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.

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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