Table of Contents
- 1 How to Maximize Your Tax Credits and Increase Your Savings
- 2 Taxes are a Budget Burden
- 3 S.P.E.C.I.A.L Rules to Save Money in Taxes
- 4 S – Savers Credit
- 5 P – Premium Tax Credit
- 6 E – Earned Income Tax Credit (EITC)
- 7 C – Child Tax Credit
- 8 I – Investments
- 9 A – Adoption
- 10 L – Learning
- 11 Tax Planning
- 12 Tax Planning Isn't just for the Rich
- 13 The Tax Code to Answer Your Questions
How to Maximize Your Tax Credits and Increase Your Savings
Today we are going to talk about tax planning. Now I realize tax planning is not the most fun financial subject. Most people rather talk about the stock market then discuss how to get the most money from the Child Tax Credit. However, if you want to make more money, pay down debt, and save for your retirement it is imperative that you have a tax plan.
One of the biggest challenges for people trying to take control of their finances is where to direct their resources. Questions I often hear are,
• Should I Invest or pay down debt?
• Fund retirement or save for children’s education?
• Fund a Traditional Retirement account or a Roth?
It may surprise you to hear that these questions are really all the same.
What people are truly asking is, “What’s the most efficient use of my money?”
In many households the budget is tight, and tight budgets do not typically allow for paying down debt, saving for retirement, and setting aside money for education all at the same time. Savers, and especially those with more modest incomes, will need to both compromise on their goals and focus on being as efficient with their money as possible.
So, if your budget doesn’t allow you to do it all, here’s what you need to know.
Taxes are a Budget Burden
The first step in being efficient with your money is reviewing your income taxes. Taxes can consume anywhere from 15% to 30% or more of your income.
After housing costs, taxes can represent the average households 2nd or 3rd most significant expense. That's right; taxes can consume more than your hobbies, cable bill, and the other perennial blogging favorite whipping post – lattes!
Yet, you don’t see tax planning mentioned much in the blogosphere or the personal finance community. I can’t blame the community. Taxes indeed are not very fun, and taxes are nowhere near as sexy of a topic as investments.
However, if you want to be as efficient with your money as possible, you need to get wise about taxes. You need to know the special rules that can save you thousands.
Understand how the rules work, and you’ll be able to answer these questions:
• Is it best to invest or pay down debt?
• Should I fund a retirement account or save for my child’s education?
• 15-year or 30-year mortgage?
• How do I save money on health insurance costs?
• Should I fund a Roth or Traditional Retirement Account?
Resource: How To Estimate Taxes
This guide is designed to give you a high-level overview of the programs and benefits you should familiarize yourself with to save money in taxes. While I intend for this guide to be comprehensive, the internal revenue code itself is over 4000 pages and the instructions for most forms are several pages long, as such it would be nearly impossible to detail every, caveat, exemption, and extenuating circumstance that may impact your ability to utilize these programs.
Many tax professionals disagree on how to interpret IRS rules. Further clouding the issue, the IRS itself is not always sure about how a provision should be interpreted, causing many questions to end up getting settled in court. Proceed with caution and seek further assistance from an insured tax professional who will put any recommendations or suggestions in writing.
Use this guide as a resource to kick off your journey to maximizing your tax credits and deductions.
S.P.E.C.I.A.L Rules to Save Money in Taxes
Ever wonder why some people seem to pay very little in taxes, or get much larger refunds than you?
Well, it’s probably because those people understand the special rules of tax planning. The tax code is not as simple as income multiplied by a specific tax rate or rates. Several rules modify how much you may have to pay in income taxes.
Don't Worry, If thoughts of tax planning have your head spinning, I’ve devised an acronym to help you save money in taxes – S.P.E.C.I.A.L.
S – Savers Credit
The Retirement Savers Credit provides a tax credit for eligible contributions to a traditional retirement account or Roth. The Credit can be worth up to 50% of the contribution with a maximum credit of $2,000. ($4,000 if married filing jointly) The tax credit is in addition to any deductions you may receive for contributing to a retirement account.
The Savers Credit uses Adjusted Gross Income (AGI) to determine eligibility. Since eligibility is based on income it’s imperative to familiarize yourself with the income limits of the program. Many taxpayers who procrastinate tax planning and wait until tax season, find they miss out on the Savers Credit because their income was slightly too high.
The Retirement Savers Credit is an underappreciated and underutilized tool.
The income limits to qualify for the credit are modest, and families with higher incomes may have difficulty qualifying for the credit. Thus, making it essential to create a tax budget and a plan.
If you create a tax plan and you don’t qualify for the retirement savers credit one year, maybe you can plan to qualify in the second year.
Warning, Keep in mind that there are limits on how much you can contribute each year, you should familiarize yourself with the limits to ensure you do not miss out on being able to contribute.
Example, a young couple can only afford to save $5,000 a year in their retirement accounts. Saving just $5,000 though would not lower their AGI enough to qualify for the credit. However, if they can save $10,000, they would be eligible to qualify for a 20% credit. So, the couple decides to contribute $10K every other year instead of $5,000 per year.
Resource: Retirement Savers Credit
P – Premium Tax Credit
The Premium Tax Credit, created as part of the Affordable Care Act, is one of the primary mechanisms used to make health insurance affordable for individuals and families. The Premium Tax Credit essentially subsidizes your monthly insurance premiums if you purchase your health insurance under the Affordable Care Act.
The amount of your Premium Tax Credit is based on the size of your household and your Modified Adjusted Gross Income (MAGI). MAGI is slightly different than AGI used by other programs; your MAGI is AGI plus certain non-taxable sources of income added back in.
Many people neglect to plan for the Premium Tax Credit because it works differently than other credits. Most individuals choose to have the credit paid to the insurance company each month to reduce costs, so when they go to file their return, they are not thinking about the credit unless there is a problem.
However, if you reduce your MAGI, you could potentially increase the amount of your Premium Tax Credit and lower your monthly health insurance costs.
If you can reduce your MAGI to within 250% of the Federal Poverty Level, you could qualify for cost-sharing.
Cost sharing modifies your out of pocket health insurance expenses further, as well as lowering the deductibles on your health insurance policy. Cost sharing is great for reducing your yearly out of pocket health care costs and could save you 30% or more a year.
Resource: Premium Tax Credit
E – Earned Income Tax Credit (EITC)
The Earned Income Tax Credit (EITC) is a tax credit for low- and moderate-income families. The Amount of the Credit varies depending on the number of children you have and your Adjusted Gross Income (AGI). The lower your income, the larger the credit could be.
The EITC is a refundable tax credit, meaning that is possible to get more back than what you paid throughout the year in income taxes. So, if you zero out your tax bill, the EITC could represent “extra” money from the Government.
Reducing your Adjusted Gross Income could have two benefits with the EITC;
1. Lowering your AGI could increase the amount of your eligibility for, or amount of the credit
2. Reducing your tax bill could increase the amount of money refunded.
As with any refundable tax credit, the best value comes from lowering the taxes you owe as much as possible with other credits and deductions to increase how additional money is refunded.
Resources: Earned Income Tax Credit
C – Child Tax Credit
The Child Tax Credit was changed significantly during the most recent tax bill. The two most important changes are the doubling of the tax credit and making the tax credit now partially refundable. The Child Tax Credit is income sensitive. However, the income limits for the maximum credit are so high most people will not need to worry about it.
The Child Tax Credit is available for claiming on all qualified children under the age of 17 at the end of the year.
What is interesting about the Child Tax Credit is it’s now refundable. Refundable tax credits are arguably the most lucrative tax credits because they could represent “free” money from the government. If you can reduce your tax bill to zero through other means, then the government would pay you up to $1,400 per each qualifying child.
Resource: Child Tax Credit
It’s Like Free Money
If you have two children and engage in tax planning, then the IRS could pay you an additional $2800. A refundable tax credit is like receiving a pay raise, and that money could be used to save for retirement (Roth IRA, maybe?), pay down debt, or squirreled away for the children’s education.
When you are eligible for refundable credits, the goal is simple. Use other deductions and credits to reduce your income tax to zero, to collect the maximum credit. Planning is imperative because you have fewer options to lower taxes after Dec. 31.
Once the tax year is over your options are limited to IRA contributions and Health Savings Accounts. Additionally, by waiting until the last minute, you may not have budgeted the cash to come up with a substantial enough contribution to max out your benefits. With planning, you can strategically time education expenditures, business purchases, 401k contributions, and loan interest payments.
I – Investments
The tax rate you pay on long-term capital gains is partially dependent on your taxable income. The Tax rate could be as low as zero to as high as 20%. Long-term gains are generally considered to be taxed at more favorable rates than earned income.
Keep in mind though, while long-term capital gains are taxed at potentially lower rates, gains do add to AGI and MAGI. This could cost you more than you think.
Long-term capital gains could impact your health insurance premiums, your ability to qualify for other credits and deductions, and they could cause your social security benefits to be taxable. If you are trying to qualify for the tax advantages of other tax programs, it makes sense to plan out your long-term capital gains strategically.
If you have highly appreciated assets, such as a business or real estate you have inherited that you now wish to sell, they are options available to stretch the Capital Gains out over time.
Should you have stock you wish to sell to pay for a child’s college education, it may make sense to consider gifting the stock to the child (limitations apply).
Resource: Capital Gains and Losses
A – Adoption
The Federal Adoption Tax Credit helps offset the high cost of adoption and allows more families to afford adoption and provide children with permanent families. The Adoption credit phases out at high levels of income so most families looking to adopt should not have trouble qualifying. However, adoptions are expensive. And you will want to make sure you can take advantage of the credit if eligible, so some preplanning is prudent.
Resource: Adoption Credit
L – Learning
The Government wants to help you pay for education and offers several income-sensitive credits and deductions to help your family. These programs phase out at higher income limits than the other credits. However, it’s still worthwhile to plan to make sure you do not miss them.
Resource: Education Credits
The American Opportunity Credit
The American Opportunity Credit is the most popular and generous education credit, and it's also the most restrictive. To qualify for the credit, the person the tuition is paid for must meet specific criteria, such as:
• Be in their first four years of postsecondary education
• Taking classes at least full time
• Be enrolled in a degree or certificate program
• Not have any felony drug convictions
Should you meet all the requirements, the credit is worth 100% of the first $2,000 of qualifying expenses and 25% of the next $2,000, for a maximum credit of $2,500 per student.
A unique difference with The American Opportunity Credit over other credits is the tax credit is partially refundable if you manage to reduce your tax bill to zero. You will want to familiarize yourself with the math on the refundable portion, but essentially the IRS will refund 40 percent of any remaining credit up to a $1,000.
This provides another great incentive to plan ahead. Strategize to reduce your tax bill through other credits and deductions then use the AOC to get back an additional thousand dollars.
When you qualify for a non-refundable tax credit, you are merely getting back your own money that you worked for. However, when you are eligible for a refundable credit you are getting extra money back, in essence, you are getting a pay raise.
Resource: The American Opportunity Credit
Lifetime Learning Credit
The Lifetime Learning Credit (LLC) provides a tax credit of 20% of eligible tuition and is worth up to $2,000 per tax return. The LLC has fallen out of favor to some extent because of the more generous AOC. However, the LLC will cover some situations not covered by the AOC, such as graduate work, to improve job skills, or if you or your dependents are in the 5th year of college.
Resource: Lifetime Learning Credit
Tuition and Fees Deduction
The Tuition and Fees Deduction allows you to exclude up to $4,000 from your taxable income. Generally, the Tuition and Fees Deduction is thought of a being more valuable for high-income filers. And most publications would suggest that a $4,000 tax deduction is not as useful as a tax credit. However, taxes are not as simple as the amount of a deduction multiplied by the appropriate tax rate.
The Tuition and Fees Deduction lowers both AGI and MAGI. If the Tuition and Fees Deduction lowers your taxable income enough to qualify for other tax credits such as the Premium Tax Credit the savings could be significant.
Resource: Tuition and Fees Deduction
Student Loan Interest Deduction
The Student Loan Interest deduction allows you to deduct up to $2,500 of interest paid on qualifying student loans. The deduction phases out at much higher income thresholds than some of the other credits, however, it's still worth familiarizing yourself with.
Tip, The Student Loan Interest Deduction helps to lower AGI, so some preplanning could save you a lot of money.
Unsubsidized student Loans accrue interest while in deferment or forbearance, ultimately adding to the balance you need to pay back in the future. Paying this interest ahead of time each year not only is a great way to slow down the growth of the loan but could also help save you some money in taxes.
A $2,500 reduction of AGI may not appear to be that big of a deal. However, $2,500 could make the difference between you getting a portion of your AOC refunded or not. Also, it could be the deciding factor in you qualifying for cost-sharing under the Affordable Care Act.
The opportunity to engage in tax planning may be more valuable than you realize. Credits and Deductions interact with each other, and when you combine a few of them, the results can be significant.
I’ve seen situations where reducing taxable income by $10,000 produced over $7,500 in tax savings. Many people feel like they cannot afford to do tax planning, however, if you are potentially eligible for some of these programs you can’t afford not to engage in tax planning.
The Retirement Savers Credit alone could be used to turn a $1,000 IRA contribution into $2,000 or more.
Tax Planning Isn't just for the Rich
The Government offers some nice tax incentives for people at modest incomes. But it can be challenging for many families to take full advantages of these incentives because money may be tight. This is why budgeting and planning ahead is so important. When you calculate out potential tax savings, you may find an untapped source of money for savings.
Example, if you find you could potentially be eligible for a refundable tax credit if you contribute to your IRA, you can use the anticipated credit indirectly to help fund the contribution. Instead of paying extra on loans each month, you could use those funds to reduce taxes, then use your larger refund to pay down debt.
The hardest part of doing tax planning is coming up with the initial contributions for your health savings accounts, retirement accounts, or for prepaying deductible interest and expenses. While these things need to be done before you file your tax return, knowing you will receive a large tax refund may take the sting out.
With planning ahead, it may not be too difficult to set aside the money. However, if you wait until tax season making the contributions could be insurmountable, and you could be out of options.
Once you get the initial plan going, the refund can be applied to the following year’s tax planning endeavors and tax planning will get a bit easier.
The Tax Code to Answer Your Questions
I promised to answer your burning financial questions, and the answer is…check your tax return.
If you are struggling to determine if you should pay down debt or save for retirement, consider the impact of reducing taxes. No one wants to pay loan interest. But, if contributions are made correctly, they could net you a 50% or more return on your money. Unless you’re borrowing from the mob, you’re hopefully not paying 50% or more in loan interest.
15-Year Vs. 30-Year?
Should you pay down the mortgage or make extra payments, or should you do a 15-year or 30-year loan? Again, it really depends on your tax return. You may be better off setting aside the extra money or the difference in mortgage payments for tax planning to meet specific requirements.
Roth V. Traditional IRA
Should you fund a Traditional IRA or a Roth? This is going to be dependent on your goals and your AGI. If you’re not able to max out your retirement account contributions, utilizing the combination of deductions and credits may allow you to contribute more money to retirement.
However, it may not be an all or nothing proposition. You could use traditional retirements accounts to zero out your tax bill and maximize credits, then put the tax savings into a Roth.
Note: I have seen countless articles, blog posts and reach on whether it a Roth beats a Traditional IRA. The common mistake these posts make is conflating your Marginal Tax Rate, with your Effective Tax Rate. Additionaly, these posts typically make a series of assumptions and hold variables constant. Real tax planning is much more complicated than X figure multiplied by Y rate of tax.
The only real way to calculate how much a contribution to a retirement account would save you is to run it through the tax return. The savings could be much larger than expected by just using effective or marginal tax rates.
Most advocates of Roth IRA's, would point out the government is in massive debt, tax rates currently are low, and as such will be much higher in the future. The Reality is we do not know what the government will do with taxes in the future, I'm not trying to dissuade anyone from funding a Roth. All I am suggesting is it does not makes sense to overpay income taxes now, on the assumptions tax rates may be different down the road.
If contributing to tax-deductible accounts helps you qualify for significant tax credits than it is worth considering your best course of action.
Where to Go from Here?
Hopefully learning about some of these tax benefits have inspired you to create a tax budget. Grab your last years tax return, your most recent pay stub, and print off the rules and requirements for and programs you will to use. Compare your anticipated income with the requirements for the programs you intend to use, there still plenty of time to make corrective actions.
How to Maximize the Child Tax Credit and EITC Today's question comes from a lovely reddit user who asked how she could get the maximum value from the Child Tax Credit. Its an interesting case study and a great opportunity to showcase how to create a tax plan and a tax budget.