now before your income rises over the years and you can no longer take advantage of these credits.


**A "for AGI deduction" is a deduction that reduces your Adjusted Gross Income, (line 37 on form 1040) which is commonly used to determine which tax payers are allowed to use certain credits such as the EIC.

Should You Do Your Own Taxes?

With tax season coming up, you might be wondering how your taxes will get done. In this post I hope to provide a little insight into whether preparing taxes by yourself is good idea or not.

I believe there are 3 ways to get your taxes done 1) by yourself, 2) "big box" tax preparers 3) your local CPA or other Tax professional.

1) By yourself -
If you don't have a particularly complex return I believe there are a few times you can skate by with preparing taxes yourself:
a) you are not in school (or if you are in school you are familiar with the education credits such as the lifetime learning credit, or the american opportunity credit and know when to appropriately take each)
b) you do not have kids
c) you only recieved income listed on a W-2
d) you plan on taking the standard deduction (i.e. you do not have substantial deductible expenses like a mortgage, charitable contributions, medical expenses etc).

If you fit into this category and feel somewhat comfortable with preparing your own taxes, than feel free to use whatever your DIY software you prefer. Of course your ability to prepare your own taxes depends on your competency level.

2) "big box" tax preparers -
Due to sheer volume of returns prepared, it is likely that I will offend someone by saying this, but I think this is the worst option. Last year I was offered a job at one of these "Big Box" firms (and denied) and I learned that thier hiring process is very poor. Most of the preparers go through a tax theory crash course and begin preparing taxes. It could be possible that your tax preparer is just working parttime to supplement his walmart paycheck.

After studying only a few years of tax accounting, it is nearly impossible for these people to be "professionals" after a few months crash course. I personally feel that one should never use this alternative (unless maybe you could do it yourself, but aren't up to the task)

3) Local Tax CPA
I believe that finding a trusted tax advisor is the best option for preparing your taxes. Dave Ramsey (a personal finance guru) recently put out an article highlighting that people who paid for a preparer typically save between $347-$841 on thier taxes. When you are likely to pay $100-$250 for an average return, you win here. (depending on your actual circumstances fees or savings can differ).

Keep in mind that not all CPA's are created equal, and that you should find a CPA firm that is most fitting for you. CPA firms are typically equipped to serve a certain type of client. For example a Big 4 firm usually is equipped to serve the largest of clients, like Microsoft, Amazon, Boeing and their executives. Some CPA's specialize in smaller businesses/individuals. Regardless of your choice of CPA keep in mind you are paying for quality advice and direction. When choosing a tax advisor find someone who:

a) "has the heart of a teacher". Regardless of how much you would (or wouldn't) like to know about your taxes, if your advisor has the heart of a teacher you know they aren't just in it for the money, but are willing to help and teach you.

b) plans to build a relationship with you. A good preparer knows that 2013 isn't the only time you need your taxes done. A good CPA wants to plan to help minimize your tax liability for the future, instead of leaving the tax return up to fate to decide.

c) is familiar with the portion of the tax code that pertains to your needs.

Lastly, I would like to highlight a personal experience to show the importance of using a quality accountant.

Last year I had a friend who wanted to me solve a complicated problem on his taxes in which he prepared online. After solving his problem I noticed he was neglecting to take a specific credit he did not know about. After filing the return he saved over $1,000 just by having me look over it.

There are two points to be made. First, you can't let webMD properly diagnose you with cancer and you can't let free online tax software properly diagnose your tax problems. Second, its not about what you know, its about what you don't know; as well as what you think you know, but actually don't.