Temporary Tax Credit Is a Gift for Savers
It’s never easy for lower-income Americans to save for retirement, but Uncle Sam is offering tax breaks that may make it worthwhile to forgo some holiday spending in favor of building a nest egg.
Beginning in January, a new tax break will give certain lower-income workers big tax benefits if they put money into retirement plans. But because the biggest tax benefits are available to those who can least afford to save, cutting back--particularly in this season of largess--is key.
“Everybody needs to save, but the lowest-income families have the hardest time, because they have so much less to work with,” said Ken Scott, a spokesman for the National Foundation for Consumer Credit.
For that reason, everyone from the Internal Revenue Service to tax professionals is urging lower-income taxpayers--such as married couples earning less than $50,000--to attempt to accumulate some excess cash to put into retirement savings. Don’t overspend this holiday season, experts advise. And, if appropriate, request money instead of gifts.
This summer’s tax law created a new but temporary tax credit for lower-income taxpayers who set money aside for retirement. This credit could provide up to $115 in tax breaks for each $200 saved.
But the savers credit lasts only five years--2002 through 2006.
“We are telling people to look at the five-year window that was opened with this credit,” said Don Blandin, president of the American Savings Education Council in Washington. “If you qualify, and if you have a tax liability, try to take advantage of it. It is essentially free money.”
However, as with nearly everything income-tax related, there are complexities and caveats.
For instance, some lower-income parents risk losing a portion of the earned-income tax credit--a break that’s particularly valuable for families with young children--if they try to take advantage of the savers credit with contributions to tax-deductible retirement plans such as a 401(k) or IRA, said Brenda Schafer, senior tax research coordinator at H&R; Block in Kansas City, Mo.
These families--the lowest-income taxpayers--would be unwise to claim this credit by saving in a tax-deductible plan, even if some windfall allowed them to, Schafer said.
In the byzantine formula that determines eligibility for the earned-income credit, tax-deductible retirement-plan contributions reduce eligibility for the more generous earned-income credit. The net result: Poor working families could lose hundreds of dollars in tax breaks, Schafer said.
“Don’t rush into this. Saving is great, but saving in a savings account [rather than an IRA] might be a better option for some people,” she said.
Some taxpayers--single filers earning up to $25,000, married couples earning up to $50,000 and heads of households earning up to $37,500--should start crunching numbers to see whether they should take advantage of the break, said Donna LeValley, a New York attorney and contributing editor to “J.K. Lasser’s Your Income Tax 2002.”
“You only have this for five years, so you should try to get every dollar you can from the federal government,” LeValley said. “Even if you can just put $100 away for yourself, you’d have gotten started. It’s certainly worth it.”
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The Details
The savers credit will be in effect from Jan. 1, 2002, to Dec. 31, 2006. The credit provides up to 50 cents in federal income tax breaks for each dollar taxpayers save in a qualified retirement plan, such as an IRA, Roth IRA, 401(k), 403(b) or 457 plan.
For example, a taxpayer earning $15,000 who put $1,000 in a Roth IRA would claim a $500 credit (50% of the $1,000 saved) on his or her tax return the following April. The credit would reduce this taxpayer’s federal income tax on a dollar-for-dollar basis, but it can’t reduce the tax below zero.
Consequently, if this taxpayer owed $420 in tax, the savers credit would wipe out that liability but it would not result in an $80 refund.
Those who save in a tax-deductible plan--that includes all qualified retirement accounts except the Roth IRA--could claim their contributions as a deduction on their tax return, saving them an additional 10 to 15 cents for each $1 contributed, depending on their tax bracket.
The maximum credit that can be claimed each year is $1,000. To claim the maximum, however, a lower-income worker would have to save $2,000 annually in a retirement plan.
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Phaseouts
The value of the credit varies based on income, with the biggest credits going to the lowest-income taxpayers.
For a single filer whose income exceeds $15,000, the value of the credit drops to 20 cents on the dollar, for instance. For a taxpayer whose income exceeds $16,250, the credit rate drops to 10 cents on the dollar. Single filers earning more than $25,000 can’t qualify for the savers credit.
For married couples, the 50% credit is available to those earning up to $30,000; a 20% credit is available for those earning $30,000 to $32,500; and a 10% credit is available for those with adjusted gross incomes of up to $50,000. (See chart)
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Exclusions
The credit isn’t available to anyone younger than 18 or who can be claimed as a dependent on someone else’s tax return.
There is no upper age limit, but the credit is reduced by distributions from retirement plans. Couples with great age differences should be aware that if one spouse takes a distribution from a retirement plan, the other spouse is also excluded from claiming the savers credit.
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How it works
The income thresholds that determine the amount of the credit are based on adjusted gross income, which is wage and salary income minus deductible retirement plan contributions.
So a single taxpayer who earns $16,000 can get the 50% credit by saving $1,000 in a tax-deductible IRA. By making this tax-deductible contribution, adjusted gross income drops to $15,000, which qualifies the taxpayer for a 50%, or $500, tax credit.
If this taxpayer chose to save in a Roth IRA, which does not provide upfront tax deductions but allows tax-free withdrawals when the money is used at retirement, his adjusted gross income would remain at $16,000. That would subject him to the income-based credit phaseouts, meaning he would qualify for only a 20% credit--a saving of just $200 on a $1,000 contribution to his retirement plan.
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Cautions
Singles and couples with children should consult a tax advisor about the credit, Schafer said, to find out how saving in retirement plans can affect other valuable tax breaks, including the child tax credit and the earned-income tax credit.
Moreover, if there is a chance the family will need the savings before retirement, it makes little sense to save in retirement plans--tax credit or no tax credit, Blandin said. The penalties for withdrawing money early from a retirement plan are onerous.
“If you feel as if you are teetering on the financial edge--if there’s a risk of having to take the money out early--don’t put it in a retirement plan,” Blandin said.
“Build up an emergency fund or cash reserve first. If at some point, you still have the money and you know you’re not going to need it for near-term expenses, then put it in a retirement fund.”
* Saving Grace
A special savers tax credit goes into effect in 2002, providing lower-income workers with up to 50 cents in tax credits for each $1 they put into retirement savings. The maximum credit is capped at $1,000 annually.
Credit Income level:
rate Married Head of household Single
50% $0-$30,000 $0-$22,500 $0-$15,000
20 30,001-32,500 22,501-24,375 15,001-16,250
10 32,501-50,000 24,376-37,500 16,251-25,000
0 50,001+ 37,501+ 25,001+
Source: Internal Revenue Service
Times staff writer Kathy M. Kristof, author of “Investing 101” (Bloomberg Press, 2000), welcomes your comments and suggestions but regrets that she cannot respond individually to letters or phone calls. Write to Personal Finance, Business Section, Los Angeles Times, 202 W. 1st St., Los Angeles, CA 90012, or e-mail kathy.kristof @latimes.com. For past Personal Finance columns visit The Times’ Web site at www.latimes.com/perfin.
