Why I needed to lower my taxable income

To be rich in this country, you need to know the tax code or have a good tax attorney

When my college professors talked about going back to graduate school, they used to say it would be hard because you will have experienced what it’s like to have a paycheck and you won’t want to give that up. I didn’t think that would be a problem for me; I don’t need much, honestly.

What they didn’t tell me is once you start having a regular and somewhat high income, that will impact your FAFSA numbers when you apply to grad school. That is, you might find yourself in a situation where you’re making too much money (i.e., to the point where the Federal Government thinks you don’t have “financial need”), which might prevent you from being eligible for Federal grants or special fellowships that require you to provide proof of “financial need” (whatever that means). And if you’re not getting financial aid for grad school, that might make you question whether pursuing that master’s degree is a good idea in the first place.

Six figure student debt, any takers?

Some might say: “Come on, stop whining. You’re making too much money? That’s a problem I wanna have!”

Well, not so fast.

Have you looked at the cost of living in places like NYC or San Francisco? Or how much you pay in taxes there as a W-2 employee? On paper, one might look like a high income earner, but when you crunch the numbers … I digress.

For someone who only intended to work full-time for only 2-3 years and then return to school for graduate studies, that can really hit them negatively.

With this in mind, I wanted to introduce the very sexy topic of lowering your taxable income.

I know, you’re yawning already.

But it’s these seemingly boring things that can add some more scholarship money for you down the road and decrease your tax bill.

In 2019 I found myself in a situation where I needed to lower my taxable income. I was working full-time in New York City, making a decent income for a recent college grad. When I looked at my paystub towards the end of the year, I saw that my taxable income for 2019 would put me in an income threshold where I’d basically have to say goodbye to all federal student grants.

What’s even more important is understanding how my 2019 tax return numbers would drag their impact for a few years down the road due to FAFSA’s lookback period. For example, if I apply to begin my studies in the fall of 2022, I’ll have to show my 2019 returns – the year where I worked full-time and had a relatively high income. So if I have a very low income for 2020, the numbers from my 2020 tax return would only kick in when I file my FAFSA to study in the 2023 fall semester. So if there is no rush in going to grad school, it makes more sense to go in 2023 because I might get more financial aid.*

Naturally, I needed a legitimate way to lower my taxable income.

I took another look at my paystub and realized that I’ve only contributed $360 that year towards my HSA account. So I decided to max out my HSA contributions for that year as a way to lower that taxable income ($3,500 was the maximum HSA contribution amount in 2019).

There are a bunch of other things that can help you lower your taxable income, such as 401(k) and Traditional IRA contributions. Not only is this beneficial for the purpose of FAFSA, but it’s also lowering your tax bill. And who doesn’t want to pay less taxes?

Pro tip about HSA accounts: After doing some research, I realized that this is not only a strategy to lower your taxable income, but also a way to save for your retirement (disclaimer for all you FIRE folks: I use the word “retirement” in the traditional sense here).

Here’s the idea: Don’t spend money from your HSA (if you can afford it, of course). Invest that money in the stock market. In your 60s or so, when you’re ready to retire, you can spend that money tax-free on healthcare costs or – the part that many people don’t know – you can spend it on anything else penalty-free (it doesn’t have to be healthcare related; you’ll just have to pay income taxes on that, but you’ll probably be in a lower tax bracket anyway). And by the time you’re ready to spend that money, it will have grown thanks to compound interest that happened over the course of a 25-35 year time period.

You can also lower your taxable income by contributing to a Traditional IRA, because you can then deduct those contributions when you file your taxes. There are a few caveats with this, so check the IRS website for the most current information. For instance, in 2020 if your employer doesn’t offer a 401(k) plan, you can deduct the full amount you contributed (so you’re golden). If your company offers a 401(k) plan, there are income tiers that will determine the amount you can deduct (if any).

Other things that lower your taxable income: your 401(k) contributions, health insurance costs (you can see these on your paystub as already deducted). But with a Traditional IRA – you’ll have to deduct that yourself when you file taxes.

Additionally, investing in these accounts is a way to “park” your money in a tax advantaged account which doesn’t count as an asset for the purpose of FAFSA. To get the full benefit of these accounts, you should apply these strategies if you know you won’t be tapping into these funds for a while. That’s because you don’t want to end up being penalized for an early withdrawal.

Conclusion: Traditional IRA and HSA accounts can be your best friends regarding lowering your taxable income.

* I am simplifying things here, of course. FAFSA does ask you for your current income and assets, too. But my point is that having a high income for the tax year they’re requesting will probably not benefit you in receiving federal grants.

Besides your taxable income, the other monetary components of the FAFSA are your current assets. Anything in your taxable brokerage account counts as an asset, which you’ll have to declare on the FAFSA (as opposed to things that you stocked away in your IRAs or 401(k) accounts). Also, if you own a house as a primary residence, that doesn’t count as your asset. Not saying you should buy a house because of that, but if you already own one you might benefit in this situation.

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