If you earn relatively little, there’s good news for your 401k: a federal tax credit. A tax credit is better than a deduction because it directly reduces the amount of taxes you owe, making it as good as cash. Unfortunately, the federal tax credit is limited.
Eligibility for Retirement Savings Contribution Credit (in 2008):
Single person with income less than $26,500 a year
Head of household with income less than $39,750
Joint return with income less than $53,000
These amounts change every year. Check out the IRS web site for the latest figures by searching IRS.gov for “Retirement Savings Contribution Credit.”
The credit is not available to full time students and people claimed as a dependent on someone else’s (like a parent’s) tax return.
The tax credit runs on a sliding scale, starting at 50 percent for single filers with income under $15,500 and joint filers with incomes less than $31,000. The 50 percent tax credit means that for every dollar that you contribute to your 401k, your tax bill is reduced by 50 cents. As incomes rise, the tax credit falls, until it reaches ten percent for those just under the threshold of eligibility.
Think about what this means for the lowest income workers whose companies will match half of their contributions: putting money into the 401k is free! Half the contribution is matched by the company, and the other half offsets federal taxes. It’s a great deal if you can tighten your belt a little to be able to make the contribution.
Keep in mind, however, that this is not a “refundable credit.” If you have enough deductions that you owe no tax whatsoever, you will not get cash back from the government. You’ll only benefit if you have a tax liability. (I’m NOT talking about whether you get a refund after you file your taxes; I’m talking about whether your tax return shows that you pay any tax at all.)
The Retirement Savings Contribution Credit is a very good help to lower income workers concerned about their retirement. Unfortunately, it does not apply to very many people. Those folks who are eligible often feel that they have very little discretionary income. Saving for retirement is hard for low-income workers, but it is possible. This tax credit will make the task a little easier.