Retirement Savings Credit Doubles Payoff

Contributors to retirement plans already know the long-term tax advantages of an individual retirement account or 401(k). Taxes are deferred, and in some cases never collected, on money put away for the golden years.

Now a tax credit will let some savers reap the rewards of their retirement thrift early.

The retirement savings contributions credit, also called the saver's credit, appears on Form 1040 and Form 1040A tax returns as a way to reward lower-wage earners who sock away retirement money.

Because the tax break is a credit instead of a deduction, it's a better deal. Tax deductions reduce taxable income, but credits come into play after you calculate how much tax you owe, and they reduce your Internal Revenue Service bill dollar for dollar. For example, if you owe $500 and you are eligible for a $250 credit, the check you have to write to Uncle Sam is cut in half.

Income limits

A filer eligible for the saver's credit could shave as much as $1,000 off his or her tax bill. The actual credit amount depends on your income, filing status and just how much you put into retirement plans.

Basically, the lower your income, the bigger your credit. The income limits that determine how large a credit you can claim are adjusted annually to keep pace with inflation. The precise credit percentages for 2011 filings are found in the table below.

Retirement savings credit guidelines; earnings are adjusted gross income

As the table shows, the maximum available credit is 50% of contributions for filers in the lower end of the earnings ranges. There is, however, a limit on the retirement plan contribution amount you can use to figure the tax break.

Although tax law allowed you to put up to $5,000 in 2011 ($6,000 if you're age 50 or older) in your IRA, only $2,000 of that will count in figuring the saver's credit. That makes it worth at most $1,000 for single taxpayers. Of course, if you're married and you and your spouse put away at least two grand toward retirement, your joint return would reflect a $2,000 credit.

Which contributions count?

Contributions to traditional and Roth IRAs as well as to employer-sponsored 401(k) plans count toward computing the credit. So does money you put into a Savings Incentive Match Plan for Employees, or SIMPLE, plan; a 403(b) program; a governmental 457 plan; or a salary reduction Simplified Employee Pension, or SEP. You can only count the money you put in your workplace account, not any matching amounts your company contributed.

The credit is based on your total contributions to all your eligible retirement accounts, not for contributions to each. So if you put $2,000 into a Roth and another $2,000 into your 401(k) at work, you still can only calculate your credit on the allowable maximum of $2,000.

Enter all your retirement saving amounts on Form 8880, Credit for Qualified Retirement Savings Contributions, and complete the form to arrive at your exact credit rate and amount. Once you get the dollar amount, transfer it to line 50 of your 1040 or line 32 if you file the 1040A. The credit isn't available for 1040EZ filers, so you might want to consider changing your choice of returns if you've been putting away retirement cash.

If your IRA contribution is to a traditional account, you may be able to get a double tax break. In addition to the saver's credit, look into whether you're eligible to deduct your IRA contributions on the front page of your 1040 or 1040A. This tax break is one of several adjustments to income that are available to all taxpayers, regardless of whether they are??itemizing or taking the standard deduction, and the IRS says you can claim the retirement savings credit and deduction for your IRA contributions.

The credit also is attractive to workers who are eligible to participate in a 401(k) plan but who earn just over one of the saver's credit income limits. By signing up for a company-sponsored account, such workers could get under the earnings cap while simultaneously boosting the potential credit amount.

Take, for example, a married employee who is the sole earner in her family and who reports adjusted gross income of $35,000 on her joint tax return. She's already eligible for a partial credit, but if she contributes $2,000 to her 401(k), she will knock her income down enough to take the maximum credit.

Some other restrictions apply

In addition to the income limits, there are a few other restrictions on who can claim the saver's credit. A taxpayer who was younger than 18 last year, a full-time student or claimed as a dependent on another's tax return can't take the retirement savings break.

The saver's credit is also what the IRS calls nonrefundable. That means you can use it to reduce your tax bill to zero, but you can't take advantage of any excess credit amount to get a refund. So if you owe no taxes, the credit is of no use to you.

Still, even if you can't take full advantage of the credit, it's not too shabby of a break when you take into account the additional tax savings you get by contributing to a retirement account in the first place.

Just remember, the key to this credit is participation in retirement accounts. If you haven't opened a retirement account yet, or have one but haven't contributed for the 2011 tax year, you have until the April tax-filing deadline to open one and put in money. The deadline is the same for either a Roth or traditional IRA.

As for your 401(k), you're locked into your credit for the 2011 tax year based on the contributions you made last year. Make sure the W-2 you got from your company reflects the correct amount of all your pension contributions so that you can get the maximum credit.

If you're not yet participating in your company plan, you can improve your future saver's credit potential by signing up as soon as you're eligible. Then contribute as much as you can afford without doing major cash-flow damage to your paycheck. It could pay off at tax-filing time as well as when you retire.