Tax Tip: Combine a Traditional IRA Deduction with the Retirement Savings Contribution Credit

Corey —  January 10, 2011 — 12 Comments

Uncle Sam says,        With tax time fast approaching, I thought it might be a good idea to share a tax tip with you all that I’ve found useful for my clients. By combining a Traditional IRA deduction with the Retirement Savings Contribution Credit (sometimes called the Retirement Saver’s Credit), you can reduce your taxes by quite a bit after the tax year has ended because you don’t have to make IRA contributions until April 15. You may be able to reduce your taxes (and increase your refund) by up to $2,000 with this tip.

This tip works because the size of the credit increases as you reduce your adjusted gross income (AGI). Making a deductible Traditional IRA contribution lowers your AGI. Depending on your income, you can make yourself eligible for the Retirement Savings Contribution Credit or increase the amount of your credit. Here’s what you need to know.

The Drawbacks

This tip won’t work if you’re under 18, a full-time student, or can be claimed as a dependent on someone else’s tax return. Those are basic requirements for the Retirement Savings Contribution Credit. If any one of those apply to you, this won’t work.

Additionally, this tip only works at lower incomes (and it works best at very low incomes). The problem here is that people with low incomes often have a more difficult time contributing to retirement accounts. Here are the adjusted gross income limits for 2010 before counting the IRA deduction:

  • Single or Qualifying Widow(er) – $32,750 ($33,750 if you’re 50 or older)
  • Head of Household – $46,625 ($47,625 if you’re 50 or older)
  • Married Filing Jointly – $65,500 (up to $67,500 if you’re both 50 or older, $66,500 if only one of you is 50 or older)

This tax move doesn’t work if your filing status is married filing separately because the phaseout range for a deductible IRA contribution is so small.

Finally, the Retirement Savings Contribution Credit is not a refundable tax credit. This means it will only reduce your tax liability to $0 – beyond that it won’t get you any extra money. That doesn’t mean it’s useless though. If you have other refundable tax credits, this tax tip could increase the refund you get back from those credits because it reduces your tax first.

How to Do It

Assuming you meet the requirements, your income isn’t too high, and you have some tax due, the next thing you’d want to figure out is how much you should contribute to an IRA to get the most benefit from the Retirement Savings Contribution Credit. You’re going to need to do a little math to figure this out, including considering ira rates. Alternatively, you can just do your tax return several times using different IRA contributions to see how things work out.

If you’re going to figure it out manually, you’ll need to first look at your tax due to figure out how big of a credit you need. On Form 1040, you’ll find your tax due on line 60. As I said before, the Retirement Savings Contribution Credit isn’t refundable, so you only need a credit as large as your tax due. Any more than that is useless.

Once you know the maximum amount you’d need from your credit, you’ll want to figure out how much of a credit you can get. There are two things you need to keep in mind. First, the Retirement Savings Contribution Credit is calculated as a percentage of your retirement contributions. But the credit is only calculated on up to $2,000 in contributions (or $4,000 if you’re married filing jointly – $2,000 for each of you). Second, the percentage depends on your adjusted gross income (after your IRA deduction) according to the table below. You can also find this information on Form 8880 – Retirement Savings Contribution Credit.

Filing Status 50% Credit 20% Credit 10% Credit
Single or Qualifying Widow(er) up to $16,750 $16,751 to $18,000 $18,001 to $27,750
Head of Household up to $25,125 $25,126 to $27,000 $27,001 to $41,625
Married Filing Jointly up to $33,500 $33,501 to $36,000 $36,001 to $55,500

So let’s say you’re single and your AGI is $30,000. You wouldn’t qualify for the Retirement Savings Contribution Credit unless you make a deductible IRA contribution of at least $2,250 to bring your AGI down to $27,750. That would get you down to the 10% credit range. Your credit would then be $200 (10% of $2,000). It doesn’t matter that you contributed $2,250. The credit is only calculated on the first $2,000 of your retirement contributions. But you might have to contribute more than $2,000 to make yourself eligible.

Want to see a more exciting example? Let’s say you’re married filing a joint return and your AGI is $37,500. As you stand now, you’d be eligible for the 10% credit on any retirement contributions you’ve made (this credit includes 401(k) plan contributions and similar accounts). But by making two deductible IRA contributions – $2,000 for you and $2,000 for your spouse – you can bring your AGI down to $33,500. This makes you eligible for the 50% credit and would lower your taxes by $2,000 ($4,000 * 50%). You just made a $4,000 contribution to your retirement accounts at a net cost of $2,000! I’d say that’s a good deal.

I like this tax tip because I’ve seen it work for myself and many others quite well. There are a few other aspects of this tip that I didn’t cover here, but I’ve given you enough info to get started on it. It’s a great way to boost your retirement savings while reducing your taxes – sometimes by quite a bit!

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Corey

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Corey is currently pursuing a Master of Arts degree in religion. While he enjoys learning and writing about Christianity, another one of his new passions is writing about personal finances in order to help others make wise decisions with their money.

12 responses to Tax Tip: Combine a Traditional IRA Deduction with the Retirement Savings Contribution Credit

  1. Thanks, Paul, for you insight on this aspect of tax planning. I can’t say that I knew how beneficial it was to clients until I read your article.

    Sounds like there is a real “sweet spot” for their income to maximize it.

  2. Glad it was helpful, Derrik! It is quite a narrow income range, but a good many people fall in that range.

  3. Paul, this is a great tip! I know a lot of people who could take advantage of this combination, but as you said, as those levels its usually difficult to find the extra income. But it definitely can be done!

  4. Yeah, it’s certainly not easy to find extra money at those income levels, but I know it is possible if you work at it. Really, if you can make this work for you then you should try as hard as possible to come up with the money. It’s a gimme – like a 401(k) match!

  5. So, what happens if you say you will contribute to your traditional IRA but end up not doing it (for one reason or another)?

  6. If you can’t make the contribution by the filing deadline, then you’d need to file an amended 1040 to correct it. If you don’t, you’d be filing a fraudulent return at worst and a negligent return at best (the penalties are different). You would end up paying penalties and interest on top of the amount you’d be require to pay back. The IRS will easily know if you don’t make the contribution because IRA custodians send them a Form 5498 to report IRA contributions. If you claim a contribution but the IRS never gets a Form 5498, you can be sure you’ll be getting a letter from the IRS (and it won’t be a love letter…).

  7. Paul, this is an amazing tip! I didn’t know about this, but my husband and I are eligible and plan to make a contribution based on our AGI before the credit. I do have a big question about it, though: Is the contribution limit really $4,000 ($2,000 per spouse)? The reason I am asking is because of the information on this IRS webpage:

    http://www.irs.gov/newsroom/article/0,,id=107686,00.html

    In paragraph 3, it says “you may be able to take a credit of up to $1,000 or up to $2,000 if filing jointly.” That doesn’t mean $2,000 total, does it? It’s still $2,000 per individual who is married filing jointly?

    Thank you so much for your reply. We can’t wait to use this credit!

  8. Hi, K! So glad you’ll be able to use this tip. :)

    You’re confusing the terms here. When I said the contribution limit is $4,000 for married filing jointly that’s because the credit is only calculated on up to $2,000 in contributions for each spouse. The maximum credit is then 50% of that amount ($1,000 for each spouse). So the IRS website is talking about the maximum credit, and I was talking about the maximum amount of your contributions that will count toward getting the credit.

    The trick is to use deductible contributions to get your AGI down to the limit for the 50% credit. So you might end up making more than $2,000 in contributions for each spouse, but doing so will entitle you to a larger credit.

    Finally, remember this is not a refundable credit. It will only reduce the amount of tax you owe to $0, which would enable you to get back all of your withheld income tax plus the full value of any refundable credits. It’s still helpful, but it’s not as good as a refundable credit.

    Hope that helps! :)

  9. Ah-ha! I knew I was missing something! Thanks for clarifying it for me.

    I just finished filing our taxes. Before making any contribution to IRAs, our federal refund was $739 and we owed our state $150. After putting $2900 into IRAs, our federal refund was $2,281 and we owed the state $50. We basically paid $669 to save $2900 in IRAs! My husband is absolutley ecstatic. We are showing everyone this tax tip on your website. Thank you, Paul!

    I also discovered that our tax preparation website was accurately calculating the Saver’s Credit on Form 8880, but I had to re-enter our IRA contribution amounts in the “Adjusted Gross Income” section to get our IRA deduction. I used TaxSlayer.com. I don’t know how you have to enter your IRA amounts with other online programs, but it’s important to double-check the actual Form 1040 or 1040A and make sure that you are receiving both the saver’s credit AND the IRA deduction to your AGI. I hope that helps someone.

  10. Fantastic! :) It sounds like it was a good deal for you all. But really you paid $1258 to save $2900 in your IRAs. (You should only attribute the increase in your net refund to this move – not the entire new refund itself. That is, your savings for doing this was ($2281 – $50) – ($739 – $150) = $1642. So you put in $2900 but got back $1642, leaving you with a net cost of $1258.) That’s still a great deal – a 130% return on your money!

    Good catch on the tax software. I haven’t used TaxSlayer before. I use TaxAct and it transfers all that information automatically. They all have their nuances!

    Thanks for your enthusiasm and sharing the website with your friends. :)

  11. Oh, I see the math now. Thanks!

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