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Understanding the difference between a Tax Deduction and a Tax Credit (and why it’s important to know now)

Ryan Gilmore

President Biden and Treasury Secretary Yellen are looking to make some changes to the way that Americans save for retirement. If you’re currently saving in a 401(k) or Traditional IRA, proposed changes will have major implications on your tax and retirement planning.

Under current law, individuals who are putting pre-tax funds into a 401(k) or traditional IRA receive a tax deduction. Tax deductions are good in that they reduce your taxable income.

Under the proposed law,  individuals who are putting pre-tax funds into a 401(k) or traditional IRA would receive a tax credit of up to 26%. Tax credits are good in that they reduce your tax bill.

So that begs the question: which is better?

The answer: it depends.

Let’s take a quick look at tax deductions. 

In addition to, let’s say, utilizing the standard deduction when filing your taxes, there are other ways to reduce the amount of your income that is subject to tax. One of those ways is to make contributions into a tax-deferred retirement account such as a 401(k) or a traditional IRA. For those under 50, you can put away $19,500 per year in a 401(k). Depending on certain income thresholds, you can put $6,000 per year into a traditional IRA. If you’re over 50, tack on an extra $6,500 in your 401(k) and $1,000 in your IRA.

Tax deductions will favor individuals with higher income in higher tax brackets. Let’s look at two examples:

  • If you’re 45 years old and are in the 12% tax bracket maxing out your 401(k), you’d essentially have $2,340 in income tax savings due to your contributions.
  • If you’re 45 years old and are in the 24% tax bracket maxing out your 401(k), you’d essentially have $4,680 in income tax savings. due to your contributions

That example assumes that you are in the 12% bracket and could max out your 401(k). Using a more realistic savings rate of 8.6%, let’s assume that you are in the 12% bracket and are only able to put $3,440 in your 401(k). That would result in approximately $413 in income tax savings due to your contributions, a far cry from $2,340, and unlikely to put much of a dent into the taxes you owe.

Now let’s take a quick look at tax credits.

If you’re a low to middle-class earner, a tax credit could be better in that it would incentivize more people to start saving. It might also nudge higher earners toward utilizing the Roth component of their 401(k).

Under President Biden’s proposal, 401(k) and IRA contributions would receive a 26% tax credit based on contributions made, as opposed to a dollar-for-dollar deduction.

Tax credits will favor individuals with lower income in lower tax brackets. Let’s revisit our example from earlier, only utilizing the proposed tax credit:

  • If you’re 45 years old and are in the 12% tax bracket maxing out your 401(k), you’d receive a $5,070 tax credit (reduction to your tax bill) due to your contributions.
  • If you’re 45 years old and are in the 24% tax bracket maxing out your 401(k), you’d also receive a $5,070 tax credit (reduction to your tax bill) due to your contributions.

Let’s go back to the realistic savings rate of 8.6% for someone in the 12% bracket. Let’s again assume that you are in the 12% bracket and are only able to put $3,440 in your 401(k). That would result in approximately $895 in tax credits due to your contributions, a far cry from $5,070, yet this time much more likely to put a dent into the taxes you owe than under the current deduction law.

If you’re in that 24% bracket mentioned above, your traditional 401(k) contributions are going to be included in your taxable income. In this case, it might be better to utilize the Roth aspect of your 401(k) since those contributions are already going to be essentially taxed, rather than utilize the credit. Yes, you might pay a little more in tax now, but I don’t think many will complain about tax-free money in retirement.

If you have questions about how taxes could affect your retirement —click here to schedule a free meeting with one of our advisors.

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