It’s Friday, so it’s time for this week’s reader-submitted Q & A. If you’d like to submit a question, click here for more information or simply email a question.
I saw something on the news yesterday about a credit for saving for retirement. I thought you could only get a deduction for an IRA or 401(k) contribution. How do I take maximum advantage of the tax law when saving for retirement?
–John B., El Segundo, California
STRAIGHTFORWARD ANSWER:
If you qualify, the credit for retirement plan contributions is a huge opportunity.
More detailed explanation:
First, a review of the differences between a tax deduction and a tax credit: When an expense is deductible, the item reduces your taxable income. Let’s say you have a $1,000 expense related to your move from one state to another. Since moving expenses related to a move like this are typically tax deductible, your taxable income is reduced by $1,000. If you are in the 25% tax bracket, this means your taxes will decrease by $250 (25% x $1,000).
A tax credit of $1,000, however, works differently. Let’s say you recently had a child (like me!) and as such qualified for the child tax credit of $1,000. In this case, your taxable income is unaffected by the credit (no deduction), but your tax will decrease by $1,000.
In short, a tax deduction is worth the amount of the expense multiplied by your tax rate, while a credit is worth the full amount of the stated credit. As a result, credits are usually much better.
Still, many credits are non-refundable.
You: Like advance-purchase airline reservations?
Sort of. Actually, not really. A non-refundable credit is one where the amount of the credit is limited to the amount of tax you would have otherwise had to pay. So if your tax liability would have been $700, the value of a $1,000 non-refundable credit is limited to $700. (What this really means is that you can’t get a refund of taxes you haven’t paid as a result of a non-refundable credit).
Now let’s talk about the credit for retirement savings contributions. This is a non-refundable credit for up to $2,000 for those making retirement saving contributions (to either 401(k)s or IRA’s). During 2008, if you are single and make less than $26,000 you’ll probably qualify for this credit. If you are married and filing jointly, then you can make up to $52,000 combined and still receive the credit. The lower your income and the more you save for retirement, the higher the credit.
You: What about the deduction?
You get that too!
You: So I’d get a deduction and a credit for the same savings?
Indeed. Of course, your income must be below the limits above, but if so, do your best to save something for retirement. Retirement savings made by those eligible for the credit cost the saver next to nothing.
Note that you must be at least 18 and not claimed as a dependent on your parent’s income tax return to qualify for the credit.
Hey, you graduating college seniors, this might be you! Think about it, you’ll be earning just a half-year’s salary this year. What a better way to start saving for retirement than doing so while you are still young and with minimal net-impact to your cash-flow. That’s what I call living Beyond Paycheck to Paycheck.
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