by Denise Appleby CISP, CRC, CRPS, CRSP, APA
Low income earners are least likely to add savings to retirement accounts as they usually have limited disposable income. However, these individuals may be eligible to receive a nonrefundable credit for contributions to their retirement accounts, thereby lessening the financial impact of the contributions. This nonrefundable credit is referred to as the saver’s tax credit (saver’s credit), which can reduce the taxpayer’s federal income tax on a dollar-for-dollar basis.
It’s ‘Like’ a Matching Contribution
For individuals who are uncertain about whether they should make salary deferral contributions to their retirement accounts, it is usually recommended that they defer (at least) the amount necessary to receive the maximum available employer matching contribution. This matching contribution serves as an incentive for many individuals to fund their retirement accounts. The saver’s credit provides a similar benefit, except in this case, it is the government that is providing the ‘match’ by means of the tax credit.
Eligible Individuals
An individual must meet the following requirements in order to receive the saver’s credit:
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He or she must be at least 18 years of age,
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He or she should not be a full-time student, and
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He or she must not be claimed as a dependent on someone else’s return.
In addition to these requirements, the individual’s adjusted gross income (AGI) must not exceed certain amounts, and the amount of credit for which the individual is eligible is also subject to AGI limits. The limits and available percentage credit are as available here.
Eligible Contributions
Eligible individuals may claim the credit for the following types of contributions:
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- Pre-tax salary deferral contributions to 401(k), 403(b) annuity, eligible deferred compensation plan of a state or local government [457(b) or governmental 457 plan], SIMPLE IRAs and salary reduction SEPs(SARSEPs)
- Voluntary after-tax employee contributions to a qualified retirement plan or section 403(b) annuity. For purposes of the credit, an employee contribution will be “voluntary” as long as it is not required as a condition of employment, and
- Contributions to traditional IRAs and Roth IRAs
An eligible individual can split the contribution among more than one of these accounts, or deposit the entire amount to one account.
How The Saver’s Credit Impact Taxes
The saver’s credit can reduce an eligible taxpayer’s federal income tax .
Individuals who are married, and have a joint AGI that exceeds the limit for receiving the credit ( as indicated in the chart above) may consider filing separate returns if their separate AGIs are lower than the limits for the “other” category of filers.
Important: Before deciding to file separately for the purpose of receiving the savers credit, married couples should consider how their overall tax profile would be affected. For instance, an individual whose tax status is married filing separately is not eligible to deduct a traditional IRA contribution, if his or her AGI is $10,000 or more. To determine the true tax impact, these individuals should have their tax preparer prepare two returns, one where the status is married filing separately, and another where they file jointly. The one that results in the lower tax being owed (or the larger refund) should be filed.
Distributions Can Reduce the Saver’s Credit
Certain distributions taken by the individual and his or her spouse can reduce the contribution eligible for the savers credit. These include any taxable distributions from a retirement plan or IRA:
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That is received during the year that the credit is claimed
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During the two preceding years, or
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During the period after the end of the year for which the credit is claimed and before the due date for filing the individual’s tax return for that year.
A distribution from a Roth IRA that is not rolled over is taken into account for this reduction, even if the distribution is not taxable.
Example:
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Mark’s adjusted gross income is low enough for him to be eligible for the credit that year
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He makes salary deferral contributions totaling $3,000 to his 401(k) account during the current year.
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During the previous year, Mark took a hardship withdrawal of $400 from his 401(k) account,
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During the current year he takes an $800 IRA withdrawal, and
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None of the distributions were rolled over.
Mark’s saver’s credit for the current year will be based on contributions of $1,800 ($3,000 – $400 – $800).
How to Claim the Credit
The saver’s credit is claimed by Filing IRS Form 8880 and following the instructions provided on the form. These include instructions on how to indicate the correct amount on Form 1040.
Form 8880 must be attached to Form 1040 in order for the IRS to approve the claim
Other Features and Benefits
Other features of the saver’s credit include the following:
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It may be claimed for the same year that an individual claims a deduction for a traditional IRA contribution. For those eligible for the deduction, this means double benefits,
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It will not change the amount of the individual’s refundable tax credits, such as the earned-income-credit or the refundable amount of the child-tax-credit,
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The saver’s credit for any year cannot exceed the amount of tax that the individual would otherwise pay (not counting any refundable credits or the adoption credit) in any year,
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If the individual’s tax liability is reduced to zero because of other nonrefundable credits, such as the Hope Scholarship Credit, the individual will not be entitled to the saver’s credit , and
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An individual can use the saver’s credit to offset both an alternative minimum tax liability and a regular income tax liability.
An individual can take a projected saver’s credit into account when figuring the allowable number of withholding allowances on Form W-4?
No Tax Liability? Credit Unavailable
The saver’s credit will not provide any benefit for individuals who have no tax liability. For instance, for the 2005 tax year, 58 million tax filers had income low enough to qualify for the 50 percent credit. However, since the credit is nonrefundable, only about one-seventh of these individuals benefited from the credit (*). Additionally, -as noted earlier- individuals with AGI above certain amounts are not eligible for the credit.
(*)Improving Tax Incentives for Low-Income Savers: The Saver’s Credit: William G. Gale, J. Mark Iwry, Peter R. Orszag, June 2005
Conclusion
Saving for the future is usually not a high priority item for individuals with low-income. Instead, importance is usually placed on being able to cover current expenses. As such, it is often a challenge for these individuals to add to their retirement nest eggs. The saver’s credit provides an incentive for some of these individuals to save towards a financially secured retirement. Where the credit is not available, individuals should still consider adding to their nest egg, as doing so will help to ensure a financially secured retirement.
