One of the many tax cuts made by the Economic Growth and Tax Relief Reconciliation Act of 2001 was the creation of the Retirement Savings Contribution Credit. Since this is a credit and not a deduction, it's a much better deal since this credit will reduce your taxes on a dollar-for-dollar basis.

I'll admit, when I first saw the provision, I thought it was more sizzle than steak. It was intended to help low- and middle-income taxpayers defray the funds lost by making retirement contributions. But now, after living with the law for year now, I'm convinced that it might be one of the most overlooked credits in the code -- and one of the most valuable for those who are eligible.

Income limits
The Retirement Savings Contribution Credit is calculated as a percentage of the amount contributed to a qualified retirement account. The percentage ranges from a high of 50% to a low of 10%, depending on income levels. Again, this credit is intended for low- and middle-income taxpayers, so if you're above the income limits, you'll receive no credit. Here is how it breaks down:

Credit %  Married/Joint             Head of Household    Others                   
50%         $0 to $30,000           $0 to $22,500           $0 to $15,000
20%         $30,001 to $32,500  $22,501 to $24,375  $15,001 to $16,250
10%         $32,501 to $50,000  $24,376 to $37,500  $16,251 to $25,000

As you can see, once your income exceeds $50,000 for married folks, $37,500 for head of household filers, or $25,000 for single and other filers, you lose the benefit of the credit. But for those who can actually claim the credit, it's pretty powerful.

Qualifying contributions
Contributions to virtually all retirement accounts qualify for this credit. They include (take a deep breath if you're reading this to your kids): traditional IRA, Roth IRA, 401(k) deferred compensation plan, SIMPLE deferral plan, 403(b) annuity plan, 457 governmental plan, and SEP plans.

You should know that your maximum contribution for credit computation purposes is $2,000 for each individual. And this maximum contribution remains in force even if you make a larger contribution to your retirement plan. For example, assume that you make a $3,000 contribution to your IRA account for 2003. Your credit will still be based on a maximum contribution of $2,000. But if you're married, and you and your spouse both contribute $3,000 to your respective retirement programs, your credit would be based upon a total contribution of $4,000.

There are other restrictions to watch out for. The credit is only available to an eligible individual who is:

1. At least 18 years old
2. Not a dependent of another taxpayer
3. Not a full-time student (part-time students are eligible)

Examples
Let's assume that Mary is a single person. She's working full-time while she's finishing up her degree on a part-time basis. Mary has $16,000 in W-2 income, with no other deductions or credits. But Mary participated in her employer's 401(k) plan, and socked away $900 in 2003. Normally, Mary's tax liability would amount to $884. But if she claims the Retirement Savings Contribution Credit, she'd get an additional tax break of $180 (20% of her $900 contribution). The credit lowers her tax bill by more than 20%. That's nothing to sneeze at.

Then consider Jack and Jill, who are married and have combined W-2 income of $40,000 with no other income or deductions. They would normally have a tax liability of $2,964. But since Jack contributes $3,000 to his 403(b) plan and Jill contributes $1,500 to her 401(k) plan, they receive a credit of $350 (10% of the maximum $2,000 for Jack, plus 10% of $1,500 for Jill). Their tax bill now is $2,614 -- almost 12% lower.

Why missed?
With all of the benefits, why is this credit overlooked? It's more than likely that most eligible taxpayers complete Form 1040EZ. With no other complicated income or deduction items, they might think that the EZ form would be best for them. After all, EZ is better, right?

Not in this case. Form 1040EZ doesn't have the capacity to compute the credit. Taxpayers eligible for the Retirement Savings Contribution Credit would have to move up to (at least) Form 1040A in order to claim the credit.

Another reason this credit is overlooked might be because there is no place on the tax return to enter your retirement contributions. If you make any contribution other than to a traditional IRA, the tax savings is already built into your W-2 form. Sure, you'll receive a notation on your W-2 of your contributions, but unless you carefully read the back of your W-2 form, you'll likely miss taking the credit. Finally, in order to claim the credit, you must complete IRS Form 8880 (.pdf reader required) and attach it to your return. Many folks simply won't know if they qualify or even review the form, especially if they complete their returns manually. It's really a sad situation.

Even if you don't qualify for this credit, I'm sure you can think of relatives and friends who would. Make sure to alert them -- this little gem shouldn't be missed.

And, unlike most tax breaks, you can still get this one before you file your 2003 tax return. That's because you have until April 15 to make a 2003 contribution to an IRA. Visit the Fool's IRA Center for more info.

Related Links:
9 Tax Return Changes
Paperwork for Tax Preparation
Retirement Plan Loans
10 Ways to Cut Your Taxes
Motley Fool IRA Center

If you like the way Roy Lewis simplifies confusing tax issues, check out his just-published book, The Motley Fool's Investment Tax Guide 2002: Smart Tax Strategies for Investors. This handy 360+ page guide covers just about every tax aspect of a typical Fool's life: investing, marriage, children, education, homes, home offices, retirement accounts, medical expenses, and much more.)

January 30, 2004

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