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Available Retirement Savings Tax Credits: one for Individuals and another for Employers

Congress passed legislation in 2001 that increased the contribution limits for individual retirement accounts (IRAs) and employer-sponsored retirement plans& created two tax credits—one for individuals who save for retirement and another for employers who adopt new retirement plans for their employees. Some qualification criteria for these potentially valuable tax credits follows:

Tax Credit for Individuals - The tax credit for individuals is available through the 2006 tax-year to qualifying individuals with a federal income tax liability who make eligible contributions to IRAs or certain employer-sponsored retirement plans. Retirement contributions that are eligible for the tax credit include:

An individual must reduce his/her total eligible retirement contributions by any distributions that he/she received from an IRA or eligible employer plan:

An individual filing a joint federal income tax return must also reduce his/her eligible retirement contributions by distributions received by his/her spouse.

The saver's tax credit is not available to any individual who:

Currently, a qualifying individual may multiply his/her eligible contributions (limited to no more than $2,000 for any tax year) by a specific percentage or tax credit rate. The current rules limit the available tax credit rate by a combination of an individual's modified adjusted gross income (MAGI) and federal income tax return filing status as shown in the following chart:

Saver's Tax Credit

Joint Return

Head of Household

All Other Cases

Credit Rate

Over

Not Over

Over

Not Over

Over

Not Over

 

$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%

$50,000

N/A

$37,500

N/A

$25,000

N/A

0%

Currently, a qualified individual may claim the tax credit in addition to a traditional IRA deduction or employer plan salary deferral. However, the credit is nonrefundable, offsetting only income taxes owed. If you owe no income tax, you cannot claim the credit.

Example - A married couple, file a joint federal income tax return for 2003 showing MAGI of $32,000. He contributed $3,000 to his Roth IRA and She contributed $3,000 to her employer's 401(k) plan. On February 2, 2004, He took a $2,000 distribution from his Roth IRA. His eligible contributions are $1,000 because he reduces his total contribution of $3,000 by the distribution of $2,000. Though she contributed $3,000, the rules limit her eligible contributions to $2,000 for the tax credit calculation. From the chart, their MAGI of $32,000 limits their credit rate to 20 percent. They are eligible to claim a $600 credit on their income tax return based on their combined contributions and their credit rate of 20 percent.

($1,000 + $2,000) x 20% = $600

A qualifying individual may claim the tax credit by filing IRS Form 8880, Credit for Qualified Retirement Savings Contributions, with his/her federal income tax return. Click here to see the form and its instructions. For even more details about the saver's tax credit, click here for IRS Announcement 2001-106. See the Instructions for IRS Form 8880, IRS Publication 590, Individual Retirement Arrangements (IRAs), and consult a tax professional to check eligibility.

Credit for Small Employers - Many employees do not have an employer provided retirement benefit because their employers think retirement plans are too expensive. To overcome this, Congress created a tax credit for a small employer to help offset the costs of with establishing and administering a new retirement plan. The credit is available for up to three consecutive years, usually beginning with a plan's startup year. If an employer cannot use all of the credit in any one year due to a low tax liability, they can potentially carry an unused credit forward to use on later tax returns for up to 20 years. The employer must have 100 or fewer employees who each received at least $5,000 of compensation in the tax year prior to the first credit year. To be eligible for the first credit year, the employer, in the three prior years, cannot have established or maintained a qualified employer plan in which it contributed for the same employees that are in the new plan. Eligible employer plans include defined benefit plans, defined contribution plans, SIMPLE plans, and SEP plans established after 12/31/01. Existing retirement plans established prior to this date are not eligible for the credit. The first credit year is generally the tax year that includes the effective date of the new eligible employer plan. However, an employer may elect the tax year prior to the effective date of the plan as the first credit year if that tax year is 2002 or a later year and the employer paid or incurred qualified startup costs during that tax year. The credit is 50 percent of the qualified startup costs paid or incurred during the tax year. Qualified startup costs include those expenses for establishing or administering an eligible employer plan, as well as plan related expenses for employee retirement education. However, the credit calculation uses qualified startup costs of no more than $1,000 each year, effectively limiting the credit to no more than $500 each year. A qualifying employer claims the tax credit by filing IRS Form 8881, Credit for Small Employer Pension Plan Startup Costs , with its federal income tax return. Click here to see the form and its instructions. An employer's tax liability can also affect the available tax credit for retirement plan startup costs, especially if the employer is claiming any other business tax credits for the same year. For a proper determination of its available tax credits, an employer must ALWAYS consult a tax or legal professional.


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