Most people should use TurboTax or TaxAct or an accountant or something besides pencil and paper to file their taxes. It's easier, less error-prone, and often free. However, the last step in that whole process must include going through the actual tax forms that got filed and understanding, at least at the most basic level, where the numbers came from and what they mean.

Let me give a simple example of how it might pay to understand your own tax situation. Adam and Eve are a young couple with one child. Adam makes only $40k salary and Eve is at home raising Cain for the next few years, so money is tight. Eve wants to start saving something for retirement now, even though she expects to go back to work and eventually have a pretty nice retirement income from pensions and social security. She posts to r/PF asking for advice.

Eve: "How should I save for retirement?"

r/PF: "First, do an emergency fund."

Eve: "Done. What next?"

r/PF: "401k up to the employer match."

Eve: "No match. What next?"

r/PF: "IRA up to $11k."

Eve: "Roth or Traditional?"

r/PF: "Your marginal rate is 10% now, and your average rate in retirement will probably be 15% or more, so Roth."

Is r/PF right?

First of all, let's just assume that r/PF is right about the 15% rate in retirement, and let's assume state tax rates don't change anything. As it turns out, r/PF is still wrong to recommend a Roth IRA. While a Roth is probably better than a Traditional IRA, both are almost certainly worse than traditional 401k contributions, even without the match.

The Retirement Savings Contributions Credit

The "Saver's Credit" provides a pretty strong incentive for low-income families to begin saving money for retirement. It offers a 10%, 20%, or 50% tax credit for contributions to 401k plans and IRAs, up to $4k for a couple. Because of the cutoff points for when it changes from a 20% credit to a 50% credit, and because the cutoff point is based on taxable income, not AGI, 401k contributions can boost Adam and Eve's Saver's credit so that their effective marginal tax rate (ie, the amount they save on taxes as a percentage of their 401k contribution) is over 20%.

Here's a table showing their tax situation assuming $5k of retirement savings:

||Naive|Saver’s Credit (real)| |-|-|-| |Salary|40,000|40,000|

changed March 11, 2015 delete history edit