I have written elsewhere about the importance of what I call “compounding discipline:” the deliberate choice to take the return you earn on alternative, irregular, and weird activities and reinvest them, instead of spending them. Exercising compounding discipline is essential to realizing the full benefits of those activities over medium and longer terms, but is next to impossible for humans.
Gaming the tax code can’t make you rich without compounding discipline
While financial independence types have raised it to an art form, people in all walks of life engage in what I consider fairly outlandish antics in order to minimize the income taxes they pay. And these antics, more or less, work. On the extreme side, you can harvest capital gains, harvest capital losses, recharacterize contributions, or roll 401(k)’s over, under and through IRA’s. Even setting those aside, ordinary people cheerfully deduct mortgage and student loan interest and claim this means they’re “saving money” on their home or education.
Consider the case of a single homeowner with $50,000 in income who paid $10,000 in mortgage interest in 2016. Since $10,000 is higher than the standard deduction of $6,300, the homeowner decides to itemize her deductions, and reduces her adjusted gross income from $39,650 by $3,700, to a total of $35,950. By deducting mortgage interest, the taxpayer reduces her tax liability from $5,690 to $4,933, a savings of $757.
My question for you is, what does she do with the $757?
The answer, of course, is that she does nothing with the $757. She never, in fact, sees the $757 unless she overpaid her taxes during 2016 (note that making interest-free loans is an odd way to get rich).
Compounding discipline turns savings into assets
I wrote back in February about bringing my adjusted gross income below $18,500 each year in order to trigger the maximum Retirement Savings Contribution Credit, and wrote:
“In 2016 my income was about $22,500, or $4,000 above the cutoff for the maximum credit, but leaving me eligible for a $200 credit. Contributing $2,500 raised that to $400, and contributing $4,000 raised it to $1,000 (I had an excess premium credit repayment in 2016 so I was able to claim my whole credit).
An $800 return on a $4,000 contribution was a no-brainer for me.”
Making a $4,000 contribution to my solo 401(k) saved me $800 in federal income taxes, but it didn’t do anything to make me wealthier because I didn’t invest the $800. I never even saw the $800! I have $800 more in my bank account than I would have without the contribution, but I didn’t make a “special” $800 contribution to any of my investment accounts.
But that’s exactly what I would have to do if I wanted to use my tax savings to become wealthier. Likewise, a homeowner deducting mortgage interest really could become debt-free faster by applying his tax savings to his mortgage, a student borrower could use her tax savings to accelerate the repayment of her loans. That’s compounding discipline, and no one does it.
It’s fine not to have compounding discipline (no one does), just be realistic
Financial independence types love to talk about how important frugality is because every dollar you save will become a zillion dollars in 100 years compounding at 50% APY (or something like that). I don’t dispute the math, although it will certainly be interesting to see how FIRE bloggers react when their investments start negatively compounding in the next bear market. What I dispute is that financial independence types actually exercise compounding discipline and invest the savings they achieve with their tax minimization antics.
That doesn’t mean the savings aren’t real! But saving $1,000 on your taxes makes you $1,000 richer. It only makes you a zillion dollars richer if you invest it, which you won’t. In fact, you’ll never even see it.
I disagree with your notion that “no one does it.” I’ll volunteer myself as an example with real scenario (but fictional numbers). Methods I used to reduce my tax burden included: 401k contributions, IRA contributions, itemized deductions, etc. I received a federal refund of $2000. It was direct deposited into my bank account. This bank account also receives direct deposits of my salary and I pay normal monthly expenses out of it. Finally, the account also functions as my emergency fund and I maintain a minimum balance of $25,000 in it.
In the course of a normal month, I earn more than I spend. In fact, at the end of virtually every month my bank account balance exceeds 25k. So, at the end of each month I transfer the amount in excess of 25k to my brokerage account where it is then immediately invested.
So in effect, my tax savings WERE invested for future growth. And I suspect many other disciplined savers behave in a similar manner. One might have multiple sources of money coming in (ie: salary, bonuses, tax refund, side gigs, etc). But as long as one is spending less than is coming in, there is an opportunity to invest the surplus and I’m sure many do.
+1 on the saving and emergency fund. Im doing something very close to your strategy
you got your AGI below 18k? You got bigger issues than compounding with a sub 50k salary.
I think the author explains how he lives on under 18k in the savers credit article comments, but it might be worth a separate post. It is intriguing in and of itself.
I agree you can do it. But I wouldnt want to live out the rest of my days that way.
How much would you like to live on?
>18k for sure. Small time stuff.
Well that’s what I was trying to ask. Small time stuff compared to what? Compared to some larger number? Obviously. Compared to some smaller number? Well suddenly I’m the high-roller.
Sounds lousy until you realize the incomes people can make on “rebates” (which are not taxable)
I’m with EightBall and SumOfAll on this one. The idea of compounding discipline just isn’t necessary at a higher level. You live below your means and put everything above your comfort level of savings into investments.
Found a way to not pay $800 in taxes? So what? Any money above your baseline savings gets invested anyway.
Found a quarter on the sidewalk? Who cares if you denote $0.25 to be added to your savings? Any money above your baseline savings gets invested anyway.
I agree, that is what compounding discipline would mean. I disagree that it is natural, easy, or even possible for most people to do what you’re describing (although they should!).