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.
And here I thought your lack of income was because you don’t pimp cc sign ups or cuddle up to Bankrate!
Russ,
Nope! Even if I sold out completely I’d still just contribute to my 401(k) until my AGI was $18.5k again!
—IF
some people cant get down to 18.5 even if they wanted to
SumOfAll,
Unfortunately that’s true, although if you’re self-employed (or have access to a workplace deferred income plan) you should be able to get down to $18.5 if your income is up to the mid-$50’s or low-$60’s, through a combination of 401k and IRA contributions.
—IF
I really never understand why we give credits (aka: welfare) in the form of “refunds” when many people who get the tax credits don’t pay taxes to support this. A flat tax seems much simpler and much more fair.
DaninMCI,
The boring answer is that you have to ask the question, “shall we raise money from people based on their ability to pay?” A 25% flat tax on all income would raise plenty of money, but would leave the poorest workers with too little money to survive. Alternatively, you could exempt a certain amount of income from the flat tax, but the higher the exemption, the higher the flat tax rate would have to be. That’s already a kind of progressive income tax, with a 0% rate on income up to a certain point and a 40%, for example, rate on income above that point.
What we instead have is a progressive income tax that exempts a relatively small amount of money (about $10k) but which starts at a very low level and only reaches 40% for extremely high incomes. Then additional credits are offered to extremely low-income earners to supplement their income, making the tax code even more progressive.
You can think of a progressive income tax as multiple “flat” taxes on income within certain ranges: a flat 10% tax, a flat 15% tax, a flat 25% tax, etc. on each pool of income. The ranges are our answer to the question “shall we raise money from people based on their ability to pay?” America has answered a resounding “yes.”
It seems that the main appeal of the flat tax to people is not its simplicity (calculating your income tax is trivial once you’ve calculated your AGI), it’s that advocates for the flat tax also want taxes to be lower, and levying a flat tax is a way of forcing low taxes since the very poor are unable to pay a high percentage of their income in taxes. I don’t think taxes should be lower (I think they should be somewhat higher), so the flat tax doesn’t have any appeal to me.
—IF
“Ability to pay” is a curious metric. On the surface it seems equitable and just, but that is a rather surface view. Consider for a moment that high income earners might also be highly productive and “worth” their pay. By increasing their marginal tax rate, you’re disincentivizing their higher output (assuming they’re really worth it). Why would we want to discourage highly productive people from being productive? Seems like a net loss to society. Also, when these people work more they’re forced to hire labor (because they no longer have time to do the more menial things). Wherever one is on the ladder, it seems that the government should be trying to incentivize distribution of labor – one of Adam Smith’s keys to an efficient marketplace. Instead, it’s prohibitively expensive for 80k earners to hire 20k earners. Why is that? Taxes, and an interface for government to make money. Taxes may need to be higher, but the byzantine set of rules makes it too expensive for simplistic things. People need to stop pretending low-end jobs have to be able to support a family. Maybe they need to simply support a kid living at his parent’s house while he figures out his life.
ed,
On the contrary, I didn’t say anything about equity and justice. My only reference point is ability to pay, as in, the amount of money one is able to provide in order to support the functions we decide the state should provide. If the US government owned a bunch of dilithium mines on the moon and sold dilithium crystals to all the other countries on Earth we wouldn’t need taxes at all.
But since we have to gather money from our citizenry in order to finance the state, we have to go where the money is in order to do so. A progressive income tax is a way of drawing resources from those who have it, while a flat tax has the problem I mentioned: a high tax can exempt relatively more income while a lower tax has to be applied to more people, including those who do not have the ability to pay it. The income tax code needs to be radically simplified, but once it’s simplified it’s trivially easy to have any number of tax brackets, since you just look up your income in the tax table and pay the amount you owe.
We have a progressive income tax for the same reason Willy Sutton robbed banks: that’s where the money is.
—IF
Ah, but we don’t have a progressive tax system at all. Once you become rich, your effective tax rate drops dramatically. The 0.1% pay an absurdly low effective tax rate – usually in the teens or mid 20% range -but only on reported income. Corporations that they own can shield huge amounts of income (like hiding it overseas setting up headquarters in low/no tax jurisdictions). That’s where the money truly is. – and will stay as long as so many remain wilfully ignorant about how the real world works.
The irony is Joe Taxpayer gets outraged at welfare queens in the ‘hood. They are oblivious that the biggest welfare queens are the rich.
I think I’m missing someone. If you put all your income into retirement except for $18,500, how do you live? Maybe in some parts of the country you could, but my very modest mortgage for a 540 sq ft home is more than $18,500 each year. Granted that’s Seattle for you….
Or is there something else I’m missing?
Thanks!
Alan,
I have very modest living expenses, and not all of my disposable income is taxable. I agree that Seattle is a very expensive city, many other places have a much lower cost of living. $18,500 per year is over $1500 per month, which is a comfortable income in many parts of the country.
—Indy
Gotcha, thank you for the reply.
There are plenty of positives of living in a big city… affordable housing is not one of them!
$22.5K in taxable income? I presume you made similar from cash back/portals and sync deals last year as well? If not, time to quit your day job…
Mser,
Are you hiring?
—Indy
I, for one, certainly wouldn’t hire someone with a degree in Slavic studies.
What makes you believe you’re qualified to speak intelligently about financial topics with such a pointless degree?
NATS,
Lol.
—Indy
When I first read the IRS page on Saver’s Credit, I thought “The amount of the credit is 50%, 20% or 10% of your retirement plan or IRA contributions up to $2,000 ($4,000 if married filing jointly)” meant that the max of CREDIT is $2000/$4000. So for us, my mouth-watering thought of $2900 ($18k + $5.5k x 2) in credits just went down to $400 at 10%…..
As long as our line 44 exceeds $400, the credit should be used up and not “go to waste”, right?
We should get $3k in Child Tax Credits this year. Last year we were able to get the “balance” of the Child Tax Credit (original credit minus taxes owed) refunded through “Additional Child Tax Credit”. If we factor in Saver’s credit this year, does the Saver’s credit get used first to cover taxes owed, then the Child Tax Credit gets used? Then we get the balance of Child Tax credit refunded again? We didn’t get Saver’s credit last year so not sure of this scenario.
Thanks
Basically saver’s credit gets used first and for the child tax credit, only the additional tax credit applies. The best way to do this is to use the free Excel 1040 worksheet, excel1040.com, and plug in the numbers to run your own scenario.