Taxes: How They Have Messed Up Our Timeline

We have our tax returns prepared by an accountant every year.  I know, I know, many in the FI community do their own but with Mr. SFF being self-employed and now having two rental properties, I would just rather have someone else, who is may more knowledgeable, do the returns for us.  Last week we got the returns back and were they a doozey!  We usually try to plan our taxes so we end up pretty close to zero.  We don’t feel the need to give the government a free loan throughout the year (getting a return) but we also don’t want to write a check huge check.  But I guess 2016 was a year where we were off, by A LOT.  It was bad enough that our accountant gave us a bottle of wine.  Yup, some good old alcohol to drown out the pain.

What contributed to this big change?  First of all we purchased a new duplex in mid January of 2016 so we had just shy of a full year of rental income with this new property.  Our other duplex is owner occupied and we usually only show a couple hundred dollars of taxable income from this one so I really had no idea what to expect from this new property.  I guess I was a little naive thinking that yes, we would have a larger gain than our current property, but that it wouldn’t amount to all that much.  Well, I was completely off as the new property  showed much more taxable income than we had expected.  This means that we owe more money to the government than we had anticipated.  Not only does this suck because we have to pay Uncle Sam and the state some more money but I also have to adjust many of my FIRE estimates.  Most of my calculations were based on a net income amount that didn’t take taxes into consideration so I have to go back and adjust all of my spreadsheets based on a lower expected income from rental properties.  I just wrote a post about how about half of our income would be coming from our rental properties back in February.  Based on these new numbers it’s probably closer to 43% of our income.  🙁

This change is not catastrophic to our plan but certainly changes things slightly.  There is a small part of me (or depending on the day a big part) that wishes we could leave our full time jobs in 2019 but with this news it will be less likely.  We are still going to shoot for 2020 though which in the whole scheme of things is not all that bad.  I mean, it is a thousand times better than waiting until our 60’s, right?

The rental property wasn’t the only part of our taxes that was the problem.  Mr. SFF is self employed and pays estimated quarterly taxes.  He thought his income was actually going to be lower for the year as he cut back some of the hours with one client which would mean some of the over-payments would help cover any taxes due from the rental property.  At least this is what we thought.  In reality he actually earned more than expected.  I guess this isn’t a bad problem to have as it means we have more household income and explains why were saved more in 2016 but that doesn’t mean we have to be happy about the resulting tax bill.

Part of our strategy once we hit FIRE is to use non-qualified money and maybe distributions from our Roth IRAs (you can withdraw contributions from a Roth tax and penalty free) during the first 5 years in retirement.  I know tax wise it makes sense to put as much as possible in tax qualified accounts (401(k) and traditional IRAs) now when we are in a slightly higher tax bracket but we don’t want to lock up too much of our money. Yes you can do Roth conversion of the tax qualified money but then you have to wait another 5 years before withdrawing it.  With this plan in mind we both made contributions to our Roth IRAs in 2016.  Apparently we should have waited to see what our taxes looked like first as we ended up recharacterlizing Mr. SFF’s $5,000 contribution to a Traditional IRA making it tax deductible and thereby reducing the amount we owe slightly.  This process is not all that complicated but it certainly was a pain.

Changes for 2017

Now knowing that our taxes will likely be even worse for 2017, especially since I got a big raise towards the end of last year, we are already making some changes to our savings strategy.  The first thing I did is to max out my HSA to maximize not only the amount I am saving for future health expenses but also reduce our taxable income (I was close to maxing anyways).  I also bumped up my 401(k) contribution amount.  My income before my raise wasn’t all that high so I only was putting in 20%.  For now I have increased my contributions to 25% which is still not maxing it out but it is certainly higher.  I may reevaluate again in a couple of months and increase again if I think all else is going well.  This does mean we will not be able to save as much in our non-qualified accounts in the next few years but based on current balances I think we should have enough to cover those first 5 years in retirement.  Plus we will have some part-time income anyways so the hope is we won’t have to withdraw all that much anyways.

We will likely make some sort of retirement contribution for Mr. SFF in 2017 but I think we are going to wait to see what his income looks like before making any decisions this time around.  We could make a Traditional IRA contribution up to $5,5000 but if we want to save more then we will have to open up a Simple IRA for him enabling to contribute up to $12,500.  We will just make sure we have enough in cash at the end of the year to contribute to either of these accounts come tax time.

Our general housing plans might also change now that we know the true net amount from our rental income.  Previously I had estimated that if we could buy a small house and rent out our current unit that our total expenses would be pretty similar.  The extra income from the additional rental unit would likely cover any costs from the new property, assuming we could find something reasonably priced which is extremely hard where we live.  As much as we both would like a little house closer to the mountains we are now not quite so sure this will be feasible, at least if we want to make the FIRE thing work in the next 3 years.  If we move out of our current duplex the amount of rent from both units will greatly exceed the expenses and just like we found out with our new duplex, we will end up owing some taxes.  It is hard to estimate exactly how much as our tax bracket should be lower but what I do know is I can’t just assume the full rent could be used to cover living expenses.  Of course nothing is set in stone but I am trying to reel in my mountain house dreams for the moment.

Our plans and dreams always seem to be changing slightly and I guess that is one of the great things about being on this journey.  We have options and aren’t just stuck with the traditional route (work, save, retire in our 60’s, die).  One thing we had previously thought of, and has resurfaced again as a logical plan, is move into the other unit of our current duplex going from a 3 bed to a 2 bed unit.  This would mean slightly more income without a lot of extra taxes.  We really like our current tenants and hope they want to stay but at some point we may want to make this switch.  I guess one of the side benefits of owning 2 duplex’s is that we have a lot of different housing options.  So for now I am off to pay this slightly reduced but still large tax bill and continue to dream about our eventual freedom.

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