Tax filers who participate in a company-sponsored retirement plan are sometimes surprised to learn that they are eligible for an extra tax credit. The tax credit is in addition to the regular tax-deferral benefits of a retirement plan. Other working individuals who are not in a company retirement plan may also receive the additional tax credit if they contribute to an individual retirement account.
The tax credit is officially known as the "retirement savings contributions credit." As a practical matter, it is often referred to simply as the saver's credit. Unlike deductions that reduce your level of taxable income, a credit is a direct offset of tax. The saver's credit is available to many individuals, but it can sometimes be optimized for those who contribute to an IRA.
The saver's credit is calculated as a percentage of your retirement account contribution. You are free to contribute more toward retirement, but the contribution ceiling for purposes of the tax credit is a separate limitation. The applicable percentage is based on your income and is either 10, 20, or 50 percent. The maximum contribution on which the percentage can be applied is $2,000 unless you are married. If you file as married filing jointly, the maximum is $4,000.
Effect of taxable income
The saver's credit is not available if your income is above the specific upper limit for your filing status. If you are eligible for the credit, your applicable percentage is determined by a certain entry line on your tax return labeled as "adjusted gross income," or AGI. Because a traditional IRA affects AGI differently than a Roth IRA, you can sometimes influence your applicable credit percentage.
Lowering current taxable income
A traditional IRA reduces taxable income, resulting in a lower AGI. In contrast, a contribution to a Roth IRA remains in AGI and is taxed up front. The three applicable percentages for purposes of claiming the saver's credit each corresponds to a different AGI range. The lower the AGI range, the higher the credit percentage. As a result, you may be able to increase your saver's credit by funding a traditional IRA instead of a Roth IRA.
Minimizing current tax
The saver's credit cannot be refunded. The credit can only be used to offset tax that would otherwise be payable. You may fund both a traditional IRA and a Roth IRA, as long as the combined total is within the annual IRA contribution limit. Once you have optimized the saver's credit with a traditional IRA, a Roth IRA can be considered for the remainder of your contributions.
Contact a local financial planning service for more information and assistance.