10/09/2013 01:32 pm ET Updated Dec 09, 2013

Lower Income? Don't Pass Up the Saver's Credit

In 2002, Congress passed legislation to create an income tax credit designed to encourage lower- and middle-income people to save money for retirement. The saver's credit, worth up to $1,000 a year for individuals ($2,000 for couples filing jointly), rewards people for contributing to an IRA or 401(k) plan -- or a 403(b), 457, SEP or SIMPLE plan if those are workplace options.

Regrettably, the people most likely to benefit from the saver's credit are also those who can usually least afford to set aside money for retirement. And it doesn't help that, according to the 2013 Transamerica Retirement Survey of American Workers, only 23 percent of people earning less than $50,000 are even aware the credit exists.

But if you can squeeze a few dollars out of your budget, the saver's credit is worth pursuing. Tax credits reduce the amount of income tax paid, dollar for dollar; so many low-income people are able to recoup up to 50 percent of the amount they contribute to retirement accounts through reduced taxes. And those whose employers match a portion of their 401(k) contributions reap even bigger rewards.

Another good selling point: Parents or grandparents who want to jumpstart their low-income kids' retirement savings can fund their IRA or 401(k) contribution, thereby making them eligible for the saver's credit even if they can't afford to contribute on their own. You won't trigger the federal gift tax ($14,000 per year, per person) and your kids will reap the power of compounding from a much earlier age.

Here's the nitty-gritty on the saver's credit:

The saver's credit is a "nonrefundable" tax credit, which means it reduces income taxes owed, dollar for dollar -- although it won't generate a tax refund if the credit is more than the taxes you owe. (By contrast, a "refundable" credit like the Earned Income Tax Credit can actually generate a tax refund if the credit amount is greater than the taxes you owe.)

The saver's credit helps offset part of the amount you voluntarily contribute to an IRA or 401(k) plan. Your credit amount is based on your tax filing status, adjusted gross income and the amount you contribute to qualifying retirement programs. It can be claimed by:

  • Married couples filing jointly with adjusted gross income (AGI) of no more than $59,000.
  • Heads of households with AGI up to $44,250.
  • Singles (or married filing separately) with AGI up to $29,500.

The credit rate is 10 percent, 20 percent or 50 percent of the first $2,000 you contribute ($4,000 for married couples filing jointly), depending on your AGI; the lower your AGI the higher the percentage. For example:

  • Single filers with an AGI up to $17,500 receive a 50 percent credit on the first $2,000 they contribute (i.e., up to a $1,000 credit); 20 percent on AGI up to $19,250 ($200 credit); and 10 percent on AGI up to $29,500 ($100 credit). Anything over $29,500, you don't qualify.
  • For joint filers the credit amount limits are: 50 percent on up to $35,500 AGI (50% X $4,000 =$2,000); 20 percent on up to $38,500 ($800); and 10 percent on up to $59,000 ($400).

Although $100 or $200 may not seem like a large amount, remember: You'd be paying that amount in taxes otherwise and you're still reaping the tax advantages of contributing to an IRA or 401(k) -- not to mention employer-matching contributions, if they're available.

Other eligibility rules:
  • You must be at least age 18.
  • You can't be claimed as a dependent on someone else's return.
  • You can't have been a full-time student during any part of five calendar months in 2013.
  • You must contribute to a 401(k) by December 31, 2013, or to an IRA by April 15, 2014.

One reason so few eligible people take advantage of the saver's credit is because you cannot claim the credit using IRS Form 1040 EZ, the form many lower-income people file. To claim it, you must submit IRS Form 8880 with Form 1040, 1040A or 1040NR. It's a little extra bookkeeping, but could be worth the effort.

If the paperwork seems daunting, remember: free tax preparation assistance is available to people who earn $51,000 or less through the Volunteer Income Tax Assistance (VITA) program, where IRS-certified volunteers provide free basic income tax return preparation with electronic filing to qualified individuals in local communities. VITA sites are generally located at community and neighborhood centers, libraries, schools, shopping malls, and other convenient locations. Use this search engine to find your nearest location.

Saving money for the future is never easy, especially when you're struggling to pay daily bills. But if you can somehow manage to take advantage of the saver's credit now, you'll thank yourself at retirement.

This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a legal, tax or financial advisor for specific information on how certain laws apply to you and about your individual financial situation.