saver's tax creditIt can be difficult to save enough money for retirement, and even more so if you don’t have much disposable income in the first place. Putting away money can become something that always happens “later”. Fortunately, Uncle Sam wants to help you afford to save, especially if you’ve got a low income. If you haven’t filed your taxes yet for 2010 (you filed a tax filing extension) or you are looking to take advantage of it on your 2011 tax return, read on. Income limitations may slightly change with inflation for your 2011 tax return (IRS will report possible changes later in year).

The “saver’s credit” (officially known as the Credit for Qualified Retirement Savings Contribution) gives you a tax credit up to $1,000 (up to $2,000 if filing jointly) just for making a contribution to a retirement account, if you meet the requirements. Here are some of the qualifications:

  • Income – This credit is limited to individuals with incomes below $27,750 who file as single, $41,625 if they file as head of household, or $55,500 if they file as married filing jointly. (Couples who file as married filing separately are not eligible for this credit.) There’s lots of evidence that individuals at these income levels or below are not financially prepared for retirement, so if you qualify, you can help set yourself up for the future and pay less doing it.
  • Age – You must be at least 18 years old in order to qualify to take this credit on your tax return.
  • Dependency – Individuals who are claimed as a dependent by someone else don’t qualify for this credit.
  • Student status – If you were not a full time student (for at least a 5 month period) at a school or through an on-farm training program though a school, you can qualify for this credit. Again,  you must meet ALL the qualifications above, including the income qualifications, in order to take this credit.

What contributions will qualify for the savers tax credit?

Any kind of contribution that you made out of your own money to a 401(k), traditional IRA, Roth IRA, Roth 401(k), SEP-IRA, SIMPLE IRA, or any other retirement account will qualify. Amounts contributed for you by others do not qualify nor do rollover contributions. For example, if your employer matches your 401(k) contributions, you can’t count their contributions toward the credit, but only your own.

Realize that this tax credit can be utilized in conjuction with deductions for all or some of the contributions to a traditional IRA for low-income earners. See publication 590 for more information.

How is the saver’s tax credit calculated?

By using Form 8880 and most tax software you can figure out the credit. As general guidelines, first, add up all the amounts that you contributed to the above accounts and minus distributions received after 12/31/2007 and before the due date of your 2010 tax return (which includes extensions). Then, take the smaller number between either that amount or $2,000.  Next, you need to consider your income reported from form 1040(A)(NR) and do further calculations. Use Form 8880 to complete a worksheet which will determine how much credit you’ll receive. The credit phases out at hirsigher levels of income, so the higher your income, the less you’ll receive in credit. However, the credit amount is also based on the amount you contributed up to $2,000, so the highest credit would be received by someone with very low income but retirement contributions in 2010 of $2,000 or more.

Once you know what your total credit is after using the worksheet, this number will be entered on Form 1040, line 46. This credit is nonrefundable, which means that it will only reduce your tax liability to zero, but not beyond that. However, keep in mind that many individuals who are eligible for this credit are also eligible for the Earned Income Tax Credit, which IS a refundable credit. So you could potentially use the “saver’s credit” to reduce your tax liability to zero, and then receive your entire Earned Income Tax Credit as a refund. Since many tax programs will automatically calculate whether you are eligible for this credit or not, it’s definitely worth it to check and see if you’re entitled to any extra money.

While there are many tax advantages to retirement accounts, many of those advantages are much bigger for individuals with high taxable income. If you already have very low income, your marginal tax rate is pretty low, so a traditional IRA or 401(k) contribution wouldn’t take as much off your tax liability as it does for a higher earner with a much higher marginal tax rate. On the flip side, though, when your taxable income is very low and you don’t pay much in taxes, you can get a much bigger bang for your buck with a Roth IRA – anything you can save now in a Roth IRA will be a great investment and “cost” you only a small potential tax deduction. That’s not only because you can qualify for an extra big refund with the “saver’s credit”, but also because that little bit will grow over time and you won’t pay taxes on it when you go to withdraw it!

Now, we know that a lot of people who are thinking about retirement are likely to be well on their way in their careers and may not qualify for this credit due to income restrictions. However, this credit can be a great help to people just starting out in the working world, such as new college graduates! If you have a graduate in the family who’ll be starting work soon, a wonderful graduation gift would be a gift of money to be deposited into their first IRA. As long as they are not a dependent this year, and they make the deposit themselves, they’ll get a great start to their nest egg, and then also turn around and reap a second benefit from their increased tax refund.

Another method that many people use to fund their IRAs on a shoestring is to use a little “float” to fill their account. In February of each year, after you’ve already gotten all your W-2’s for the year and are able to fill out your taxes, you’ll be able to tell if you’re under the income limit, and how much of a potential credit you might get, by looking at Form 4888. If you’re able to get a pretty good credit amount, you can then contribute to an IRA from your savings but ask that the money be classified as belonging to the previous tax year. Then, file your taxes electronically and you’ll have your credit refund in about three weeks – and you can stick that refund back in your savings.

As you can see, there’s more than one way to get a little help with retirement! This is not a well-known credit, but it has helped encourage many people just getting started in their careers or who want to save for retirement on a limited salary. Forward this article to someone you know who falls into either category and help them get started today!