I usually tell people that they should be putting money into their IRAs or 401(k)s to save for retirement. And while for many people I still think that’s a good idea, after this past tax season, I’m having second thoughts. Here’s why:
If you are not retired you should not be receiving income from your IRA or 401(k).
Now I understand life happens and sometimes people need to tap into those funds. But if you need to tap into your retirement funds for something other than retirement, then it means that you don’t have enough funds in your regular savings.
Here’s what happens—people tap into their 401(k) when they wind up in financial trouble. It doesn’t really matter how they got there, maybe its medical bills, maybe it was a tornado. The point is they needed money and the retirement fund was all that was available.
They get hit with taxes on the money they withdraw and they also get dinged with a penalty for early withdrawal of the funds. So they wind up being double taxed when they’re already in financial dire straits. Often, the withdrawal bumps them into an even higher tax bracket, making the hit even worse. If they would have had that money is a savings account that they could access—then there would have been no tax implications for getting at that money.
Okay I can hear you now, “Look, Sherlock, I already tapped out my savings account before I went to the IRA. I’m not stupid, I was desperate.” And yes, I do hear you. Where I’m coming from is that as a country, we all don’t put enough money into savings. We all, as a nation, are better at putting money into our IRAs and 401(k)s. We get tax incentives to do it. Sometimes our employers sign us up without our even realizing it. And it makes the IRS happy because they wind up getting more money out of us by giving us a tax break.
What’s that? Yes, the IRS makes more money off of us by giving us a tax break on our 401(k)s because we break into them so often. The sales pitch is put money into your 401(k) and you don’t pay tax on that money. Then, when you take it out, you’re supposed to be in a lower tax bracket so you “win”. The reality that I’m seeing these days is—people are putting their money into their 401(k)s while in the 25% tax bracket and taking it out while still in the 25% tax bracket and paying an additional 10% penalty on the money. The only winner I see here is the IRS!
So what’s the solution? Put money into a savings account. A real savings account—not a “this money is for our Disney vacation account“ — I mean this money is for “Dorothy and Toto blew away with the house and Auntie Em is in the hospital” account.
Savings accounts aren’t sexy. You don’t get any tax incentives to have one. Heck, you don’t even get a toaster anymore! (I still use a frying pan that my mom got for opening a bank account back in the late 40’s or early 50’s. It’s a great frying pan.)
But if it makes you feel better, think of your savings account as your way of cheating the IRS out of a little unearned bonus money. That might be all the incentive you need.
The Retirement Saver’s Credit sounds like an old person kind of tax credit, but, for the most part, it’s really more of a young person’s credit and it gets totally ignored. The coolest part about the Saver’s Credit is that it’s a credit, not a deduction. That means that it’s a dollar for dollar reduction of your tax liability. A $100 tax credit would reduce your taxes by $100. A $100 tax deduction would reduce your taxes by $10 to $35 depending on your tax bracket. See the difference? Tax credits are better than deductions. The Saver’s Credit is for people with lower incomes so we’re looking at 10 to 15% tax brackets.
The Saver’s Credit can be worth up to $1,000 ($2,000 if you’re married filing jointly), so it’s pretty valuable. Basically, it’s like the government is giving you money for saving for retirement – how cool is that?
- You have to be 18 or over
- You can’t be a full time student
- You can’t be claimed as a dependent by someone else
So what are the income limitations?
- Single, married filing separately, or qualifying widower – $28, 250
- Head of Household – $42,375
- Married filing jointly – $56,500
So what do I have to invest in to get this tax credit? That’s the easy part, you can invest in any of the following:
- A traditional or Roth IRA
- Most any employer sponsored retirement plan
The one thing that doesn’t qualify is rollover contributions. Also, if you’ve taken money out of a retirement plan, it could reduce your ability to qualify for the credit.
So if I put $1,000 into an IRA the government is going to give me a $1,000 tax credit? No. I said it’s easy, but it’s not that easy. It works on a sliding scale: the lower your income, the larger the percentage you get, somewhere between 10% and 50% of your contribution. The form you need is form 8880. Here’s a link: http://www.irs.gov/pub/irs-pdf/f8880.pdf
Let’s say you’re single, you made $18,000, and you put $2,000 into a Roth IRA. You’d qualify for a $400 tax credit. You can figure that out by looking at the chart and you’ll see you qualify for a 20% tax credit.
The coolest thing about the Retirement Saver’s Credit is that you can play with it. Let’s go back to the example above – you’re single and made $18,000. You have until April 15th to put money into an IRA, so you don’t have to have this all done before tax time. At $18,000 income, you qualify for a 20% tax credit, but at $16,999 you qualify for a 50% tax credit. So if you put $1,001 into a traditional IRA (instead of the $2,000 you were going to put into the ROTH), it will lower your overall income, making your “adjusted gross income” or AGI, $16,999. Now, instead of getting a $400 tax credit on $2000, you get a $500 tax credit on $1,001 – and you still have another $999 left over to save or spend.
So you might be thinking, “Cool, I’ll just put it all into an IRA!” And you can, but you reach a point where the credit doesn’t do you any more good. The Retirement Saver’s Credit is what’s called a “non-refundable” credit. That means that once you zero out your tax liability, you don’t get anything more.
Let’s go back to our example: you’re single, you make $18,000. This time you put the whole $2,000 into a traditional IRA. Now your AGI is $16,000, that means your taxable income is $6,500 and your tax liability is now $658. So you complete form 8880 and you see that you qualify for a 50% credit which is $1,000 but since your tax liability is only $658—that’s all the credit you get.
Now if you have $2,000 to put into savings, I am 100% behind you saving the full $2,000. But, you may be better off putting some of that money into a regular savings account instead. It’s something to play with. Never sneeze at a 50% return on your investment. Let’s be real, that’s what this is. Even the 10% and 20% return is a good deal. But once you’ve maxed out that return, then you need to look at what other options you’ve got. That’s why I like IRAs. You can figure out your tax return first before make the investment. The absolute best part – you can make the investment with your income tax refund! You can actually do your tax return, plan out your IRAs, and not fund them until after you’ve gotten your refund.
Not everyone will qualify for the Credit for Qualified Retirement Savings Contributions, but if your income is anywhere close, you’ll definitely want to at least look into it.
Updated June 1, 2013
Okay first and foremost, you’re not a dummy! But I wanted to make a simple post with simple explanations about IRAs. This isn’t the be all end all of IRA stuff. But hopefully it will give you a little clue about them.