Even higher-income investors may be able to benefit from this credit on occasion--or help someone else do so.
By Christine Benz | 02-16-17 | 05:00 AM | Email Article

As the mid-April tax-filing deadline draws close, many investors scramble to invest in an IRA for the previous tax year. The key benefit, of course, is to amass tax-advantaged savings: If you choose a deductible IRA you get a tax break on the contribution, and if you opt for a Roth IRA your tax break comes into play when you withdraw your money in retirement.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

But investors with lower and even middle incomes have an added incentive to get money into an IRA--or into a 401(k), for that matter. Assuming their income falls below certain thresholds, they can take advantage of a saver's credit, in addition to the usual tax breaks that accrue to IRA or 401(k) investors. The maximum credit is $1,000 for single filers and $2,000 for married couples filing jointly. The credit is available for contributions to traditional or Roth IRAs, as well as SEP and SIMPLE IRAs; contributions to company retirement plans like 401(k)s, 403(b)s, and 457 plans are also eligible for the credit. The credit is nonrefundable, meaning that it can reduce your tax bill all the way to zero, but won't provide you with a refund. To take advantage of the credit, you must use Form 8880, and attach it to Form 1040, 1040A, or 1040NR. (Notably, the credit is unavailable for 1040EZ filers.)

For the investor who's contributing to a 401(k) and can take advantage of the saver's credit, that means a contribution to the plan can amount to a triple win: the contribution itself lowers taxable income, and the credit can further lower the tax bill. Meanwhile, employer-matching contributions can magnify the amount of the contribution itself. (You can't use the credit for employer matching contributions, however.)

The saver's credit tends not to get a lot of attention, probably for a few reasons. First, many lower-income investors simply don't have a lot of money to invest; the biggest saver's credits accrue to those with the lowest incomes who can also manage to make large contributions--a rare confluence of factors. In addition, higher-income investors tend to be more keenly attuned to tax matters than lower-income investors, so the credit tends not to get a lot of play in the financial media. The fact that the credit isn't available to 1040EZ filers has probably also limited its uptake.

How the Credit Works
Depending on your adjusted gross income, you can claim a credit of 50%, 20%, or 10% of your contribution amount of up to $2,000 for singles and $4,000 for married couples filing jointly. (Note that you can, of course, contribute much more than $2,000--or $4,000 for couples--to various retirement plans; you just won't be able to take the credit on contributions of more than $2,000/$4,000.)

The lower your income, the greater the percentage of your contribution you can take as a credit. This page on the IRS site details the income thresholds and the corresponding credit percentages for taxpayers of varying filing statuses. The 2017 income thresholds are largely the same as they were for 2016, except for a few tiny upward adjustments.

Let's say, for example, that Natalie had adjusted gross income of $17,000 in 2016, but she was living rent-free at her parents' house so she managed to find $3,000 to contribute to her company's 401(k) plan. Because she can claim a 50% credit on a contribution of up to $2,000, she's eligible for a $1,000 credit--the highest available for single filers.

For some households, the credit will turn out to be smaller--a lot smaller. A couple with adjusted gross income of $60,000 that makes $10,000 in retirement-plan contributions will only be able to claim a credit of $400--10% of their contribution of up to $4,000. They'll still be able to take advantage of the other tax breaks that come along with their entire $10,000 in contributions--a tax break on contributions and tax-deferred compounding in the case of traditional contributions, and tax-free withdrawals in retirement in the case of Roth--but their credit will be limited.

Higher-Income Investors: Don't Rule It Out
Many investors might see the relatively income thresholds for the credit and tune the whole thing out, but it's worth looking alive for opportunities to take advantage of the credit (or helping a loved one do so).

Workers who previously earned too much to quality for the credit may find that it's within reach in low-income years; this is a common scenario for contractors whose income is lumpy. It's also common for one partner to retire while the other continues to work for a few more years; such couples may qualify for the saver's credit in those years because their income is low but they still have earned income.

There's a notable caveat, however. If you or your spouse has taken a retirement-plan distribution within the past two years of claiming the credit, that reduces the amount of your credit accordingly. (The instructions on Form 8880 provide further detail on this topic.)

In addition, parents and grandparents of children with earned income may be able to help young people in their lives kickstart their retirement-savings programs and take advantage of the credit. Even if your child or grandchild doesn't have the financial wherewithal to make a contribution to an IRA or 401(k), there's no rule against her steering a financial gift from you into such an account. The only caveat--and this is true of any retirement-account contribution--is that she personally must have enough earned income to cover the contribution amount. As long as the child or grandchild is over 18, you don't claim her as a dependent on your tax return (and no one else does, either), and she's not a full-time student, she can then take advantage of the credit for the contribution. Just remember that the credit is hers to claim--not yours--even though the contribution amount came out of your coffers.

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