Free Money with the Saver’s Credit

I was talking with my friend Eric a few weeks ago about writing a personal finance blog and he was totally excited about learning more. He went on to tell me how his dad preached to him and his brother, when they were younger, to “always save something from every paycheck, even if it’s only $1.” This is part of his plan, but it’s tough as a twenty-something who is early in his career trying to grow and build a small business and where all of his money gets plowed back into that business with little or no money left over for himself. So I told him I’d do some research to see if there was any “free money” out there. I think I found him some, so this post is for my friend Eric.

Usually, “free money” sends up all kinds of red flags. But this is straight from the Government. The “free money” I found is the Saver’s Credit, which is designed to encourage Americans to save for retirement by giving a tax credit as an incentive.

As described on Bankrate’s site, the Saver’s Credit “is one of the best deals going for people without fat-cat incomes. In short, you save $2,000 for retirement, and Uncle Sam will reward you by reducing your tax bill by as much as $1,000.”

From MarketWatch’s “Don’t forget the retirement saver’s credit,” a lot of people don’t know about this. “In fact, just 24% of American workers with annual household incomes of less than $50,000 are aware of the credit, according to the 15th Annual Transamerica Retirement Survey. And that’s too bad because the credit, for those low- to moderate-income workers who qualify, could mean a $1,000 to $2,000 tax break.”

And it’s also perfect for young millennials just starting out in their careers (i.e., before they start to get big bumps in their salaries).

So how does it work? Here are the details and we’ll show a simple example at the end.

Savings Benefit:

The maximum benefit for the Saver’s Credit is $1,000 for a single person and is based on 50%, 20%, or 10% of your retirement contribution depending upon your income (the credit % goes down as your income goes up – see Income Limits below). If you are married, the maximum benefit is $2,000 for your household.

It’s also important to make clear that the Saver’s Credit is a federal tax credit which is different and much better than a tax deduction. A tax credit is a dollar-for-dollar reduction to your tax bill. If you are single your taxable income is $15,000, your total tax is $1,793 from the tax tables. If you have a tax credit of $1,000, then you would only need to write a check to the IRS for only $793. The $1,000 tax credit is a straight reduction to your final tax bill.

On the other hand, a tax deduction is only a reduction to the income upon which your tax bill is calculated. Following the example above, a $1,000 tax deduction would reduce your taxable income from $15,000 to $14,000. As a single person, your tax liability would then drop from $1,793 to $1,643. This only saves you $150 off the check you have to write to the IRS. So the tax credit is worth $850 more than the tax deduction in this example.

Note: If your standard or itemized deductions or personal exemptions eliminate your entire tax liability, you won’t be able to claim the Saver’s Credit.

Income Limits:

There are pretty tight income limits that you must meet to qualify for the Saver’s Credit.  For a single person, the upper limit is $30,500. For married filing jointly, it is $61,000. And those only get you 10% credit. IRS income limits for Savers Credit:

2015 Saver’s Credit
Credit Rate Married Filing Jointly Head of Household All Other Filers
50% of your contribution AGI not more than $36,500 AGI not more than $27,375 AGI not more than $18,250
20% of your contribution $36,501 – $39,500 $27,376 – $29,625 $18,251 – $19,750
10% of your contribution $39,501 – $61,000 $29,626 – $45,750 $19,751 – $30,500
0% of your contribution more than $61,000 more than $45,750 more than $30,500

Retirement Contributions and Deadlines:

Contributions to traditional and Roth IRAs, 401(k) plans, SIMPLE IRA, 403(b), 457 plan, or a SEP qualify for the credit. You can only count the money you put in your workplace account, not any matching amounts your company contributed.

The deadline for contributing to a 401(k), 403(b) or other employer retirement plan is December 31. If you’re talking about an IRA, you still have plenty of time. The deadline for contributions is typically the date taxes are due (April 15; some years differ like this year when taxes are due April 18, 2016). If you had any self-employment income—even if it was only some freelance work on the side—you have until April 15 (or October 15 if you file an extension) to make tax-deductible contributions to a simplified employee pension (SEP). Cited from: Kiplinger’s “Deadlines for Retirement-Plan Contributions in 2014”.

If you already made retirement contributions during the year, then don’t forget to fill out IRS Form 8880 to get your tax credit (instructions below).

A Simple Example:

Let’s say that Laura is 23 years old, single, and earned $24,000 in 2015. She doesn’t itemize and just takes the standard deduction of $6,300. So her adjusted gross income (AGI) would be $17,700 ($24,000 – $6,300). Based on the IRS tax tables, she would have a total tax liability of $2,130. Finally, let’s assume she had withholdings of $2,000 from her paychecks for the year.

Option A: If Laura made no retirement contributions at work (401K) and made no contributions to an IRA (regular or Roth), she would get no Saver’s Credit and her tax liability would still be $2,130. Laura would now need to write a check to the IRS for the $130 ($2,130 tax liability – $2,000 withheld) by April 18, 2016 (normally April 15 during most years).

Option B: If Laura took advantage of the Saver’s Credit, she would save money right off the bat. Since her AGI is less than $18,250, she would qualify for the top benefit of 50%. Now, if she were to contribute $2,000 to an IRA before April 18, she would get the maximum Saver’s Credit tax credit of $1,000, which would reduce her tax bill from $2,130 down to $1,130. Now instead of writing an additional check to the IRS, Uncle Sam sends her back a tax refund of $870 ($1,130 tax liability – $2,000 withheld).

Using the Saver’s Credit, Laura ends up with a retirement account worth $2,000 for the cost of only $1,000. She just has to front the $2,000, but will get back $1,000 “immediately” from a reduced tax bill. So instead of paying Uncle Sam the $1,000, Laura pays herself by funding her retirement. And now her retirement account can grow tax deferred (if regular IRA) or tax-free (if Roth IRA) until she starts taking withdrawals when she retires.

Summary:

If you qualify for the 50% Saver’s Credit, which in effect is a 100% guaranteed and immediate return on your investment, it’s hard to pass up. The trade-off is that your money is tied up into a retirement account and can’t be touched without penalties until you are 59 1/2 years old. But that’s kind of the point, isn’t it? You need to be saving now in order for you to have a retirement in the future.

And remember the doubling cycles and the power of compounding…these early years are the most valuable ones to growing your savings. In the example above, if Laura generates an average return of 10%, her money will double every 7 years. If she retires at age 65 (42 years in the future), her $2,000 will compound by 64x (2 to the 6th power) through 6 doubling cycles and be worth $128,000. And that’s a nice chunk of change.

As always, with all major tax items, remember to review your specific situation with your tax advisor.

Sources and Other Articles:

IRS Tax Form Instructions:

Enter all your retirement savings 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 51 of your 1040 or line 34 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. Cited from: Bankrate.

Another tip: If you are doing this for 2015 tax return, make sure to designate the contributions to your IRA to 2015.

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