Faculty Can Lower Their Tax Burden By Optimizing Tax-Advantaged Accounts: But Is It Worth It To Do So?
College faculty do okay financially, but it is hardly where the money is at. This is particularly true when taking into consideration the decade plus of professional training that college professors have completed.
There are other advantages to academia aside from the money, of course, such as the cushy schedule and generous vacations. But in this post I want to focus on the hidden financial advantages to being a college professor. The examples I will give below pertain to faculty who work at public colleges and universities. They may also apply to faculty at private schools, but I don’t know those details personally.
I also realize that this post is more than a little presumptuous or naïve to discuss the benefits of a job that is increasingly out of reach for all qualified applicants.
This is not about maximizing income, which I will most likely address at a later time. What follows is for college professors or staff (in the United States of America) who wish to optimize their salaries for the purposes of building wealth. They can do this by working with their silent business partner, the United States Government, to minimize their tax burden and thereby maximize the money that goes into wealth-building.
Imagine that Georgina is a sociology professor with a salary of $50,000—a nice, round figure. She is able to teach courses in the summer, which bumps this up to $65,000. We know, since we received our first paycheck back in high school, that a portion of this $65,000 will go to the government in the form of taxes. There are a lot of taxes. Depending on the state where Georgina lives, there are the following taxes she will have to pay out of her $65,000:
· Federal income tax
· State income tax (if applicable)
· FICA tax (Social Security and Medicare)
· City tax (if applicable)
For calculations, we will assume that Georgina lives in Georgia (5% state income tax) and she does not owe city tax.
The federal tax structure is designed to help people with lower incomes. College faculty and staff incomes are right around the point where they start to take on a higher tax burden.
Georgina’s Federal Income Tax Table
Looking only at federal income tax, we can see that the top $10,000 that Georgina makes is taxes nearly double of the rest of the money she makes. This means that she will receive a smaller percentage of any bonuses or overloads she takes for her job.
Unforunately Georgina owes more than federal income tax. Below is a table that has added state and FICA taxes as well.
Federal, State (5% with $9000 standard deduction), and FICA (7.65 with no standard deduction) income taxes combined.
Georgina could earn another $37,000 before she would reach the next federal tax bracket, which is 24%. As it stands, she is only paying ~$10,500 at the higher 22% tax bracket.
That last $10,500 she makes, which is the top end of her pay, is very tax inefficient. She only gets to keep 2 dollars for every 3 that she makes. Any increase in salary that she gets will be taxed at this higher rate. This is true up to a salary of just over $100,000, which would be taxed even higher.
The goal for Georgina is to avoid paying anything at this higher federal tax bracket. With the sample figures I have used, this won’t be hard for her to do. She only needs to find a way to protect $10,276. This can be done by minimizing her realized income, or finding tax exemptions.
The US government offers exemptions for health insurance premiums. This means that the state-subsidized healthcare plan Georgina pays into will be tax exempt. Let’s say that she pays $300/month, or $3,600/yr. The state pays the rest of this coverage.
Now she has to protect $6,676. She can do this in the state provided 401a tax-deferred retirement plan. The public university system of Georgia allows employees to put 6.5% of their income into a 401a retirement plan, to which the university system contributes another 9%. This is at a $4,225 cost to Georgina each year, but she gets an annual $10,075 added to her retirement account, which she can invest however she’d like.
Georgina still needs to protect $2,451. She has a few options still available to her. She can put this money into an IRA through her own bank. The US government allows Georgina to save up to $20,500 in tax-deferred retirement accounts each year, which means she still has over $10,000 left before she reaches her limit. (She will pay income tax on this when she withdraws from these accounts during retirement, but she will also be able to control how much she withdraws and from which accounts each year to have the most tax-efficient strategy. If she doesn’t want to open an IRA, then she can use the state provided 403b to save the additional $10,000.
A downside to the 401a and 403b accounts is that Georgina has to wait until she is 59.5 years old and retired before she can begin withdrawing. She will have to pay a penalty to withdraw any earlier, no matter how young she is when she retires.
Because she works for the government, Georgina can save an extra $20,500 in a 457b tax-deferred retirement account. The bonus with the 457b is that Georgina can withdraw this money whenever she retires without penalty.
Retirement accounts defer state and federal income tax, but they still owe the 7.65% FICA tax. A loophole here is an HSA or health savings account. Georgina can contribute $3,250 each year to an HSA, which she can treat like an investment account. All of the money she puts in is tax and FICA exempt, and it can be invested where it will grow tax free. She can withdraw the money at any time without tax and without penalty as long as the money is used for healthcare costs. As a bonus, the University System of Georgia matches the first $325 Georgina puts into the account.
This adds up to $44,250 in tax-advantaged retirement accounts.
Summary
So even though Georgina doesn’t make a killing, she has tons of options for keeping the money she does earn. If she could find a way to live on $20,700, then she could get her total effective tax rate down to 14%, which would save her a few thousand dollars.
Seems Hardly Worth It
In the end, I have to exclaim: Big whoop! Even by following the minimal 6.5% contribution to retirement accounts, Georgina has an extremely low tax burden—around 15% combined effective tax rate. I’m not sure the increases to tax-advantaged accounts would really be worth it if the only goal is avoiding federal and state taxes. Sure, these are something, but only a few hundred dollars at the end of the year.
The biggest advantage to saving so much, whether she saves in tax-deferred retirement accounts or after-tax brokerage accounts, would be in increasing her wealth and decreasing her cost of living. If she could learn to live on around $36,000/year, which is doable but pretty lean, and if she invested the money she saved, then she could retire in 10-12 years. That seems a lot more attractive than saving an extra $800-$2000 per year for the tax benefits.
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