While the income tax code is packed full of adjustments and credits for “reservists, performing artists, and
fee-basis government officials” and those engaging in “domestic production activities,” the only income tax benefit a low-income self-employed person can deliberately trigger is the retirement savings contribution credit.
By saying someone can “deliberately trigger” the credit, I mean to exclude things like the earned income credit, which requires you to calculate it based on both earned income and adjusted gross income and claim the lower amount, and the student loan interest deduction, which you can only trigger by going back in time and taking out student loans.
The retirement savings contribution credit isn’t like that: it’s calculated exclusively based on your adjusted gross income, which means you can deliberately trigger it by lowering your adjusted gross income below the cutoff point.
What’s the cutoff?
In order to receive the maximum credit, your AGI must be no greater than:
- $18,500 if your filing status is single, married filing separately, or qualifying widow(er);
- $27,750 if your filing status is head of household;
- $37,000 if your filing status is married filing jointly.
What’s the credit worth?
The maximum credit allowed by law is $2,000 if your filing status is married filing jointly, or $1,000 for all other filers.
However, the retirement savings credit is very poorly designed. Specifically, it is capped at the sum of lines 44, 45, and 46 on Form 1040.
- A single filer with an AGI of $18,500 only owes $818 in taxes on line 44;
- A head of household with an AGI of $27,750 and a single dependent owes $1,033 in taxes on line 44;
- A couple that’s married filing jointly with an AGI of $37,000 and no dependents owes $1,628 on line 44.
The more dependents you add, the lower your line 44 taxes will be and the lower the cap on your retirement savings contribution credit.
Getting around the cap
As I said, the credit is capped at the sum of lines 44, 45, and 46. Line 44 is your income tax calculated from the income tax table, and line 45 is the alternate minimum tax, so there’s not much you can do about either of those.
What you can control is line 46, the “excess advance premium tax credit repayment,” which is the amount of Affordable Care Act premium subsidy you received during the tax year in excess of the amount you ultimately ended up being entitled to.
If you purchase health insurance on the ACA marketplaces, you can request a monthly premium subsidy in excess of the amount you’re eligible before, thus paying a lower monthly premium throughout the year and incurring an “excess” advance premium tax credit. You can then repay that “excess” out of your “excess” retirement savings contribution credit, which would otherwise be wasted, since you can’t roll your retirement savings contribution credit forward to future years or apply it to previous years.
Adjusting your income
If you’re self-employed, adjusting your income so it’s at or just below the earnings cutoff is easy. After calculating your taxes as normal, determine by how much your adjusted gross income exceeds the cutoff, and contribute the difference to a traditional IRA or as a pre-tax contribution to a 401(k).
Note that there’s no reason to contribute additional money to a pre-tax account once you’ve lowered your AGI to the cutoff, so any additional retirement contributions should be made to after-tax Roth accounts, where earnings won’t be subject to capital gains or income taxes.
Is it worth it?
I like to say nothing worth doing exclusively for tax reasons is worth doing, and the retirement savings contribution credit illustrates the point nicely: if the credit is worth triggering, it’s worthwhile because saving for retirement is worth doing!
Obviously, the more your unadjusted income exceeds the cutoff by, the heavier a lift it is to trigger the maximum credit. 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. On the other hand, a single filer with an income of $58,500 would have to make $40,000 in contributions to trigger a $818 credit, getting just 2% of their contribution “rebated” in the form of a retirement savings contribution credit. That may or may not still be worth doing, but it’s a much smaller nudge and such a person would need to look closely at their tax situation before making a decision.
Finally, note that this whole discussion is completely separate from the question of pre-tax traditional versus post-tax Roth contributions, since the tax savings are realized in cash the year the contribution is made, not in the form of deferred or up-front income taxation of the contribution amount.