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Taking a retirement tax break before retiring

George SaenzDear Tax Talk,
I am doing my taxes for the very first time by myself. I'm kind of proud of myself because I've been able to understand everything except one line on Form 8880, the retirement savings credit form. I'm e-mailing you because I was hoping to get some help. The IRS is no help. They put me on hold for 20 minutes.

Here are my questions: Line 4 of Form 8880 says to put down any distributions received after 2001 but before the due date of the 2004 return. Well, I'm confused because I've only taken money out of a retirement account (401k) once and that was in 2001 when I left a job and they took it out for me and took the taxes out of the check. I don't see why I would need to put this down because I've already paid the taxes on it. Maybe I'm not understanding it and I'm not thinking of the right thing to put in the blank for line 4. However, last year my tax preparer put $1,616 in the blank and I've never had a distribution even close to that amount. I did all this rambling to ask you if you knew what I'm supposed to put in this blank.

By the way, I love your Web site. I read it daily. -- Kelly

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Dear Kelly,
Flattery will get your question answered.

In order to encourage retirement savings among lower-income taxpayers, Congress created a tax credit. Because lower income taxpayers don't receive as much of a benefit as higher income taxpayers when they deduct retirement savings, the credit is intended to equalize the tax benefit.

The credit can be from 10 percent to 50 percent of the amount that you put into a retirement plan such as an IRA or a 401(k).

The credit decreases as your adjusted gross income increases as shown on Form 8880. If a married couple with an AGI between $37,500 and $50,000 contributes a total of $5,000 to their IRAs ($2,000 for him; $3,000 for her) they will get a 10 percent tax credit on their joint return to reduce their tax bill dollar for dollar. The catch here is that the percentage is not calculated on the full $5,000 that they contributed, but rather on only $4,000 total because the contribution amount that can be used is capped at $2,000 per filer. That gives them a $400 credit. However, this couple will also likely save 15 percent income tax on the contribution so that their combined savings is $1,150. Since a higher income taxpayer will save 25 percent or more in income taxes by claiming a deduction only, the credit equalizes the lower income taxpayer.

To discourage subsequent withdrawals of the retirement savings and manipulation of the credit, a taxpayer has to reduce current creditable contributions by the amount of their withdrawals since 2001. For example, if in 2002 you withdrew $1,000 from your IRA and you have $2,000 in 2004 credit-eligible contributions, you can only claim a credit on $1,000. So in your case you would enter zero on this line as the only distributions you received were in 2001.

If you're not sure you took money out since 2001, you should look back at lines 15 and 16 of your forms 1040 for 2002 and 2003. You should also note that the credit applies to various pension plan contributions that you would find in Box 12 of your 2004 Form W-2.

-- Posted: March 11, 2005

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