Do you know your marginal & effective tax rate now and what it will be when you retire? Have you ever left part of your child tax credit on the table in the past? What is the optimum income for the additional child tax credit? It affects if a Roth IRA or Traditional IRA (or 401k) is the best type of retirement account. I’ve updated this child tax credit article for the latest tax law for 2018 and beyond.
Why should you care? Because tax planning to reduce taxes has a big effect on how much you’re able to accumulate to support yourself.
Disclaimer: I’m not an accountant or financial planner, or any other professional. This is information based on what we do and what I have found. Taxes are 42 times more complicated than they need to be. You need to check your individual situation or see a professional.
This is the first part of a series and includes the high level discussion and how to think about optimizing your retirement contributions when you have a family.
The Child Tax Credit Reduces Your Marginal & Effective Tax Rates
The Child Tax Credit (CTC) is a credit, not a deduction, which means it reduces the taxes owed dollar for dollar. This drives down your effective tax rate and can also effectively push you into a lower marginal bracket.
The Tax Cuts & Jobs Act, which changes the tax code for years 2018 through 2025, made several significant changes to the CTC in addition to the overall tax rate changes.
- Credit doubled from $1,000 to $2,000
- Start of Income phase-out increased from $110,000 to $400,000
- Income excluded from Additional Child Tax Credit (ACTC) reduced from $3,000 to $2,500
- Maximum ACTC set at $1,400 per child
- Added a $500 tax credit for other dependents that don’t qualify as children for the CTC. I’m not including this in the analysis because it’s too situation specific.
Many more people will now be able to use this credit to reduce their taxes.
This chart shows the effective tax rate for a given adjusted gross income (AGI) with varying family sizes from 0 to 6 kids. I only included even numbers of kids to make the graph easier to read. If you have an odd number of kids, your line will be about halfway between the even numbers.
This shows the federal tax due for a given income level. Each line represents the number of kids in the household under age 17 eligible for the child tax credit. I based the taxes on the 2018 married filing jointly rates. The CTC phases out completely by $440,000 AGI.
It also shows the 2017 effective tax rate for a married couple without kids, including the personal exemption phase out after $313,800.
The negative rates mean you get money back that you did not pay the IRS during the year since the ACTC is a refundable tax credit.
The 2018 plot lines are applicable to more people than the simplified 2017 federal tax calculation. With the higher standard deduction, and higher Alternative Minimum Tax (AMT) amounts, more people will only take the standard deduction plus the CTC & ACTC. Additionally, the AMT doesn’t impact filers that only use the standard deduction with the new higher AMT thresholds and AMT exemptions.
For comparison, here’s 2017 and 2018 effective tax rates for a family with four children:
A family with four children can have an AGI of $93,800 and owe $0 federal taxes. In 2017, they would need to stay below $69,900.
How To Choose Roth or Traditional Account
A Roth IRA or 401k does not reduce your AGI now. You pay tax on the money today and then put it into the account. A traditional IRA or 401k reduces your AGI by the amount invested that year. When you withdraw the money from a Roth account, there is no federal tax due. When you withdraw it from a traditional IRA or 401k account, it’s taxed as ordinary income.
In general, if the rate is higher now, contribute more or all to traditional IRA/401k accounts. If the rate will be higher in retirement, contribute more or all to Roth IRA/401k accounts.
You need to estimate your retirement income based on 2018 dollars (not inflation adjusted dollars). The tax brackets will index with inflation and take care of the adjustment.
- Determine your AGI. If you’re contributing to traditional IRA/401k accounts then subtract that amount from your income.
- Find the effective rate for your family size on the graph below. I split the graph into two income ranges to make it easier to read.
- Estimate your retirement income in today’s dollars. If you will have Roth money, the yearly distributions from those accounts DO NOT become part of your AGI.
- If the rate now is significantly lower than in retirement, pay the tax now by putting most/all of the money into Roth IRAs/401ks. If the rates are close, put money into both account types.
Family of Four Example
A family with two kids eligible for the CTC has an income of $80,000 in 2018. The parents estimate their desired retirement income as $60,000. If they contribute $18,000 to a traditional 401k, their AGI is now $62,000.
Looking at the effective tax rate graph, they will have a rate of approximately 0% (actually 0.29%).
In retirement, their 401k withdrawals will be taxable and the effective rate is 6.75% assuming congress extends the current rates, or 8% assuming the rates revert to the 2017 levels.
It looks like Roth contributions are better. Let’s see what happens with that scenario.
If they make $18,000 in Roth 401k contributions, their AGI stays at $80,000. This makes their effective rate with kids 2.92%. When they retire though, they will be able to withdraw the Roth money tax free. Their AGI will be less than their desired retirement income of $60,000.
Assuming they invested well enough that the Roth account has the funds to withdraw $18,000 (remember that everything is in today’s dollars) per year, their AGI will be $42,000 from other taxable sources.
This results in a tax rate of 4.29% at current rates or 5% at the 2017 rates.
Marginal rate changes don’t have an effect in this range, it’s 12% at $80,000, $68,000 and 10% at $42,000. But remember, that 12% is only on the amount of income in that bracket, so the net effect is small.
If this were our situation, I would do all Roth contributions, assuming our fixed expenses allowed it. This way we would pay 2.92% rate now, instead of a 6.75% (or 8% with 2017 rates) later in retirement.
If the rates are relatively close, then you could put 401k contributions into whichever account type resulted in better rates (Roth in the above example) and IRA contributions into the other type of account. This hedges changes in your assumptions. Plus, it’s always good to have options when trying to predict the future.
In general, since the CTC is so high right now and it’s a credit you know is going away once the kids grow up, the Roth account will most likely be the optimal solution. If your income now is very high relative to your retirement income a traditional account may be better.
Why You Might Not Want To Do This
I described a simplified process for optimizing which account to use. There are other benefits other than net worth optimization you may want to consider. I can think of a few examples:
- General hedging of future tax rates and future retirement income as discussed above. Options are good to have.
- You may not have the room in your budget to maximize your Roth contributions, but a traditional IRA/401k reduces taxes enough to do maximize contributions. Be honest with yourself about your expenses before saying you can’t contribute to a Roth instead of a traditional account.
- Roth contributions, but not earnings, can be withdrawn penalty and tax free prior to age 59 1/2. You may want to do this to use the money for early retirement, a backup emergency find, or for college expenses.
- A Roth account would allow you to withdraw a large amount as soon as you’re 59 1/2 tax free. Maybe you want to retire and buy a sailboat so you need a large amount of money in a single year. Withdrawing from a traditional account would push you to a higher tax rate.
- Less restrictions on Roth IRAs when leaving the money to others. Whomever inherits a Roth account would not have to pay taxes on withdrawals.
I’ll discuss CTC eligibility, marginal rates, account limits, and other details in the next post.