Retirement may seem like a far-off prospect, but saving for your future should still be a priority. Your Social Security benefits may not be able to cover all of your expenses later in life, especially since the program’s payouts are expected to be reduced after 2035. That means that today’s workers have to find other ways to provide for themselves during retirement.
Unfortunately, it can be difficult for low- and middle-income earners to save enough of their paycheck to contribute toward long-term goals. But there are some tricks you can use to help put aside a little extra for your future. The Retirement Savings Contribution Credit (now called the Saver’s Tax Credit) is a great example.
How Does the Retirement Savings Credit Work?
The Retirement Savings Credit is a tax break designed to reward lower-income earners for contributing to their tax-advantaged retirement accounts.
Congress and the IRS know that it can be difficult to save money when you’re earning just enough to get by, and they decided to show a little mercy (for once).
You may not notice unless you check your pay stubs, but taxes are almost always among your biggest household expenses. Reducing them is a great way to put more money in your pocket without actually increasing your income.
In general, there are two ways to reduce your tax liability (besides earning less):
- Tax Deductions: Indirectly reduce your tax bill by lowering your taxable income
- Tax Credits: Directly reduce your tax bill, dollar for dollar
Let’s look at an example to demonstrate the difference between the two:
If you made $50,000 in 2019 and took the standard deduction, you would owe the IRS $8,167.
If you received an additional $5,000 worth of deductions, your taxable income would be reduced to $45,000, making your tax bill $7,470. But if you received $5,000 in tax credits, your tax bill would be slashed down to $3,167.
The credit would save you $4,303 more than a deduction of the same size. That’s why tax credits are so valuable. They’re essentially a direct payout from the government.
It’s also why they usually have some pretty strict eligibility requirements.
Who is Eligible for the Credit?
Tax credits are often created to provide relief to a target demographic or reward positive action. The Retirement Savings Credit is meant to encourage low-income earners to save, and the eligibility rules reflect that.
To be eligible for the credit, you must:
- Be 18 years or older
- Not be claimed as a dependent
- Not be a student
You’re considered to be a student if you were enrolled full-time at a school during any point in the tax year, including technical, trade, and mechanical schools. The IRS also makes it a point to note that full-time, on-farm training courses count too, for some reason.
How Much You Can Save With the Credit?
The Retirement Savings Credit allows you to save up to 50% of the first $2,000 you contribute to an eligible retirement account each year.
That means that the most it can save you is $1,000 annually, per taxpayer. However, there are some limitations that might reduce how much you can claim.
The first limitation is that this credit is non-refundable. Here’s what that means:
- Refundable Credits: If your liability is low enough, these tax credits can put money back into your pocket.
- Non-refundable Credits: These can reduce your tax liability to zero, but can’t provide you with a refund if your liability is negative.
Also, since this is a credit for lower-income earners, taxpayers can’t claim the credit if their income exceeds the limits below.
In 2020, the upper limits for qualifying adjusted gross income are:
- $65,000 for married filing jointly
- $48,750 for head of household
- $32,500 for single, married filing separately, or qualifying widow(er)
As your income approaches these maximums, the size of your credit gets phased out.
There are three ranges your income can fall into, which decides whether you’ll qualify for 50%, 20%, or 10% of your total contribution.
Take a look at the chart below for a summary of the income limitations and credit rates for each type of filer.
It’s not enough to mentally earmark your savings for retirement, your contributions need to go into one or more of the following eligible retirement accounts:
- Traditional or Roth IRAs
- 401(k), 403(b), governmental 457(b), SARSEP, or SIMPLE plans
- Thrift Savings Plans
- 501(c)(18)(D) plan
- ABLE accounts for which you are the designated beneficiary
Rollover contributions don’t count, and neither do contributions from your employer (such as 401(k) matching).
To put all of this together, here’s a demonstration of the proper calculation:
Imagine that you just graduated high school and are working at a coffee shop for a couple of years to save up for college. You’ve moved out of your parent’s house and support yourself, though you’re still single. You make $20,000 a year and you manage to save $2,000. You set aside half for college, and contribute the other half to a Roth IRA. That $1,000 contribution reduces your AGI to $19,000, allowing you to claim 50% of your contribution as a credit and save $500 more on your taxes.
Why You Should Care
There are only three aspects to growing wealth for retirement or any other financial goal: Earning, saving, and investing. When your earning power is lower than average, you have to be extra careful with your saving and investing.
$1,000 a year might not sound like much, but if your take-home pay is $19,500, receiving a grand is like getting a 5% raise. These seemingly small wins are significant, especially when compounded over time.
So, are you going to take advantage of the Retirement Savings Contribution Credit this year? What other strategies have you found to help you save more of your paycheck?
Let us know in the comments below!