Retirement Savings Contribution and Earned Income Credits for the self-employed

The Retirement Savings Contribution and Earned Income credits are two of the most widely available and lucrative credits in the tax code. You don’t have to buy a house, pay for educational expenses, or donate to charity: you just have to file your taxes and, in the case of the RSCC, make a contribution to a qualified retirement account.

Having said that, they’re also unbearably opaque. But don't worry – I’m here to help.

There are a few values we’ll need to manipulate throughout this process.

“Earned income:” for the self-employed this is 92.94% of your profit from self-employment, plus any wages, salary, and tip income reported on a form W-2.

“Adjusted gross income:” this value comes from Form 1040, line 37, and consists of your “total income” from Form 1040, line 22 (and therefore includes taxable interest) minus a number of possible adjustments. For the self-employed, the most important of these is Form 1040, line 27, the “deductible part of self-employment tax” and line 28, “self-employed SEP, SIMPLE, and qualified plans,” but you may also have traditional IRA deductions (line 32) or student loan interest deductions (line 33).

“Taxable income:” this value comes from Form 1040, line 43, and consists of your AGI minus the standard deduction and personal exemption.

In all the calculations below I’ll be using my own situation (single, no children), but once you understand the principle you’ll find it’s replicable for the married and childful, as well.

Retirement Savings Contribution Credit

The Retirement Savings Contribution Credit offers a rebate of up to 50% of contributions to traditional and Roth IRA’s and “as the employee” contributions to one-participant 401(k) plans, with three important restrictions:
  • To qualify for the 50% rebate your AGI must be below $18,000;
  • The amount of the rebate is calculated on a maximum of $2,000 in eligible contributions;
  • And the amount of the rebate is capped at the amount of your federal income tax due (remember, this has literally nothing to do with the self-employment tax, which is 14.13% of your profit from self-employment).
Since the standard deduction and personal exemption are together $10,150, the Retirement Savings Contribution Credit is only maximized for AGI values between $10,155 and $18,000: below that range, there will be no taxable income and therefore no federal income tax due, and above that range the Retirement Savings Contribution Credit rapidly shrinks.

Within that range, the amount of taxable income will range from $5 to $7850, and the amount of tax owed will range from $1 to $788.

Therefore, in that range, the following condition holds: for each additional $100 of AGI, an additional $10 of taxes is owed, allowing an additional Retirement Savings Contribution Credit of $10 (for a $20 retirement savings contribution).

Remember: for the RSCC, AGI is the only number that matters, and it’s pretty easy to manipulate AGI.

First of all, you can contribute to a traditional IRA, up to $5,500 per year. That means you can suddenly have up to $23,500 in income (calculated as 92.94% of your profit from self-employment, plus wage, interest and other income).

Next, you can contribute up to 18.59% of your profit from self-employment “as the employer” to a SEP IRA or one-participant 401(k) and deduct it on Form 1040, line 28. If your income exclusively comes from self-employment, you can now have total income up to $28,866 (contribute $5,366 to a SEP IRA and $5,500 to a traditional IRA).

This is a good time to make clear the two different things that are happening here:
  • First, you are deferring income tax by making contributions to a traditional IRA. There is no great advantage to doing this: your AGI already puts you in the lowest federal income tax bracket, so you will, by definition, be in the same or higher federal income tax bracket in retirement, when you make withdrawals from your traditional IRA accounts and pay income tax on withdrawals at the then-prevailing federal income tax rate. Contributions to a Roth IRA, on the other hand, would not be deductible in the present (when you’re paying a low federal income tax rate anyway) but withdrawals on any gains in the account would be completely tax free (assuming the Roth IRA as a concept makes it that long).
  • But the second thing you’re doing is getting an immediate rebate on your retirement contributions in the form of the RSCC. That means the larger the contributions required to bring your AGI down into the highest RSCC rebate band, the lower your rebate as a percentage of those contributions is. If you have an AGI of $18,000 before any qualified retirement contributions, then a contribution of $1,576 to a Roth IRA will have an immediate RSCC rebate of $788. If you have an AGI of $19,000, a $1,000 traditional IRA contribution followed by a $1,576 Roth IRA contribution will have the same rebate of $788 — but now it’s just 30.1% of your total retirement contributions! That’s still superior to the statutory 20% RSCC rebate on AGI’s of $18,000 to $19,500, but not by much.
In other words, the more you have to contribute to traditional IRA and one-participant 401(k) accounts in order to secure the maximum RSCC, the lower the RSCC is as a percentage rebate on your retirement contributions. Since the statutory RSCC rate for incomes between $19,500 and $30,000 is 10%, it’s not worth driving your effective rebate rate any lower than that. This occurs when you make $7,880 in SEP and traditional IRA contributions to lower your AGI to $18,000 – in other words at a pre-IRA-deduction AGI of $25,880. That’s the point when $7,880 in retirement contributions will yield a $788 credit no matter which retirement vehicles you contribute to (the proof of this is left as an exercise for the reader).

Earned Income Credit

The Earned Income Credit is a "refundable" credit, not capped at the amount of federal income taxes owed.

The EIC is based on two numbers: “earned income” and “adjusted gross income.” To find the amount of EIC you’re entitled to, you have to check the values for your earned income and your adjusted gross income against the EIC Table, found in the IRS Form 1040 instructions for lines 66a and 66b. You’re entitled to the lesser of the two resulting values.

In other words, it’s not possible to goose your Earned Income Credit by making retirement contributions that lower your AGI. It IS possible to goose your Earned Income Credit by adjusting your Schedule SE to produce the highest possible EIC. But to do this, you need to understand how the EIC works.

Single, childless filers are entitled to the EIC starting with their first dollar in earned income. The EIC quickly ramps up to a maximum of $496 for earned income/AGI of $6,450 to $8,150, then slowly ramps down to nothing at earned incomes/AGI of $14,550 and up (remember you must use whichever value, earned income or AGI, that produces the lowest EIC).

This produces the interesting situation that between earned incomes/AGI of $10,155 and $14,550, filers are eligible for both the EIC and the RSCC. By a freak coincidence I fell in this exact income range last year: earned income of $13,030 and AGI of $12,957.

Since this range is on the “down ramp” of the EIC, unless you have unearned income that exceeds your AGI deductions (taxable interest, for example), you’ll have to use your earned income for the EIC and your AGI (as always) for the RSCC.

It’s worth taking a close look at what happens in this range. Holding all other variables constant, for each additional $107.60 in profit from self-employment, your earned income and AGI will increase by $100 (92.94% of $107.60). You’ll owe an additional $15.20 in self-employment taxes and $10 in federal income tax. You’ll also be eligible for an additional RSCC of $10 (for a $20 retirement contribution). But you’ll lose $8 in EIC, for a net loss of $23.20 — an effective tax rate of 21.6% on that $107.60 in profit from self-employment.

You may have heard the poor pay a higher percentage of their income in taxes than the rich. This is (one of many reasons) why.

The flip side of this is that within this range, any deductions you’re able to take against your business income on schedule SE are magnified by reducing your self-employment tax, reducing your federal income tax, and increasing your EIC, all of which is only partly offset by reducing the allowable RSCC as well.