Future Tax Rates
Deciding between a Traditional or Roth IRA depends, basically, on how you think your income – and by extension, your income tax bracket – will compare to your current situation. In effect, you’re trying to determine whether the tax rate you pay on your Roth IRA contributions today will be greater or smaller than the rate you’ll be paying on distributions from your Traditional IRA after you’ve retired (or have to start making them, at age 70½).
Of course, it’s hard to predict what federal and state tax rates will be 10, 20 or 40 years from now. Given today’s historically low federal tax rates and the large U.S. deficit, many economists believe federal income tax rates will rise in the future – meaning Roth IRAs may be the better long-term choice. But of course, no one knows.
Still, you can ask yourself some basic questions about your personal situation: Which federal tax bracket are you in today? Do you expect to be in a higher or lower one after you retire? Will your annual income increase or decrease? Although conventional wisdom suggests that gross income declines in retirement, taxable income sometimes does not. Think about it. You’ll be collecting (and owing taxes on) Social Security payments. You might opt to do some consulting or free-lance work, on which you’ll have to pay self-employment tax. And once the kids are grown and you stop adding to the retirement nest egg, you lose some valuable tax deductions and tax credits. All this could leave you with higher taxable income, even after you stop working full-time.
Tax Deductions Vs. Tax Credits
A tax deduction is an item the government lets you write off of your taxes to lower your total taxable income. Deductions usually only apply if you itemize them, rather than taking the standard deduction (which comes to $6,350 for single taxpayers and $12,700 for married taxpayers filing jointly in the 2017 tax year). Itemizing deductions is beneficial only if the total amount surpasses the sum for the relevant standard deduction you qualify for. Deductions basically get you a discount on the tax you pay. You don’t take a dollar off of taxes for every dollar spent; instead, every dollar that is deducted from your taxable income lowers the amount of income you will be taxed on. If you are in the 25% tax bracket, for example, every dollar you deduct gets a 25-cent tax break.
In contrast, a tax credit is a direct reduction of the amount of tax you owe. Common credits are issued for spending money on green home improvements or for going back to school. No matter which credits you use, you are slashing your tax bill to the federal government: If you have $2,000 in tax credits, your taxes drop by $2,000. You can take credits whether you take a standard deduction or itemize deductions.
Tax credits are usually more elusive and not as easy to claim as tax deductions – but they are much better, because they always reduce your taxes. If you have the opportunity to take a $5,000 tax credit or a $5,000 tax deduction, the credit is the better deal. Say you have a tax bill of $10,000. The deduction would lower your taxable income by $5,000; so, if you were in the 25% tax bracket, your taxes would be reduced by $1,250 to $8,750. A credit would directly lower the tax due to $5,000, and that’s regardless of your bracket.
There are numerous tax deductions and tax credits that are often missed each tax season. At Blue Oak CPA, we will help you zero in on them ensuring that you save as much as possible on your taxes!