Q - I've noticed that the software is giving my client 'tax credits'. Could you explain why and how the tax credits come about?
A - The short answer is that what the software displays as a “tax credit” is effectively a refund resulting from an overpayment of taxes in the prior year.
In each year of the plan, the software performs two stages of tax calculation:
- During the year – taxes are estimated and applied based on income (similar to withholding or estimated payments)
- End-of-year – a final tax calculation is performed based on total income, deductions, and contributions
In the example demonstrated above the Federal and State Income tax & Federal withholdings are calculated and deducted at source.
Let us assume that this individual is also making contributions, to Qualified Retirement accounts and that they qualify for the standard deduction:
For pre-tax qualified retirement contributions, taxable income is reduced, which may lower the final tax liability. This reduction in taxable income may result in less income being taxed at higher marginal rates.
The reduction in their total taxable income (illustrated above), of course, results in a reduction of tax to be paid at the individual's marginal tax rate. The result is that, when the software carries-out its end-of-year tax calculation, it recognizes that the individual has overpaid tax in the current year and is entitled to a refund that will be credited in the following year of the plan, as illustrated below.
Several factors can contribute to this overpayment, including:
- Pre-tax retirement contributions (e.g., Traditional 401(k), IRA), which reduce taxable income
- Standard or itemized deductions, including mortgage interest
- Other deductible expenses
Because these adjustments reduce the final tax liability, they can create a situation where taxes paid during the year exceed what was actually owed, resulting in a refund applied in the following year.
Think of this as an annual true-up of taxes, modeled one year in arrears.