The Problem with Low-Income Tax Credits

The federal tax code offers a nifty tax credit to low-income workers who save for retirement. If only it reached more people.

The Saver’s Credit offers what appears on its face to be a strong incentive: the IRS will return up to 50 percent of the amount low-income workers and married couples put into a retirement plan.

But Barbara Wollan, an 18-year volunteer in Iowa with the Volunteer Income Tax Assistance program, or VITA, which provides free tax preparation to low-income workers, said her clients often don’t qualify. The reason: the tax credit is not what the IRS calls “fully refundable.”

For example, a single person earning $19,750 or less is eligible for a tax credit equal to 50 percent of the amount saved – the maximum retirement plan contribution eligible for the credit is $2,000. The credits are either 10 percent or 20 percent for single workers earning between $19,751 and $33,000. (The income limits are higher for households.)

The catch is that the credit is subtracted from the taxes owed, and low-income people usually pay little or no taxes to the IRS after they take the standard deduction given to all taxpayers. If they don’t owe taxes, they don’t get the credit.

“To dream big about helping low-income people save for retirement, we would make it a refundable credit,” said Wollan, an educator with Iowa State University Extension and Outreach, which distributes research information in her state on topics like finance and agriculture.

Congress is considering providing a refundable credit of up to $500 to single and married savers even if they don’t owe anything at tax time. But lawmakers often get into a political disagreement about whether people who don’t pay taxes should get money back from the IRS.

Wollan feels her low-income clients should be rewarded for making what is, for them, a Herculean effort to save. “When I see that they have contributed to a 401(k) or other retirement account, I just want to jump up and down and cheer and pat them on the back,” she said. But “because their income is so low, they don’t get to take advantage of these credits, and that is so sad.”

In contrast to the Saver’s Credit, the Earned Income Tax Credit for low-income workers is fully refundable, and the American Opportunity Credit for the college expenses paid by low- and moderate-income parents is partially refundable.

Historically, another credit for parents – the child tax credit – was partially refundable. If the $2,000 credit exceeded the amount a low-income family owed in April, they were limited to a $1,400 refund. To broaden its reach, the American Rescue Plan passed in March made the credit fully refundable through 2022, which means parents receive the full cash payments regardless of the taxes they owe. The legislation also increased the credit to $3,600 for children under 6 and to $3,000 for older children and teenagers.

Now the Biden administration hopes to persuade Congress to make these changes permanent, as well as raising the top age of eligibility from 16 to 17. If the administration succeeds, the Urban Institute said the provisions would pull more than 4 million children out of poverty in urban and rural areas.

In 13 states, the poverty rate would drop by at least half: Alabama, Alaska, Arkansas, Louisiana, Mississippi, Missouri, Nebraska, New Hampshire, New Mexico, Ohio, Vermont, West Virginia, and Wyoming.

Among the three temporary changes made to the child tax credit, Elaine Maag at the Urban Institute said, “full refundability is the most effective at reducing poverty.”

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