Getting a tax refund this year? The IRS reports that it’s returning nearly $3,000 to the average American this tax season. And though your March Madness buddies may be unanimous in believing you should use yours for a high-definition big-screen TV, your empty bank account -- and big credit card bills -- say otherwise.
The more vexing question is this: Would you be better off paying off debt or using that refund to start a savings account? The surprising answer is that if your income is low, saving for retirement might provide twice the aftertax return than you would realize from paying off debt.
The reason is a little-known break called the “Retirement Savings Contributions Credit,” or the “savers credit” for short.
This credit was put into the tax code to give low-income filers -- those least able to afford socking away money for retirement -- an incentive to save. The less you earn, the bigger the incentive. Single filers earning less than $18,500 and married couples earning less than $37,000, for instance, get a tax credit worth 50 cents for every $1 they put into a retirement account.
However, the credit amount drops for those earning more, falling to 20 percent of retirement contributions for singles earning $20,000 and to 10 percent once single income exceeds that amount. Once you earn more than $31,000 when single or more than $62,000 when married, the credit evaporates completely.
It’s worth mentioning that tax credits are considerably more valuable than tax deductions. The latter simply reduce the amount of income that’s subject to tax, while tax credits provide a dollar-for-dollar reduction in the tax that you owe. A taxpayer who pays 30 percent of his income in federal and state taxes, for instance, would save $300 with a $1,000 tax deduction, but save $1,000 from a tax credit of that amount.
That said, those who qualify for the Retirement Savings Contributions Credit can double-up on tax breaks, claiming both this credit and a tax deduction for saving in a tax-favored account.
Who gets this credit, and how can you claim it?
The credit is available to people who are over the age of 18 and can’t be claimed by another taxpayer as a dependent. You’re also barred from claiming it if you’re a full-time student. Otherwise, the only restriction is based on earnings.
To claim it, you must do two things: Contribute up to $2,000 (single) or up to $4,000 (married) to a qualified retirement account, such as a 401(k) or an IRA, and fill out the IRS Form 8880. And since IRA contributions can be made until the tax deadline of the following year, those who qualify for the credit can still claim it for the 2016 tax year, as long as they put money in an IRA before April 18.
How does it work?
Consider, for example, my son Michael, who started full-time work last year, earning $17,558. He lived frugally enough to sock away $1,000. If he saved that money in a simple bank account, he wouldn’t qualify for any tax breaks. After accounting for standard deductions and personal exemptions, he would pay tax on $7,208 in income and owe $723 in federal income tax.
On the other hand, if he socked the $1,000 into a tax-deductible IRA, his taxable income would drop by $1,000, and his tax obligation would fall to $623.
But he’s not done. By filling out form 8880, he realizes that he also gets a credit of $500 -- 50 percent of his $1,000 deduction. That cuts his tax bill to just $123. Net tax savings: $600. That’s the equivalent of getting a 60 percent return on your money -- before the money is even invested.
Incidentally, if Michael owed money on a credit card -- even at 30 percent interest -- the net benefit of paying off a $1,000 debt would be $300 – less than half of the tax break you get for saving this money. Indeed, the truly smart answer in this case would be to save in the IRA to get the credit and deductions, and then use your $600 tax savings to pay off your credit card debt.