Retirement Savings Credit Doubles Payoff

Contributors to retirement plans already know the long-term tax advantages of an individual retirement account or 401(k). Taxes are deferred, and in some cases never collected, on money put away for the golden years.

Now a tax credit will let some savers reap the rewards of their retirement thrift early.

The retirement savings contributions credit, also called the saver's credit, appears on Form 1040 and Form 1040A tax returns as a way to reward lower-wage earners who sock away retirement money.

Because the tax break is a credit instead of a deduction, it's a better deal. Tax deductions reduce taxable income, but credits come into play after you calculate how much tax you owe, and they reduce your Internal Revenue Service bill dollar for dollar. For example, if you owe $500 and you are eligible for a $250 credit, the check you have to write to Uncle Sam is cut in half.

Income limits

A filer eligible for the saver's credit could shave as much as $1,000 off his or her tax bill. The actual credit amount depends on your income, filing status and just how much you put into retirement plans.

Basically, the lower your income, the bigger your credit. The income limits that determine how large a credit you can claim are adjusted annually to keep pace with inflation. The precise credit percentages for 2012 filings are found in the table below.

As the table shows, the maximum available credit is 50 percent of contributions for filers in the lower end of the earnings ranges. There is, however, a limit on the retirement plan contribution amount you can use to figure the tax break.

Although tax law allowed you to put up to $5,000 in 2012 ($6,000 if you're age 50 or older) in your IRA, only $2,000 of that will count in figuring the saver's credit. That makes it worth at most $1,000 for single taxpayers. Of course, if you're married and you and your spouse put away at least $2,000 toward retirement, your joint return would reflect a $2,000 credit.

Which contributions count?

Contributions to traditional and Roth IRAs as well as to employer-sponsored 401(k) plans count toward computing the credit. So does money you put into a savings incentive match plan for employees, or Simple, plan; a 403(b) program; a governmental 457 plan; or a salary reduction simplified employee pension, or SEP. You can only count the money you put in your workplace account, not any matching amounts your company contributed.

The credit is based on your total contributions to all your eligible retirement accounts, not for contributions to each. So if you put $2,000 into a Roth and another $2,000 into your 401(k) at work, you still can only calculate your credit on the allowable maximum of $2,000.

Enter all your retirement saving amounts on Form 8880, Credit for Qualified Retirement Savings Contributions, and complete the form to arrive at your exact credit rate and amount. Once you get the dollar amount, transfer it to line 50 of your 1040 or line 32 if you file the 1040A. The credit isn't available for 1040EZ filers, so you might want to consider changing your choice of returns if you've been putting away retirement cash.

If your IRA contribution is to a traditional account, you may be able to get a double tax break. In addition to the saver's credit, look into whether you're eligible to deduct your IRA contributions on the front page of your 1040 or 1040A. This tax break is one of several adjustments to income that are available to all taxpayers, regardless of whether they are itemizing or taking the standard deduction, and the IRS says you can claim the retirement savings credit and deduction for your IRA contributions.

The credit also is attractive to workers who are eligible to participate in a 401(k) plan but who earn just more than one of the saver's credit income limits. By signing up for a company-sponsored account, such workers could get under the earnings cap while simultaneously boosting the potential credit amount.

Take, for example, a married employee who is the sole earner in her family and who reports adjusted gross income of $35,000 on her joint tax return. She's already eligible for a partial credit, but if she contributes $2,000 to her 401(k), she will knock her income down enough to take the maximum credit.

Some other restrictions apply

In addition to the income limits, there are a few other restrictions on who can claim the saver's credit. A taxpayer who was younger than 18 last year, a full-time student or claimed as a dependent on another's tax return can't take the retirement savings break.

The saver's credit is also what the IRS calls nonrefundable. That means you can use it to reduce your tax bill to zero, but you can't take advantage of any excess credit amount to get a refund. So if you owe no taxes, the credit is of no use to you.

Still, even if you can't take full advantage of the credit, it's not too shabby of a break when you take into account the additional tax savings you get by contributing to a retirement account in the first place.

Just remember, the key to this credit is participation in retirement accounts. If you haven't opened a retirement account yet, or have one but haven't contributed for the 2012 tax year, you have until the April tax-filing deadline to open one and put in money. The deadline is the same for either a Roth or traditional IRA.

As for your 401(k), you're locked into your credit for the 2012 tax year based on the contributions you made last year. Make sure the W-2 you got from your company reflects the correct amount of all your pension contributions so you can get the maximum credit.

If you're not yet participating in your company plan, you can improve your future saver's credit potential by signing up as soon as you're eligible. Then contribute as much as you can afford without doing major cash-flow damage to your paycheck. It could pay off at tax-filing time as well as when you retire.

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The Best Tax Breaks for Retirement Savers

The federal government encourages saving for retirement by giving tax breaks to people who save in specific ways. There are several types of tax perks for retirement savers, each with special rules and restrictions. Here are some of the best tax breaks available to people who save for retirement:

401(k). One of the best ways to get a tax deduction while you save for retirement is through a 401(k) or similar type of retirement account, like a 403(b) or the federal government's thrift savings plan. Employees who are eligible for these workplace retirement accounts can defer income tax on up to $17,500 in 2013, $500 more than in 2012. And people age 50 and older can delay paying income tax on as much as $23,000 in 2013, $5,500 more than younger people. Income tax won't be due on your contributions until you withdraw the money, which you are required to do beginning after age 70 1/2. Traditional 401(k)s generally work best for people who expect to be in a lower tax bracket in retirement than they are now. "You get the employer match and tax-deferred growth, and you get to take it out when your taxes are theoretically going to be lower," says John Dulmage, a certified financial planner for Financial Pathways in Londonderry, N.H.

[Read: Retirement Tax Deadlines for 2012.]

Roth 401(k). Roth 401(k) contribution limits are the same as those for traditional 401(k)s, but the tax treatment is different. Roth accounts allow you to contribute after-tax dollars, and then withdrawals from the account, including the earnings, are tax-free in retirement. Employers are increasingly offering a Roth option, and even allowing workers to convert some of their existing retirement savings to a Roth by paying income tax on the amount converted. A recent Aon Hewitt survey of 300 large U.S. employers found that about half of these companies already offer a Roth account and 29 percent of those without a Roth option are planning to add this feature in the next 12 months. Roth accounts often produce the biggest rewards for young and low-income retirement savers. "I usually recommend that my clients who are in the 15 percent tax bracket use the Roth as the vehicle," says Dulmage.

IRA. Workers can defer income tax on up to $5,500 by contributing to an IRA in 2013, which jumps to $6,500 at age 50 or older. However, the ability to claim this tax deduction is phased out if you have a retirement plan at work and a modified adjusted gross income between $59,000 and $69,000 in 2013 ($95,000 and $115,000 for couples). For investors who don't have a workplace retirement plan but are married to someone who does, the deduction is phased out if the couple's income is between $178,000 and $188,000 in 2013. IRAs generally give you more investment options than a 401(k), and savvy investors can seek out lower fees. "If you have a lot of funds in your 401(k) that have high expense ratios of 1 percent or above, then the best bet is to go with the IRA where you can invest in practically anything you want to," says Kirk Kinder, a certified financial planner for Picket Fence Financial. And while the deadline has already passed to make 401(k) contributions that count for the 2012 tax year, you have until April 15, 2013, to make an IRA contribution that will get you a tax deduction on your 2012 tax bill.

[Read: How to Claim the Retirement Saver's Tax Credit.]

Roth IRA. You can prepay income tax on up to $5,500 ($6,500 at age 50 or older) in a Roth IRA. The ability to contribute to a Roth IRA is phased out for individuals and heads of household earning between $112,000 to $127,000 ($178,000 to $188,000 for couples) in 2013. However, people who earn above these limits may still be able to contribute to a Roth IRA by converting some of their traditional IRA assets to a Roth. Roth accounts give retirees flexibility in retirement because withdrawals are not required during the original account owner's lifetime. "There are no strings attached to when the money comes out," says Philip Watson, a certified financial planner for Watson Planning in Franklin, Tenn. "You don't have to take the money out in your lifetime. You can pass a Roth to your heirs."

IRA tax-free charitable contributions. Individuals age 70 1/2 and older are generally required to withdraw money from their traditional IRAs and pay income tax on each distribution. But retirees in the fortunate position of not needing the money they have stashed away in their IRA can avoid paying income tax on their required withdrawals by donating up to $100,000 of their distributions to charity. To qualify for the tax break, charitable distributions for 2013 must be paid directly from the IRA to a qualified charity by the end of the calendar year.

[Read: Understand Your Rollover Options.]

Saver's credit. Low- and moderate-income people who save for retirement in a 401(k) or IRA are eligible to claim the saver's credit, which can be worth up to $1,000 for individuals and $2,000 for couples. People age 18 and older who are not full-time students or dependents on someone else's tax return can claim this tax credit until their income exceeds $29,500 for singles, $44,250 for heads of household, and $59,000 for couples in 2013. The credit is calculated based on up to $2,000 of retirement account contributions and your income, with the biggest tax credit going to retirement savers with the lowest incomes. For example, a married couple earning $30,000 that contributed $1,000 to an IRA would get a $500 credit. But few people get that much. Among the 6.1 million income tax returns that claimed the saver's credit in 2010, the credits averaged $204 for couples, $165 for heads of household, and $122 for individuals. There's still time to claim the saver's credit on your 2012 tax return. Workers have until April 15, 2013, to make an IRA or Roth IRA contribution that will qualify them for a tax-year 2012 saver's credit.

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4 Keys to a Successful Retirement

All of us hope that at the end of a long career we will be able to enjoy retirement secure in the knowledge that we can support our desired lifestyle without ever running out of money. Given that Americans are living longer than ever before, however, the risk of outliving our money in retirement is real. Diligence, careful planning and realistic expectations are therefore essential to achieving a successful life once our working life is done.

Here are some key areas to focus on as you plan ahead for your retirement.

1. Save Enough

In order to realize our desired retirement lifestyle without fear of outliving our money, we need to accumulate enough savings. But how much is enough? That depends on the annual cost of our desired lifestyle. For many, maintaining their current lifestyle in retirement is the goal, so knowing what it currently costs to support that lifestyle is important.

Once we have determined a target annual income in retirement, we can calculate how much of a nest egg will be required to support that income.

One way to calculate the size of the required nest egg is to back into it using a common rule of thumb known as the “4% Rule.” This rule is typically used to determine a “safe withdrawal rate” in retirement but is also useful in determining the required savings amount to support a target retirement income stream.

The 4% rule states that a retiree aged 60-65 can safely withdraw 4% a year from a reasonably diversified portfolio divided equally between stocks and bonds (adjusting that rate by annual inflation) and not run out of money for at least 30 years.

Using this rule of thumb, one would need to accumulate $1.5 million by the start of retirement in order to safely withdraw an inflation-adjusted $60,000 per year for 30 years. This is certainly not an insignificant sum. Supporting an inflation-adjusted income of $100,000 per year requires an accumulation of $2.5 million, an even more imposing amount. (Note that the 4% rule has been refined over the years and is also being called into question by some in light of the current low yield environment for bonds.)

While Social Security can provide additional income to supplement a portfolio in retirement, it is clear that saving as much as we can during our working lives is key to being able to afford a quality retirement. Taking advantage of workplace retirement savings plans, such as a 401K, and supplementing that by additional tax-deferred and taxable savings is essential. Target saving at least 10% of your gross annual income throughout your working life and remember that the key to accumulating wealth is to save as much as you can for as long as you can in order to allow the power of compounding to work for you.

2. Tax Diversify Your Savings

The effect of income taxes on our retirement should not be forgotten. Taxes are another “cost” impacting retirement cash flow. It is therefore important to minimize this impact as much as possible through good tax planning.

One way to achieve tax efficiency in retirement is to diversify pre-retirement savings across taxable, tax deferred and tax-free accounts. This practice of “tax diversification” will allow one to fine-tune portfolio withdrawals in retirement, depending on their relative tax impact, and carefully choose which “buckets” to tap for ongoing income needs.

Tapping taxable accounts first often makes the most sense given that this strategy typically enables a retiree to pay less income and capital gains tax while allowing savings to continue to grow in tax-deferred IRA and Roth accounts.

Ongoing tax planning is crucial for single retirees, given how quickly income tax rates rise for single people, as well as for married couples since it is inevitable that one spouse will predecease the other at some point in the future.

3. Use Effective Social Security Taking Strategies

The future of Social Security is often called into question raising concern regarding whether this program will be available to supplement our portfolio income in retirement.

It is true that current projections show Social Security benefit payouts starting to exceed program revenues beginning in 2016. However, even if no reforms are implemented, it is expected that Social Security will continue to be able to pay out 100% of benefits until 2033, and approximately 75% of benefits thereafter.

Social Security is therefore likely to remain a resource in retirement and maximizing this benefit is important. The fact that Social Security benefits are indexed for inflation throughout the benefit period and continue to be paid to surviving spouses make this program unique and an important supplement to an investment portfolio.

A discussion of the array of Social Security taking strategies is beyond the scope of this article. It is important to note, however, that there is a penalty of approximately 8% for each year benefits are taken before full retirement age. This reduction is permanent and also impacts surviving spouse benefits.

Deferring Social Security at least until full retirement age (age 66 for those born during 1943-1954) can result in significant additional retirement income. Waiting until the maximum deferral age of 70 will increase benefits by an additional 8% each year, to a maximum of 132% of the full retirement age benefit for most baby boomers. This strategy is recommended for the higher earning spouse in a married couple.

4. Have Realistic Expectations

Perhaps the biggest key to retirement success is to have a realistic expectation of the lifestyle we can afford. If savings and other sources of retirement income fall short of our goal as we near target retirement age, we need to assess our options. These essentially come down to living a more modest retirement lifestyle, working longer, or some combination of the two. Rarely is it prudent to swing for the fences by increasing the risk of our investments in an effort to overcome a savings shortfall. This strategy can backfire, leaving you in a deeper hole with no time to recover.

Retirement planning is fraught with complexity. There are no guarantees that we will achieve our goal and lots of risk of falling short given the vagaries of the stock market and the uncertainty around Social Security. The above discussion did not even touch on healthcare costs and the cloudy future of Medicare.

It can be daunting to try to navigate the retirement planning maze on one’s own. Consider working with a fee-only financial adviser to be your guide along the way and increase the chance that you will achieve your retirement goals, whatever those may be.

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