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Eligible Employees and Other Workers Who Can Should Jump at Saver's Tax Credit

November 12, 2001

Authors: Richard I. Cohen

When Congress last June passed the massive tax relief and pension reform legislation known as the Economic Growth and Tax Relief Reconciliation Act of 2001, the pension provisions receiving the most fanfare were the increased 401(k) and IRA dollar limits, as well as the catch-up contributions available to older employees who are 50 or older in 2002. But building on its theme over the past few years of trying to entice Americans, particularly lower-paid workers, to save more for their retirement, Congress included in the law a fairly innocuous looking tax credit (IRC Section 25(B)) that packs quite a tax-savings wallop for America's lower-paid workers. For taxpayers who meet the Saver Tax Credit's Adjusted Gross Income limits, the tax savings realized from the credit can be as high as 86% of the tax bill that the taxpayers would owe if they neglected to contribute to an IRA or 401(k) plan. A tax shelter in the range of 86% is a phenomenal savings that, with the right measure of education by employers, should convince every eligible employee to set aside some amount toward their IRA or 401(k) plan. Employees who continue their pattern of not contributing to a retirement plan because their finances are too strapped need to re-think their position; by opting not to contribute, they will be giving their money to the IRS in taxes instead of having it grow toward their own retirement nest egg.

THE BASICS

The new tax credit, appearing in Section 25(B) of the Internal Revenue Code, takes effect January 1, 2002 (and unless Congress makes it permanent, is scheduled to expire at the end of 2006), and applies to any contribution made on or after that date by an eligible worker to either an IRA account or an employer's 401(k), 403(b), SIMPLE IRA, or 457 plan. The credit reduces the employee's federal income tax on a dollar-for-dollar basis, and is based on the employee's contribution amount and his or her credit rate. The maximum annual contribution amount that qualifies for the Saver's Credit is $2,000. For married taxpayers filing jointly, each spouse has his or her own $2,000 contribution amount. There are three tiers for the credit percentage rate: 50%, 20% or 10%. The credit percentage phases out to zero for a married taxpayer filing jointly who has Adjusted Gross Income over $50,000; a head of household taxpayer who has Adjusted Gross Income of $37,500; or a single or married filing separately taxpayer who has Adjusted Gross Income over $25,000.

The following chart shows how the Saver's Credit phases out for different types of taxpayers as their AGI increases:

Adjusted Gross Income


Married filing jointly

Head of household

All other filers

Credit


$0-$30,000

$0-$22,500

$0-$15,000

50% of contribution

$30,000-$32,500

$22,501-$24,375

$15,001-$16,250

20% of contribution

$32,501-$50,000

$24,376-$37,500

$16,251-$25,000

10% of contribution

Over $50,000

Over $37,500

Over $25,000

Credit not available

 

To be eligible for the credit, the taxpayer must be at least 18 years old, not a full-time student, not be claimed as a dependent on someone else's tax return, and have Adjusted Gross Income for the year of the credit below the above AGI limits.

EXAMPLE*

Assume joint taxpayers, Sally and Bob Smith, have Adjusted Gross Income of $34,000. If they choose not to make any pre-tax retirement contributions, their federal income tax would be $3,000. However, if Sally and Bob each were to contribute $2,000 to either an IRA or a 401(k), so that their combined contribution of pre-tax contributions was $4,000, their Adjusted Gross Income would be reduced to $30,000. Their $4,000 contributions would qualify them for a $2,000 tax credit under Section 25(B). Over and above the $2,000 credit, they will receive an additional tax savings of $600, which is produced from the tax deduction of $4,000 from their taxable income due to their pre-tax contributions. The overall tax savings to Sally and Bob is $2,600, the sum of the $2,000 tax credit plus the $600 tax savings from their $4,000 pre-tax contribution. On a percentage basis, they have saved 86% of their federal income taxes, plus they have set aside $4,000 into a tax-deferred retirement account. If the employer also makes a matching contribution, then their $4,000 starts to grow "right off the bat." The choice facing Sally and Bob Smith is a simple one: They can pay the IRS $2,600 in federal income taxes and never see a penny of that go toward their own, or they can use the $2,600 they would be saving in federal income taxes and have it go toward their own retirement nest egg. By reducing the amount of tax withholding taken from their paychecks, the Smiths can achieve this amazing 86% tax savings by reducing their take-home pay by as little as 4% per paycheck.

* This example is similar to the one appearing in IRS Announcement 2001-106, which IRS issued in October.

SOME TECHNICALITIES

Some technical rules apply with respect to taxpayers who take withdrawals from their IRA or 401(k) plans during the period shortly before or after claiming the Saver's Credit. This period is referred to as the testing period, which begins two years prior to their making a pre-tax contribution to an IRA or 401(k) plan and ends with the tax filing due date of the year after the contribution is made. For withdrawals during the testing period, the contribution eligible for the Saver's Credit is reduced by the withdrawal amount. (In essence, the IRS only wants the credit to apply to long-term contributions that will remain in qualified retirement accounts for the long-term.) These impermissible withdrawals, though, do not reduce the overall $2,000 contribution limit. Instead, they just get subtracted from the amount of the annual contributions the worker is considered to have made into the IRA or 401(k) for the year. For example, if the worker otherwise contributes $3,000 for the year 2002, but in 2001, he or she withdrew a $400 hardship from a 401(k) plan, and in the year 2002, he or she takes an $800 withdrawal from an IRA, the contribution amount that would count toward the Saver's Credit would be only $1,800 ($3,000 minus $400 minus $800).

The Saver's Credit is not a refundable tax credit in the same way that the earned income credit or child tax credit is. This means that the amount of the Saver's Credit is capped by the amount of tax the taxpayer otherwise owes. So, if a taxpayer's tax liability is already reduced to zero because of other nonrefundable credits, such as the Hope Scholarship Credit or the Lifetime Learning Credit, then the taxpayer is not entitled to a refund of the unused portion of the Saver's Credit.


CONCLUSION

Every so often, Congress "hits a home run" in the pension and retirement plan area. When it passed the new tax relief/pension reform law, Congress was definitely "swinging for the fences." Hopefully, all workers who are eligible for the Saver's Tax Credit will be "stepping up to the plate" to hit one "out of the park" themselves.

 

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