Saver's Credit Can Spur Retirement Plan Contributions
Many employees are not aware of employer-sponsored retirement accounts, or individual retirement accounts (IRA), which could be costing those more money. Tax season is the best time for employers to educate their employees on how they can earn extra tax credits through their 401(k) plans. Read this blog post to learn more about how to educate employees on what retirement account opportunities that are available to them.
Many workers don't know that they're eligible for a tax credit by saving in an employer-sponsored retirement plan or individual retirement account (IRA)—and that could be costing them money. Tax time, however, is prime time for employers to inform eligible workers about the saver's credit.
The Retirement Savings Contributions Credit, or saver's credit, is available to low- and moderate-income workers who are putting money aside for retirement. But only 29 percent of workers with annual household income below $50,000 know about the saver's credit, according to the nonprofit Transamerica Center for Retirement Studies in Los Angeles, which surveyed nearly 6,000 employees last fall.
"Tax season is an ideal time to tell eligible workers how they can earn extra tax credits by saving through their employer's 401(k) or a similar retirement plan," said Catherine Collinson, president of the Transamerica Center. "The saver's credit might just be the motivator for those not yet saving for retirement to get started."
Scott Spann, a senior financial planner with Financial Finesse, a provider of workplace financial wellness programs in Charleston, S.C., said, "Saving for retirement is a challenge for many households in America. Special tax incentives help make the process of saving easier."
What Is the Saver's Credit?
Like other tax credits, the saver's credit can increase a taxpayer's refund or reduce the tax owed. Here's how it works:
The amount of the credit is a maximum of 50 percent of an employee's retirement plan contributions up to $2,000 (or $4,000 for married couples filing jointly), depending on the filer's adjusted gross income as reported on Form 1040. Consequently, the maximum saver's credit is $1,000 (or $2,000 for married couples filing jointly).
The saver's credit "is different than a tax deduction due to the fact that a tax credit is a dollar-for-dollar reduction of your gross tax liability, which is the total amount of taxes you're responsible for paying before any credits are applied," Spann explained.
The saver's credit also differs from the separate tax benefit of contributing pretax dollars to a qualified retirement plan, such as an employer-sponsored 401(k) or an IRA. "Many eligible retirement savers may be confusing these two incentives because the notion of a double tax benefit"—pretax contributions and an additional tax credit—"seems too good to be true," Collinson said.
Who Can Claim the Saver's Credit?
The credit is available to workers age 18 or older who have contributed to a company-sponsored retirement plan or an IRA in the past year and meet the income requirements shown in the table below. The filer cannot be a full-time student nor claimed as a dependent on another person's tax return.
Income Caps for Tax Years 2019 and 2020
For eligible workers, the amount of the available tax credit diminishes as adjusted gross income (AGI) rises. To help preserve the credit's value, income thresholds are adjusted annually to keep pace with inflation. Below are the AGI caps for tax year 2019 (for tax returns filed this year) and 2020 (for returns filed next year).
| 2019 Saver's Credit | |||
| Tax Credit Rate | Single Filers and Married, Filing Separately* | Married, Filing Jointly | Heads of Household |
| 50% of contribution | AGI not more than - $19,250 | AGI not more than $38,500 | AGI not more than $28,875 |
| 20% of contribution | AGI of $19,251 - $20,750 | AGI of $38,501 - $41,500 | AGI of $28,876 - $31,125 |
| 10% of contribution | AGI of $20,751- $32,000 | AGI of $41,501 - $64,000 | AGI of $31,126 - $48,000 |
| No credit | AGI more than $32,000 | AGI more than $64,000 | AGI more than $48,000 |
| 2020 Saver's Credit | |||
| Tax Credit Rate | Single Filers and Married, Filing Separately* | Married, Filing Jointly | Heads of Household |
| 50% of contribution | AGI not more than $19,500 | AGI not more than $39,000 | AGI not more than $29,250 |
| 20% of contribution | AGI of $19,501 - $21,250 | AGI of $39,001 - $42,500 | AGI of $29,251 - $31,875 |
| 10% of contribution | AGI of $21,251 - $32,500 | AGI of $42,501 - $65,000 | AGI of $31,876 - $48,750 |
| No credit | AGI more than $32,500 | AGI more than $65,000 | AGI more than $48,750 |
Deadlines for Retirement Contributions
"You must make eligible contributions to your employer-sponsored retirement plan or IRA for the tax year for which you are claiming the income tax credit," Spann said.
While 401(k) contributions for a tax year can be made only up to Dec. 31, those who are eligible but did not save last year can still make a tax year 2019 IRA contribution until April 15, 2020.
Filing for the Saver's Credit
Employers can advise eligible workers to take the following steps to claim the saver's credit, according to the Transamerica Center:
- If using tax-preparation software, including those programs offered through the IRS Free File program, use Form 1040 or Form 1040NR for nonresident aliens. Answer questions about the saver's credit, which may be referred to as the Retirement Savings Contributions Credit or the Credit for Qualified Retirement Savings Contributions.
- If preparing tax returns manually, complete Form 8880, Credit for Qualified Retirement Savings Contributions, to determine your exact credit rate and amount. Then transfer the amount to the designated line on Form 1040 (Schedule 3) or Form 1040NR.
- If using a professional tax preparer, ask about the saver's credit.
Financial planners advise having tax refunds directly deposited into an IRA to further boost your retirement savings.
The Transamerica Center has additional information, in English and Spanish, on its Saver's Credit webpage, along with a downloadable fact sheet.
IRS Free File Program Is Available
Another potentially overlooked opportunity for workers is the IRS Free File program, which offers federal income tax preparation software at no charge to tax filers with an AGI of $69,000 or less.
Free File opened on Jan. 10, 2020, for the preparation of 2019 tax returns. Eligible taxpayers can do their taxes now, and the Free File provider will submit the return once the IRS officially opens the tax filing season on Jan. 27.
For 2020, the Free File partners are: 1040Now, Inc., ezTaxReturn.com (English and Spanish), FileYourTaxes.com, Free tax Returns.com, H&R Block, Intuit, On-Line Taxes, Inc., Tax ACT, TaxHawk, Inc. and TaxSlayer (English and Spanish).
Here's how Free File works:
- Taxpayers go to IRS.gov/FreeFile to see all Free File options.
- They browse each of the offers or use a "look up" tool to help find the right product. Each Free File partner sets its own eligibility standards generally based on income, age and state residency. But if the taxpayer's adjusted gross income was $69,000 or less, they will find at least one free product to use.
- They select a provider and follow the links to their web page to begin a tax return.
- They complete and e-File a tax return if they have all the income and deduction records they need. The fastest way to get a refund is by filing electronically and selecting direct deposit. For taxes owed, they can use direct pay or electronic options.
Many Free File online products also offer free state tax preparation, although some charge a state fee. Taxpayers should read each provider's information carefully.
"The IRS has worked to improve the program for this year, and we encourage taxpayers to visit IRS.gov, and consider using the Free File option to get a head start on tax season," said IRS Commissioner Chuck Rettig.
Nearly 57 million returns have been filed through the Free File program since it began in 2003, and 70 percent of U.S. taxpayers (about 100 million people) are eligible for Free File, according to the IRS.
SOURCE: Miller, S. (10 January 2020) "Saver's Credit Can Spur Retirement Plan Contributions" (Web Blog Post). Retrieved from https://www.shrm.org/resourcesandtools/hr-topics/benefits/pages/remind-low-wage-earners-about-savers-credit.aspx
The Mega Backdoor Roth IRA and Other Ways to Maximize a 401(k)
Did you know: Numerous 401(k) retirement plans allow after-tax contributions. This creates financial planning opportunities that are frequently overlooked. Read this blog post for more information on maximizing your 401(k) plan.
The most popular workplace-sponsored retirement plan is far and away the 401(k) — a plan that can be both simple and complex at the same time. For some of your clients, it functions as a tax-deductible way to save for retirement. Others might see its intricacies as a way to maximize lifetime wealth, boost investments and minimize taxes. One such niche area of 401(k) planning is after-tax contributions, an often misunderstood and underutilized area of planning.
Before we jump into after-tax contributions, we need to cover the limits and the multiple ways your clients can invest money into 401(k) plans.
Employee Salary Deferrals and Roth
The most traditional way you can contribute money to a 401(k) is by tax-deductible salary deferrals. In 2019, employees can defer up to $19,000 a year. If they’re age 50 or older, they can contribute an additional $6,000 into the plan. In 2020, these numbers for “catch-up contributions” rise to $19,500 and $6,500 respectively.
Someone age 50 or over can put up to $25,000 into a 401(k) in 2019 and $26,000 in 2020 through tax-deductible salary deferrals. Additionally, the salary deferral limits could instead be used as a Roth contribution, but with the same limits. The biggest difference is that Roth contributions are after-tax. And as long as certain requirements are met, the distributions, including investment gains, come out income tax-free, whereas tax-deferred money is taxable upon distribution.
Employer Contributions
Employers often make contributions to a 401(k), with many matching contributions. For instance, if an employee contributes 6% of their salary (up to an annual indexed limit on salary of $280,000 in 2019 and $285,000 in 2020), the company might match 50%, 75%, or 100% of the amount. For example, if an employee earns $100,000 a year and puts in $6,000 and their employer matches 100%, they will also put in $6,000, and the employee will end up with $12,000 in their 401(k). Employers can also make non-elective and profit-sharing contributions.
Annual 401(k) Contribution Cap
Regardless of how money goes into the plan, any individual account has an annual cap that includes combined employee and employer contributions. For 2019, this limit is $56,000 (or $62,000 if the $6,000 catch-up contribution is used for those age 50 and over). For 2020, this limit rises to $57,000 ($63,500 if the $6,500 catch-up contribution is used for those age 50 and over).
Inability to Max Out Accounts
If you look at the limits and how people can contribute, you might quickly realize how hard it is to max out a 401(k). If a client takes the maximum salary deferral of $19,000 and an employer matches 100% (which is rare), your client would only contribute $38,000 into the 401(k) out of the maximum of $56,000. Their employer would need to contribute more money in order to max out.
Where After-Tax Contributions Fit In
Not all plans allow employees to make after-tax contributions. If the 401(k) did allow this type of contribution, someone could add more money to the plan in the previous example that otherwise maxed out at $38,000.
After-tax contributions don’t count against the salary deferral limit of $19,000, but they do count toward the annual cap of $56,000. After-tax contributions are what they sound like — it’s money that’s included into the taxable income after taxes are paid, so the money receives all the other benefits of the 401(k) like tax-deferred investment gains and creditor protections.
With after-tax contributions, clients can put their $19,000 salary deferral into the 401(k), get the $19,000 employer match, and then fill in the $18,000 gap to max out the account at $56,000.
Mega-Roth Opportunity
If the plan allows for in-service distributions of after-tax contributions and tracks after-tax contributions and investment gains in separate accounts from salary deferral and Roth money, there’s an opportunity to do annual planning for Roth IRAs.
Clients can convert after-tax contributions from a 401(k) plan into a Roth IRA, without having to pay additional taxes. If a plan allows in-service distributions of after-tax contributions, the money can be rolled over to a Roth IRA each year. However, it’s important to note that any investment gains on the after-tax amount would still be distributed pro rata and considered taxable. Earnings on after-tax money only receive tax-deferred treatment in a 401(k); they aren’t tax free.
Clients can roll over tens of thousands of dollars a year from a 401(k) to a Roth IRA if the plan is properly set up. They can even set up a plan in such a way so the entire $56,000 limit is after-tax money that’s distributed to a Roth IRA each year with minimal tax implications. This strategy is referred to as the Mega Backdoor Roth strategy.
Complexities Upon Distribution of After-Tax Contributions
What happens to after-tax contributions in a 401(k) upon distribution? This is a complex area where you can help clients understand the role of two factors:
- After-tax contributions are distributed pro-rata (proportional) between tax-deferred gain and the after-tax amounts.
- Pre-tax money is usually considered for rollover into a new 401(k) or IRA first, leaving the after-tax attributed second. The IRS provided guidance on allocation of after-tax amounts to rollovers in Notice 2014-54.
Best Practices for Rollovers
Help your clients navigate the world of rollovers with after-tax contributions by following best practices. If a client does a full distribution from a 401(k) at retirement or separation of service, they can roll the entire pre-tax amount to a new 401(k) or IRA and separate out the after-tax contributions to roll over into a Roth IRA. The IRS Notice 2014-54 previously mentioned also provides guidance for this scenario.
You can help your clients understand after-tax contributions by envisioning after-tax money in a 401(k) as the best of three worlds. These contributions enter after taxes and give your client tax-deferred money on investment growth, allow them to save more money in their 401(k) while also giving them the opportunity to roll it over into a Roth IRA at a later date.
After-tax contributions build numerous planning options and tax diversification into retirement plans. Before your clients allocate money toward after-tax contributions, it’s important they understand what their plan allows and how it fits into their overall retirement and financial planning picture.
SOURCE: Hopkins, J. (17 December 2019) "The Mega Backdoor Roth IRA and Other Ways to Maximize a 401(k)" (Web Blog Post). Retrieved from https://www.thinkadvisor.com/2019/12/17/the-mega-backdoor-roth-ira-and-other-ways-to-maximize-a-401k/