If you have or are considering starting a Solo 401k, you are financially savvy. But you’re not likely a CPA, which means tax terminology can be challenging. You often hear the phrases “tax deduction” and “tax credit.” Both sound financially enticing but there is a significant difference between the two. And there is also the phrase “before taxes”, which is where a Solo 401k begins.
Basic Tax Reduction Definitions
Let’s begin with some basic definitions about how taxes are calculated. You can relate to this if you understand a business’s financial statement. These are business phrases like “top line”, “bottom line, and “below the line.” On your income taxes, the top line is your Gross Income. Any changes (reductions) made to gross income before arriving at your Adjustable Gross Income are “above the line deductions.” Your adjustable gross income (AGI) is “the line”.
Any changes made to the AGI are “below the line deductions or credits.” After the deductions are made, you get your “Taxable Income or AGI.” Adjustments made below your taxable income are “Credits” that further reduce your tax liability. Credits are sometimes known as “below the line” adjustments. You arrive at the amount of taxes owed (bottom line) after the credits are subtracted from your taxable income.
Clear as mud. Right? Let’s add some context to these definitions.
Clarifying Tax Deductions and Tax Credits
Tax Deductions. A tax deduction does not directly lower your tax bill. It reduces the amount of income that will be taxed. This is one place where your Solo 401k becomes highly significant. In 2020, your Solo401k qualifies for a deduction up to $63,500 (possibly $127,000 by including your spouse). This means that if your potential individual gross income is $149,000, the $63,500 deduction can reduce your taxable income to $85,500. Even before making any other adjustments for credits, exemptions, or other deductions, your tax bracket drops from 24% to 22% (filing single). This is an “above the line” deduction.
Something important to understand with above the line deductions. These reduce your tax liability even if you don’t itemize your income tax return. Not being able to itemize deductions is one of the drawbacks that came from the 2018 tax reform bill. Above the line deductions are a powerful tax strategy.
Tax Deduction Examples
Other above the line deductions can include:
- Almost any expense from a sole proprietorship is deductible on Schedule C. This includes but is not limited to, rent, utilities, the cost of equipment and supplies, insurance, legal fees, and contract labor.
- Work-related moving expenses.
- Contributions to Health Savings Accounts (HAS) and Medical Savings Accounts (MSA). These are fully deductible as long as you do not have access to group policy coverage. The same goes for health insurance premiums.
- Half of the self-employment tax.
- Most educator expenses for professionals who teach grades K-12 and work at least 900 hours during the year.
- Early withdrawal penalties for a CD or savings bond that is reported on Form 1099-INT or 1099-DIV.
- Interest paid on federally-subsidized student loans if your income is below certain limits.
Some deductions are “below the line.” This is where many people used to itemize a lot of deductions. Now, more people are taking the standard deduction following the tax changes in 2018. The most common below the line tax deduction is the interest you pay on a home mortgage loan. Exemptions for yourself and dependents also fall into this category. Remember, below the line deductions don’t reduce your tax bill dollar-for-dollar. However, they do lower your taxable income, which decreases the amount you owe. These are only beneficial if your costs go above the standard deduction amount, which is no longer a common occurrence for many people.
Tax Credit Examples
What makes a tax credit different from a tax deduction is that credits directly lower the amount of tax you owe. That means for every tax credit dollar you have, it reduces the taxes on your AGI dollar-for-dollar. Tax credits do not reduce your gross income or your AGI. Credits directly reduce the tax owed. Credits can be high-impact reductions on your tax bill.
Tax credits come in a wide variety of applications. You can receive an energy tax credit for replacing certain appliances or making other energy improvements. The Child and Dependent Care Credit can get you between 20% to 35% off (up to $3,000) child care and similar costs for a child under age 13, an incapacitated spouse or parent, or another dependent so that you can work. There are three types of tax credits.
Types of Tax Credits
- Non-refundable tax credits lower your tax liability until it reaches zero. But you do not receive a tax refund for costs beyond the credit limit. This means that if the credit limit is $3,000 but your actual cost is $3,500, your tax liability will reduce by $3,000. But you will not receive a tax refund for your remaining $500 in costs. Also, if your costs were only $2,000 but the credit limit is $3,000, you reduce your tax liability by $2,000 but the remaining $1,000 does not benefit you.
- Refundable tax credits can be the most beneficial. Any cost you have above the tax credit can be received as a tax refund. In the above example where your actual costs were $3,500 but the tax credit limit was $3,000, your additional cost ($500) would become a tax refund.
- Partially Refundable Tax Credits are a hybrid of the two above. You can reduce your tax liability by the full $3,000 but the remaining $500 is only partially available as a tax refund. If the partial refund is 50%, you would receive $250.
Common tax credits are:
- Earned Income Tax Credit
- Low-Income Housing Credit
- Child and Dependent Care Credit
- American Opportunity Tax Credit
How Your Solo 401k Cuts Your Taxes
Once you understand how much you save on your taxes, you realize the amount you contribute to your Solo 401k retirement costs you less in today’s dollars. Instead of paying taxes on it and spending the leftover amount, you are able to invest the money in any way that you decide is right for your retirement. Not only are you saving big on taxes today, but you have the opportunity to earn double-digit returns to fund your future retirement.
For instance, if you contribute $187.50 per pay period, the real amount of your pay is reduced by only $165. This is because you’re paying tax on less income. The $22.50 difference represents your pre-tax savings. Your actual pre-tax savings will vary depending on your total annual income, other deductions and credits, as well as state or local income taxes.
Pay Less, Keep More
The higher your tax bracket, the more important tax-lowering opportunities become; like a Solo 401k. The 2018 change in tax laws is an inspiration to review your tax strategy. Small business owners are able to keep more of their money through expert tax planning. Probably the biggest tax slashing move you can make is owning a small business that enables you to open a Solo 401k. Maximizing contributions can save tens of thousands in taxes every year. Not only have the new tax laws probably changed your tax strategies but as your business profits grow, a different tax strategy is often needed.
Even if you are already benefitting from a Solo 401k, you may want to see if there are more advantages available from a Roth 401k. However, with the Roth 401k option, your contributions do not reduce your taxable income. Instead, your contributions are made with post-tax income. The tax advantage here kicks in when you begin withdrawing money after retirement. You will not owe taxes on these distributions.
Nabers Group understands that you want to minimize taxes. When you have questions, we have answers. There are several ways you can open your Solo 401k. We work with you to meet your financial strategy and needs.
Have questions about growing your retirement account? The 401k experts at Nabers Group will help you get your retirement funds into your control, where they belong.