Retiree Portfolio A Useful Tax Credit

The recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) provides a nonrefundable income tax credit to lower-income workers who make an elective contribution to employer-provided retirement plans or to IRAs. This tax credit presents a unique tax savings opportunity to those eligible to use it. Additionally, it offers some interesting gifting opportunities to others who wish to assist those lower-income workers.

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By David Braze (TMF Pixy)
July 30, 2001

In an effort to encourage increased retirement savings by lower-income workers, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) includes a provision that gives a nonrefundable income tax credit to eligible individuals who make an elective contribution to a 401(k), 403(b) or 457 plan; a SIMPLE; a SEP; or a traditional or Roth IRA. Because the credit is in addition to any deduction or exclusion that would otherwise apply to the contribution, the contribution may reduce both taxable income and the income tax liability on that reduced income.

(Just to make sure we're all on the same page, let's review the difference between a deduction and a credit. A deduction reduces taxable income, which thus reduces your taxes. Example: If you make $25,00 and you have a $1,500 deduction -- perhaps from contributing $1,500 to a traditional IRA -- then you'll pay taxes on only $23,500 of income. That'll save you a couple hundred bucks. A credit, on the other hand, reduces your taxes, dollar for dollar. Example: Your tax bill for the year comes to $8,000, but you have a $500 tax credit. Therefore, you only owe $7,500 in taxes.)

Be aware that this provision is currently available only for tax years beginning after Dec. 31, 2001, and before Jan. 1, 2007 (i.e., 2002 through 2006, inclusive). Therefore, the tax credit may or may not be extended by a future Congress. (So what else is new, right?)

The EGTRRA defines an "eligible individual" for this credit as someone who is age 18 or older, not a full-time student, and not claimed as a dependent on someone else's income tax return. The allowable tax credit is based on a percentage of the person's retirement plan contribution. The allowable percentage is based on the taxpayer's filing status and adjusted gross income (AGI). And the retirement plan contribution to which that percentage is applied may not exceed $2,000. The table below shows the percentages allowed for various taxpayers.

                 Adjusted Gross Income
Joint Head of All Return Household Others Applicable % $0-30,000 $0-22,500 $0-15,000 50% $30,000-32,500 $22,500-24,375 $15,000-16,250 20% 32,500-50,000 $24,375-37,500 $16,250-25,000 10%

Because the maximum credit available to any one person is 50% of $2,000, or $1,000, a couple filing a joint return could be eligible for a tax credit of $1,000 each. That means the potential exists for a dollar-for-dollar income tax reduction of $2,000 on their joint income tax return. And that, in turn, could erase any income tax liability that couple has for the year.

Granted, to get such a large tax credit they must make a contribution of $2,000 each to a retirement plan. Assuming that contribution is excludable from their income, then their joint income may not exceed $34,000 before their retirement plan contributions to ensure their joint AGI remains within the range that allows the maximum credit. That means they must save 11.8% of their income, something that may be difficult to do for those with a limited income.

Let's look at another couple who somehow manages to contribute $2,000 each to a deductible traditional IRA next year. After that contribution, they will still have a joint AGI of $30,500. Based on their IRA contributions, both will be eligible for the tax credit. The table above indicates they will receive a credit of $800 (20% of $4,000) on their income taxes.

But next year, the allowable IRA contribution rises to $3,000. Thus, if they could come up with an additional $500 to contribute to at least one of their deductible traditional IRAs, they would reduce their AGI to $30,000. That reduction would increase their allowable tax credit percentage from 20% to 50%. For credit purposes, they may each still use a maximum of only $2,000 of their individual contributions. Nevertheless, the additional $500 contribution will reduce their joint AGI, and that means their maximum allowable credit would rise from $800 to $2,000 (50% of $4,000), a jump of $1,200.

Assuming they would owe at least $1,200 in income taxes without the additional credit, the larger contribution would result in the total elimination of that bill and an immediate and risk-free return of 140% on their additional $500 investment (($1,200 - $500) / $500). Now there's a return that I, for one, would find difficult to turn down.

Not everyone at this income level could afford to make such a contribution. But it's not impossible. That's particularly true when an older, wealthier generation wishes to assist a much younger generation as it starts out. To me, this proviso provides those of us who can afford it a great opportunity to help our children or grandchildren with both their tax bills and their future retired lives.

Let's look at a two-income couple who next year will each contribute at least $2,000 to a qualified retirement plan. Their joint AGI will be $55,000. In this case, their AGI will exceed the maximum allowable amount to receive a tax credit. But let's say one of them, filing separately, would have an AGI of $15,000. By filing a separate return, this spouse could take a tax credit of $1,000 (50% of $2,000). The other spouse, by also filing separately and by using an AGI of $40,000, would still be ineligible for the credit. Therefore, their taxes would be reduced only by the $1,000 credit the first spouse would receive. But that's still better than no credit at all.

By filing separately, would this couple reduce their overall tax bill from that they would have by filing jointly? They could. But the only way to know for sure is to compare the results of filing either a joint return or separate returns.

How neat! Now we've got another way to increase our fun at income tax time. Is it any wonder the EGTRRA is also known as "The Tax Preparer's Job Preservation and Security Act"?

See you next week. In the interim, post away -- as always -- on the Retirement Investing or Retired Fools boards.

Best to all...Pixy 

Dave Braze is devoted to his grandkids. He is glad the EGTRRA provides a potential means for him to help them get a head start toward retirement security. Dave just hopes this tax break lasts until they are old enough for him to invest in their futures. And, because The Motley Fool is all about investors writing for investors, he thought you would be interested in knowing about this feature of the law as well.