Dear Gail,

How do you know if you can contribute to an IRA and deduct the amount? If my wife and I qualify,  we can keep ourselves from getting pushed into a higher tax bracket.

I’ve tried to make sense of the rules, but they’re really confusing.
Paul

Dear Paul,

Join the club! You’ve highlighted one of my great frustrations with our tax code and the reason that only about 10% of those who are eligible to contribute to an IRA do. On the one hand, government officials keep telling us that because Social Security is on shaky financial ground we need to save on our own for retirement. On the other hand, Congress has played politics with the regulations that govern the accounts available for us to invest in.

IRAs are just one of many examples. Until the late 1980s the rules were simple: everyone with “earned income” (i.e. from a job) could put up to $2,000 in an IRA and deduct that amount from their taxable income. The investments in your IRA would grow tax-deferred, meaning income tax would not be due until assets were withdrawn from the account, presumably decades in the future.

Then Congress decided individuals whose income exceeded a certain amount would not be allowed to deduct IRA contributions. While they could still contribute to an IRA, they had to do it with income left over after they paid their income taxes.

Congress further complicated the rules by creating a separate category covering those who participate in a retirement plan through work.  

Roth IRAs, introduced in 1997, have their own unique qualification rules.  (I’ll cover them next week.)

Thankfully, there are a few things that both traditional (tax-deductible) and Roth IRAs have in common:

1. The maximum you can contribute for 2007 is $4,000 or up to 100% of your taxable income. (This amount increases to $5,000 if you’re making a 2008 contribution.)

        a. You can count income received as alimony or from employment, including salary, tips, and  
        commissions. You’ll find this amount in Box 1 of your Form W-2.

        b. You cannot count such things as interest, dividends, rental income, pension income, or Social 
            Security.

        c. Exception for spouse who does not work outside the home- If you don’t personally receive any
            taxable income, you can count the income of your spouse.  Based on this, you may be able to    
            make the full $4,000 contribution for 2007, plus potentially a “catch-up” contribution. (see                     No.2).

        d. Special Provision for Active-duty Military Personnel- The HERO Act allows you to count                 combat pay, which is  generally not subject to income tax- as “taxable” income so that you (and               your spouse if you are married) can contribute to an IRA. You may also be able to contribute                 retroactively.  Please consult your military adviser.

2. If you are 50-years-old or older you can also make what’s called a “catch up” contribution of $1,000.

3. If you had a 401(k) account with a company that went bankrupt, you might be able to contribute up to $7,000.

4. The deadline for making a contribution is April 15.  So if you want your contribution to count for 2007, make sure your IRA custodian receives your check by April 15, 2008. Even if you get an extension on filing your tax return,  you don’t get an extension on making your IRA contribution!

Age Limit
You may make an IRA contribution for 2007 provided you did not reach age 70½ by Dec. 31, 2007. In other words, if your 70 birthday fell on or before the end of June 2007, you can no longer contribute to a traditional IRA. You may, however, be able to make a Roth IRA contribution.

Deductible or Not?
The rules concerning who’s eligible to deduct a traditional IRA contribution vary based on your filing status, income, and whether you a participant in a work-sponsored retirement plan. IRS Publication 590 covers just about everything you need to know about whether your IRA contribution is tax-deductible or not. But, frankly, for some folks that’s exactly the problem--there’s too much information! I’ve summarized the basic rules concerning 2007 contributions to “traditional” IRAs. Find your particular situation and skip the rest:

Single Taxpayer

Work doesn't offer a retirement plan
You can make a make a fully deductible contribution regardless of your income. (No, this is not a typo.) Maximum amount is 100% of your compensation, up to $4,000. Add another $1,000 if you qualify for a catch-up contribution.

Participation in an employer-sponsored retirement plan
If your “modified” Adjusted Gross Income* (MAGI) is

• $52,000 or less:  You can deduct your contribution.
• $52,000 but <$62,000: You can deduct a portion of your contribution. (See “partial deduction” below.)
• $62,000 or more: You cannot deduct your contribution. You may make an after-tax contribution to a traditional or possibly a Roth IRA                             
  

Married Taxpayers
Things get complicated if you are married, especially if one or both of you are covered by a retirement plan through work. In addition, whether you file “married/joint” or “married/separate” plays a role. (Deep breath.)

Neither spouse had a retirement plan through work
Each spouse can make a fully deductible contribution regardless of your joint income. (Not a typo here either.) Maximum amount is 100% of each individual’s compensation, up to $4,000. Add another $1,000 if that individual qualifies for a catch-up contribution.

You or both of you were covered by a plan at work and you file “married/joint”
If your joint MAGI is

• $83,000 or less: You can deduct your contribution.
• $83,000 but <$103,000: You can deduct a portion of your contribution (See “partial deduction” below.)  
• 103,000 or more: You cannot deduct your contribution. You may make an after-tax contribution to a traditional IRA or possibly a Roth IRA.
  

You were not covered by an employer retirement plan (possibly because you don’t work outside the home), but your spouse was and you file “married/joint”

If your joint MAGI is

• $156,000 or less: You can deduct your contribution.
• $156,000 but <$166,000: You can deduct a portion of your traditional IRA contribution. (See “partial deduction” below.) You may also make a (partial) after-tax contribution to a Roth IRA.
• $166,000 or more: You cannot deduct your contribution.  You may make an after-tax contribution to a  traditional IRA. You do not qualify for a Roth IRA.
  

You file “married/separate"
Regardless if you or both of you are covered by a plan at work, if your MAGI is:

• $10,000: You can deduct a portion of your contribution.
• $10,000 or more: You cannot deduct your contribution.  You may make an after-tax contribution to a traditional IRA or possibly a Roth IRA.  
  

Figuring a Partial Deduction

The key is to remember that even if the amount you can deduct may be reduced, this does not reduce the amount you can contribute. It’s just a question of which type of IRA would be best for this non-deductible amount.

If you are single and covered by your employer's retirement plan (or, if you’re married and one or both of you are), simplify your life by skipping the confusing text and heading right to Worksheet 1-2 in IRS Publication 590. You’ll find this at www.irs.gov.  If your income falls into the “phase-out” range and your contribution is only partially deductible, this will walk you through how to calculate the amount you can actually deduct.

Note: if you are married, you have to go through this exercise separately for each spouse.

For your sake, Paul, I assumed a couple who files “married/joint.” Spouse A is 48-years-old and earns 62,000/year; Spouse B is 51, and earns $74,000/year. Spouse A participates in a retirement at work; Spouse B is an independent contractor and has no employer-sponsored plan. Their joint modified AGI is $98,000.

Let’s compute the taxable contribution for Spouse A. According to the worksheet, first enter the upper limit of the phase-out range- $103,000 for a married individual who is covered by a company-sponsored retirement plan.  From this, subtract your joint modified AGI of $98,000. Then multiply the number you get by 20%. This tells you the amount by which your deduction is reduced.$103,000

Thus, Spouse A can make a $3,000 tax-deductible contribution to a traditional IRA. The remaining $1,000 could go into the same IRA on an after-tax basis, but a better alternative would be to put this in a Roth IRA because future earnings would accumulate tax-free as opposed to tax-deferred.

The math for Spouse B is different for two reasons: this individual is over age 50 and does not have a work-sponsored retirement plan.  Nick Kanter, of tax information provider CCH, says “an individual is not considered an ‘active participant’ in an employer plan just because his or her spouse is.”  As a result, the phase-out range is significantly higher. The directions in Worksheet 1-2 of IRS Publication 590 tell us that the upper limit is $166,000. From this you subtract your modified AGI and multiply by 25%. This gives you the amount by which your total deductible contribution- $5,000 including your catch-up amount- is reduced.

As a result, Spouse B can make a tax-deductible contribution of $3,750 ($5,000-1,250) to a traditional IRA. While the remaining amount could be contributed on an after-tax basis to the same IRA, as explained above, a Roth IRA is a better option.

Speaking of Roths, did you know that the income limits on who is eligible to contribute to a Roth IRA went up last year for the first time? That and more in next week’s column.

Hope this helps,
Gail



*Modified Adjusted Gross Income is your Adjusted Gross Income with certain amounts added back in.  These include such things as your IRA deduction(s), any deduction for student loan interest or tuition, as well as exclusions for foreign earned income and employer-provided adoption benefits.  IRS Publication 590 has a complete explanation as well as a worksheet to calculate this. 

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.