Federal Income Tax: How to Determine Your FREE Money

     Taxes…everybody complains about them, but nobody does anything about them.  If you want to control your tax obligations, you first need to determine how much “free money” the government allows you to earn in a given year before it starts taxing you.  Free money is your 0% effective federal income tax bracket; any money earned after your free money limit is going to be taxed.  Once you know at what point the government starts taxing your income, YOU can decide how much you will pay in taxes.
     There are three components to your free money calculation:  the standard deduction, your personal exemptions and any tax credits you qualify for.  Here is a basic breakdown of these three free money factors.
Standard Deduction – To calculate your standard deduction you have to first determine your filing status.  Depending on your circumstances, you will file as single, married filing jointly, married filing separately, or head of household.  For 2013 these amounts range from $6,100 to $12,200.  Use these websites to find your standard deduction:  site 1site 2
Personal Exemptions – The personal exemption represents the level of income that is exempted from taxation.  Generally, each member of a household is granted a personal exemption, so a family of three would qualify for three personal exemptions.  In 2013, the personal exemption amount is $3,900, so a family of three would have personal exemptions totaling $11,700 ($3,900 * 3).  Read about personal exemptions here.     
     Here is our free money based on our married filing jointly standard deduction and three personal exemptions.
2013 Free Money for Federal Income Tax Purposes
Standard Deduction
Married Filing Jointly
Personal Exemptions
$3,900 * 3
2013 “Free Money” Total
Credits – These are the third component of your free money.  A tax credit is a beautiful thing; it allows the taxpayer to eliminate a tax obligation.  In the U.S. a common tax credit is the child tax credit allowed for “qualified children” under the age of 17.  Each qualified child represents a child tax credit of $1,000.  So, since the first tax bracket is 10% bracket, one child tax credit enables the taxpayer to earn $10,000 tax-free ($1,000 / .10).  Read about the child tax credits here.  Be aware that there are quite a few tax credits available to individuals, so do research and find out which might apply to your situation.  Useful link
      Since we have a son, we qualify for the child tax credit.  It is the only credit that we qualify for, so the math is pretty simple.  Here is what it looks like for us: 
2013 Free Money + Credits
Free Money
$12,200 + $11,700
1 child ($1,000 / .10)
2013 Free Money + Credits Total
      Now that we know our free money we can make informed tax decisions.  For example, we try to keep our income limited to the remaining* 10% federal income tax bracket.  For 2013, the 10% tax bracket is applied to the first $17,850 for a married couple filing jointly.  In our case, we have to subtract $10,000 from the total 10% tax bracket.  (Why?  It reflects the credit that we already received for the child tax credit.)  What does this mean?  Easy, we add our free money to remaining amount of the 10% bracket to determine how much we can earn before we hit the next tax bracket of 15%:
2013 “Free Money” + Credits
+ Remaining 10% Bracket
Free Money
$12,200 + $11,700
1 child ($1,000 / .10)
10% Bracket
$17,850 – $10,000
2013 Total before 15% Bracket
      Now, before I lose you with all this sexy tax talk…what the heck does this mean?  It means that on the first $41,750 of income, we will owe “only” $785 in federal income tax.  How is that?  Remember, the free money is free and the next level of money (the 10% bracket minus the credit adjusted) is taxed at only the 10% rate.  So, 10 percent of $7,850 is a “mere” $785.  Take a look at our effective tax rate for our federal income taxes: 


Total Federal 
Income Tax
Tax Rate
($785 / $41,750)
     By knowing our free money, we are able to take control of our federal income taxes instead of simply complaining about them.  Controlling your tax liability is a necessary step to our wealth building and eventual early retirement. 
 Final note:  Taxes are specific to each individual’s situation.  This is what we are currently doing; this is not intended as tax advice to anyone.  Get tax advice if you need it because you do not want to mess around when dealing with Mr. Tax Man.  
 * This post is previously had a miscalculation regarding the 10% tax bracket.  More specifically, it did not reflect how the child tax credit reduces the 10% tax bracket by $10,000 dollars ($1,000 credit in 10% bracket = $10,000).  So, the remaining 10% bracket is $7,850 ($17,850 – $10,000).  Sorry for any confusion this caused.  Let me know if the numbers in this post are not correct.  Like I said, a tax expert I’m NOT!  
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  1. Anonymous

    It is worth noting that only the standard deduction and personal exemptions are deducted from your taxable portion. Your taxes are figured on this amount and THEN any credits are applied to your amount owed such as a child tax credit. Same concept but those not knowing this might be confused if they refer back to last year’s tax return. I would also point out that two child tax credits would not equal $20,000 of “free” money because it would go over the 10% tax bracket slightly causing $2,150 to be taxed at the 15% rate. Nice post, enjoyed the read.

  2. Thanks for the insight! Yes, this is true…I just verified with my calculator. Two child tax credits DO exceed the 10% rate. Here’s the math: 2 kids * $10,000 = $20,000. But wait, the 10% bracket ends at $17,850, so $20,000 – $17,850 = $2,150. This figure of $2,150 will be taxed at the 15% rate; it results in $322.50 of tax beyond the 10% rate.

  3. I see, this makes sense. I will say I had found an online tax calculator and it wasn’t matching my numbers, so I will have to re-run my numbers. But this is still fascinating. Thanks for the clarification and update. I think this has still helped me to be aware of how my taxes work.

  4. MrsBanks

    Hi, I came over here from JLC’s stock series. You have a great blog. Im hoping you can clarify this post for me. I don’t understand why $1k in a 10% bracket is then effectively $10k. Wouldnt the credit just reduce your tax liability by $1k (here: $17,850*.10-$1k=$785 tax bill). Please help me see what I’m missing. Thanks in advance!!!

  5. Mrs. Banks, I’m sorry for the delay; we’re having fun in Cancun! You’re correct, the $1,000 credit cancels out $1,000 of my federal income tax obligation. I view that credit as allowing me to earn $10,000 more dollars (above the free money) that I will not be taxed on. Maybe I’m viewing this the wrong way, but it helps me visualize my tax planning. I hope my example didn’t confuse you.

    Best of luck reaching your goals,

  6. Anna

    Just getting a handle on your ideas here, and calculating this math for our own circumstances. When you say that you try to keep your income limited to the remaining 10% tax bracket, you mean that amount plus your “Free Money” and Credit amounts, correct? Or in your case, $41750? So then, as I understand it, you are actually making more than this amount, but you are investing in your retirement accounts and other investments “up front” to reduce your income numbers down until they reach this threshold or below? Thanks in advance for any clarification, I am working at a baby steps level here.

    • Ed Mills

      Hi Anna, it looks like you got the main points of the post. Yes, we do make more that $41,750, but we are able to whittle our taxable income down to our “free money” + the remainder of the 10% bracket amount. In 2015, our free money and the remainder of the 10% bracket was $43,050. We will earn about $130,000 in 2015, but we’ll make over $100,000 disappear into following accounts: 457s ($42,000), 403Bs ($42,000), IRAs ($12,000), and our HSA ($6,650). Our income is also further reduced by our pension contributions and our pre-tax insurance plans.

      As we need money, we pull money from our 72T IRAs and our 457 plans. Naturally, this year we’ll try to stay below our pain threshold of $43,050. If we go beyond that amount, at least we know the consequences: every additional $1,000 dollar beyond that magic number results in $150 of federal income tax and $60 of Georgia state income tax. In other words, we get to keep $810 of every $1,000 distributions once we pass the $43,050 amount.

      I hope this helped. Good luck working your plan. Ed

  7. Shan

    I really enjoy reading about your story and your tax strategy. Don’t you eventually have to pay tax on your deferred income in the future?

    • Hello Shan,
      It depends on how you take your distributions. If you take your money gradually, you can minimize the tax bite. In our case, we try to keep our distributions around $43,000 because that amount carries a $850 federal tax liability…we can live with that. However, if we took our money out in one big distribtuion, we would pay a lot of tax on the money. We don’t plan on draining our accounts for this reason.

      We also plan on minimizing our taxes by using a Roth conversion ladder. By slowly rolling our IRA amounts to Roth IRAs, we’ll be able to make our retirement savings tax-free. Ideally, we should be able to make these conversions under our “free money” threshold and pay little no tax on the conversions. We’re going to start our Roth IRA conversion ladder in 2016.

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