New Credit for IRA and Plan Contributions Under the New Tax Law

© Barry C. Picker, CPA/PFS, CFP
www.BPickerCPA.com
Email: Barry@BPickerCPA.com

Beginning in 2002 and running through 2006, PL 107-16 (H.R. 1836), "The Economic Growth and Tax Relief Reconciliation Act of 2001", gives eligible taxpayers the ability to claim a credit for contributions to a qualified plan. The credit will be in addition to any other tax benefit (i.e. tax deduction) that the contribution gives the taxpayer. An eligible taxpayer must be over age 18, not a full time student, and not a dependent of another taxpayer. The credit is based on a sliding scale percentage of up to $2,000 of contributions. The percentage is based upon the adjusted gross income.

Joint Return:

Over $0 but not over $30,000 - Applicable Percentage 50%
Over $30,000 but not over $32,500 - applicable percentage 20%
Over $32,500 but not over $50,000 - applicable percentage 10%
Over $50,000 - applicable percentage 0 %

Head of a Household:

Over $0 but not over $22,500 - applicable percentage 50%
Over $22,500 but not over $24,375 - applicable percentage 20%
Over $24,375 but not over $37,500 - applicable percentage 10%
Over $37,500 - applicable percentage 0

All Other Cases:

Over $0 but not over $15,000 - applicable percentage 50%
Over $15,000 but not over $16,250 - applicable percentage 20%
Over $16,250 but not over $25,000 - applicable percentage 10%
Over $25,000 - applicable percentage 0%

The maximum credit for any individual is 50% of $2,000 of contributions, or $1,000. The credit is available on a per individual basis, so a married couple could claim a credit of $2,000 on a joint return if income is not over $30,000 and they each contributed at least $2,000 to a retirement account.

Contributions to regular IRAs, Roth IRAs, 401(k) plans, 403(b) plans, 457 plans, SIMPLEs, and voluntary after-tax contributions to a qualified plan are eligible for the credit. The credit is non-refundable, but can be used to offset the dreaded alternative minimum tax as well as regular income tax.

Most people probably won’t qualify for the credit because of the relatively low income limits, and most people who meet the income limits can’t afford to contribute to a retirement plan in any event. However, there may be situations where children of older, wealthier, taxpayers can sneak through the requirements of not being a dependent and not being a full time student, and qualify for the credit. Also, young couples who are not making a lot of money, but their parents will pay for an IRA would be likely candidates to qualify.

Since the credit is available for contributions to a Roth IRA as well as to other plans, the credit could be an incentive to contribute to a Roth rather than to a traditional IRA, particularly if the credit could eliminate the income tax completely. On the other hand, since the IRA deduction is included in the calculation of the AGI, certain circumstances could result in the government paying for an additional IRA contribution.

EXAMPLE: John and Mary have each contributed $2,000 to their IRAs in 2002. Their AGI is $30,100, so they are entitled to a credit of 20% of the $4,000, or $800. If either John or Mary were to contribute an additional $100 to their IRA (remember that the contribution limit goes to $3,000 in 2002), the AGI will become $30,000 and the credit percentage will jump to 50%. John and Mary’s combined credit will jump from $800 to $2,000, thus giving them a $1,200 reduction in tax, for the extra $100 IRA contribution. Now THAT’S leverage!

The category "all other cases" in the above chart most likely was intended to apply to single taxpayers and to married individuals filing separate returns. However, it also appears, from a literal reading, to apply to surviving spouses. This puts a surviving spouse in an adverse position compared to a head of a household, when it comes to computing this credit. I have to believe that this result was unintended, and either a technical correction, or perhaps regulations, will indicate that the "joint return" category includes surviving spouses.

The fact that the credit is available to spouses who file separate returns means that a lower income spouse could qualify for the credit, even if the joint income were too high. For example, if one spouse had an adjusted gross income of $27,000 while the other spouse had an AGI of $24,000, the spouse with the $24,000 AGI would qualify for a credit of 10% of any qualified contribution on a separate return, even though the couple could not get any credit on a joint return. This is just one more complexity that would need to be taken into account in deciding whether a married couple should file joint or separate returns.

In computing the amount of the contribution eligible for the credit, distributions during the "testing period" will reduce the eligible contribution. The "testing period" is defined as the two tax years prior to the year of the credit, the year of the credit, and year after the year of the credit, up to the extended due date for the filing of the tax return. This means that a taxpayer who gets an extension of time to file his year 2002 tax return until October 15, 2003, will be ineligible for the credit for 2002 if he took distributions totaling at least $2,000 at any time between January 1, 2000 and October 15, 2003. To look at it another way, a taxpayer who takes a distribution of $2,000 on March 1, 2003, would be ineligible to claim this credit for 2002, 2003, 2004, and 2005. Distributions include any amount received from an IRA, a 403(b) plan, any qualified plan, and a Roth IRA, whether the distribution is taxable or not. Rollovers and refunds of excess contributions or deferrals do not count as distributions. Neither do loans to a plan participant that are treated as distributions under Sec. 72(p).

While there is a minimum age for the credit, there is no maximum age. Therefore older taxpayers can still qualify for the credit, even if they are over 70½. Since distributions, including minimum required distributions, will make taxpayers ineligible for the credit, the planning would be to make sure that there are no minimum required distributions. For qualified plans where the taxpayer does not own more than 5% of the company, this can be done by rolling over all IRA and other plan assets into the current plan, and not retiring. Alternatively, one can convert all IRAs to Roth IRAs, and not take any distributions. While regular IRA contributions are prohibited as of the year one turns 70½, this prohibition does not apply to Roth IRAs. So one can still contribute to a Roth IRA after 70½, and potentially qualify for this credit.