Tax Planning Opportunity for Recent College Grads
If you’re a recent grad you may have heard that Roth is the way to save right out of college, generally, that is correct. With the ability to take advantage of your current tax rate when your earnings are generally at their lowest point and then never pay tax on that money as it grows or when it’s withdrawn, Roth is a great option. There are certain situations, however, where you want to save in a way that reduces your AGI so you can take advantage of tax breaks that only apply at certain income levels. Below is a situation I’ve found that may support traditional deferral of income, at least right out of school.
There is a little-known tax credit that could be perfect for recently graduated college students who plan to start working almost halfway through the year. You’ll have to take into account any money you made while working during the academic semester as well, so keep that in mind. It’s called The Savers Credit and applies as the following in 2022. This chart explains what percentage of your total savings will be applied as a credit, as well as the different income levels the credit applies depending on filing status. If you’re single, you’ll be in the “all other filers” category.
As you can see this credit is aimed at lower-income households as an incentive to get them to save for retirement. However, seeing as recently graduated college students will only receive half of their yearly salary, this could be a great opportunity for people in those situations as well.
Here’s an example:
Say you graduate in May and take a job that starts in June paying $45,000. Since you started in June you’ll only be paid for half of the year or 22,500. For you to take full advantage of the saver’s credit you would need to defer $2,000 of your paycheck in a tax-deferred 401(k) plan or about 9% of your income (financial professionals recommend saving at least 12% of your income anyway). This will give you an AGI of 20,500 allowing you to take 50% of your contribution as a tax credit. Saving you $1,000 in taxes. While this isn’t a refundable credit - meaning it can only take your tax liability to $0 and you will not receive any additional refund - it can allow for you to take advantage of other refundable credits like the American Opportunity Tax Credit (AOTC). Which is refundable up to $1,000 if you’ve spent more than $4,000 on qualified educational expenses in the tax year. There are other rules surrounding the AOTC so talk with a tax professional to be sure you qualify.
For a higher earner this can still be beneficial.
If you’re single and making $66,000 per year out of college and start halfway through the year, you’ll be earning $33,000. If you follow our advice and defer 12% of your salary into a traditional 401(k) your AGI for the year will be $29,040. That means you can receive a 10% credit on the almost $4,000 you are saving this year. While this is only a $400 credit it’s good to remember that a tax credit is a dollar-for-dollar reduction on your tax liability, the best tax break there is. So this is still beneficial, especially if you were planning on saving 12% into a Roth account anyway. Combine this with the American Opportunity Tax Credit if you’ve paid more than $4,000 in tuition for your spring semester and you could be in for a huge return next tax season.
When you are being paid for a whole year, it will probably make more sense to begin Roth contributions, depending on your exact situation. In any case, it’s a great practice to work with a tax planner to make sure you’re doing what’s right for your own unique situation.
If you need help planning for your own situation, we’d be glad to help! Click the schedule link below to sign up for a free initial consultation. Working with someone who knows the tax code can save you hundreds of thousands of dollars in taxes over the course of your career and allow for a successful financial life.
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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.