tax/Roth question re: Credit for Qualified Retirement Savings Contributions

[Earl E Retyre]

I am helping out a young lady with her taxes and wanted to validate my understanding regarding the Credit for Qualified Retirement Savings Contributions.

My understanding is if she contributes $2,000 to a Roth and she earns less than $30,750 as head of household that she gets a 20% credit (or $400). Also, my understanding is that if she contributes to a Roth she is allowed to withdraw the entire $2,000 at any time with no penalty. She is only not allowed to withdraw any future gains. And, my understanding is that there is no waiting period for when she can withdraw the $2,000.

If all that is true, why would she not contribute the $2,000 on 4/15, get the $400 credit and even if she needed the $2,000 the very next week, she can withdraw it. It is free money with no obligations to keep the money invested. Or am I misunderstanding?

 

[SecondCor521]

Your understanding is accurate. A few comments:

She would have to have $2,000 or more of earned income to qualify to contribute to a Roth IRA. Sounds like she does.

Note that the credit is non-refundable, so she would have to have to have at least $400 in tax liability for the credit to offset. If she only owed $300 in taxes, then the $400 credit would offset the $300 but she wouldn't get the extra $100 as a refund. The credit goes from Form 8880 to Schedule 3 line 51 to Form 1040 line 12b. Note the instructions for Form 1040 line 13: "If zero or less, enter zero."

If she withdraws the $2,000 from her IRA, she would lose out on tax free compounding on that $2,000 from now until retirement age.

As an aside, given her income level and the fact that she has a dependent, she might qualify for the Earned Income Tax Credit (EITC). It's hard to qualify for though.

 

[meekie]

I had a friend that was making just over the limit for the full credit, so we did partial Traditional IRA/ part ROTH to get her the maximum credit.

I promote the ROTH IRA with the credit to be a great start to investing, while having somewhat of an emergency fund as the ROTH, since you can withdraw the contributions at any time.

 

[Earl E Retyre]

Your understanding is accurate. A few comments:

She would have to have $2,000 or more of earned income to qualify to contribute to a Roth IRA. Sounds like she does.

Note that the credit is non-refundable, so she would have to have to have at least $400 in tax liability for the credit to offset. If she only owed $300 in taxes, then the $400 credit would offset the $300 but she wouldn't get the extra $100 as a refund. The credit goes from Form 8880 to Schedule 3 line 51 to Form 1040 line 12b. Note the instructions for Form 1040 line 13: "If zero or less, enter zero."

If she withdraws the $2,000 from her IRA, she would lose out on tax free compounding on that $2,000 from now until retirement age.

As an aside, given her income level and the fact that she has a dependent, she might qualify for the Earned Income Tax Credit (EITC). It's hard to qualify for though.

OK, Thanks for validating! I bet that the majority of young people do not do this yet it is free money. Unless they are literally living paycheck to paycheck and do not have $2,000 then it makes no sense to not take advantage of this credit. Of course, I know a lot do live paycheck to paycheck.

On a similar note, I know a lot of young people do not take advantage of company matching 401k. That is 100% free return on investment. However, that money is tied up until they are 59.5. Whereas Roth money is immediately accessible so there should be no excuses not to do this (if they have the $2k available for at least a week).

 

[SecondCor521]

Well, there's also the hassle factor and fear of the unknown. Although it's probably worth the hassle for $400 for a person like you're talking about, I've seen a lot of young people give up without trying very hard or be intimidated by new things.

It's nice that there's an older person like you helping her out. I do the same for my kids; if I hadn't they wouldn't have known about a lot of things like this.

 

[gauss]

The various volunteer tax sites are trained in this credit and can help any young people, who have an in-scope return, fill out a tax return for free and claim the credit.

The young people just need to have made the qualifying contribution and meet the income restrictions during the tax year.

An IRS directory of these volunteer sites is available at this link.

-gauss

 

[kaneohe]

.........................................
If all that is true, why would she not contribute the $2,000 on 4/15, get the $400 credit and even if she needed the $2,000 the very next week, she can withdraw it. It is free money with no obligations to keep the money invested. Or am I misunderstanding?

You could do that but be aware that the history of withdrawals stays for
3 yrs so that would handicap getting credits in the future.

 

[SecondCor521]

You could do that but be aware that the history of withdrawals stays for
3 yrs so that would handicap getting credits in the future.

Can you explain more?

As far as I know, the only requirements for getting the federal tax credit is to have made contributions to an IRA (or 401k I think), and have a low enough AGI for their filing status.

I have never heard of an IRA custodian refusing to accept, say, a 2019 contribution because the person deposited and then withdrew their 2018 IRA contribution quickly.

 

[RunningBum]

I've never heard of a 3 year history of withdrawals on Roth contributions. What kind of "handicap" does that cause for the credit?

 

[RunningBum]

Ah, just looked at form 8880. In line 4 you include any distributions over the last 3 years (after 2015 for the 2018 form), and subtract that from any contributions. kaneohe is spot on.

 

[pb4uski]

I am quite familiar with this as DS has used this over the past few years (I prepare his return for him).

If her income is $30,450 before any retirement contributions then her best bet might be to contribute to a tIRA rather than a Roth IRA to reduce her taxable income to $28,500 or less, at which point she would get a 50% credit rather than a 20% credit.

At the 50% level (rather than 20%) she would be better off even if she later withdraws the funds and pays the 10% penalty.

So in your example... assuming TI of $30,450 before any retirement contributions and tax of $3,382.

1. Contribute $2,000 to Roth and get 20% tax credit or $400.... total tax is $2,982.

2. Contribute $2,000 to tIRA and get 50% tax credit or $1,000, reducing TI to $28,450 and reducing tax to $3,142.... and tax after credit to $2,142.

The tIRA is ahead by $840.... $240 for tax benefit of tIRA contribution at 12% and $600 for 30% higher Saver's Credit.

Now even if the taxpayer later has to drain the account, they would get $2,000 from the Roth but only $1,560 from the tIRA... ($2,000 - 12% or $240 in tax - 10% or $200 in penalty)... a net difference of $480.... but they still come out ahead by $360 with the tIRA compared to the Roth.

https://www.fool.com/retirement/2017/10/22/the-2018-savers-tax-credit-free-money-to-save-for.aspx