I find each tax filing season that my clients still have misconceptions about various tax deductions and credits. In many cases a little knowledge is dangerous. I will devote several posts to some of the misconceptions I came across during this and previous seasons.
One client, a single parent, needed to keep her Adjusted Gross Income (AGI) under a certain amount to qualify for a specific state program. To this end she made a contribution to a traditional IRA, thinking that it would be fully deductible and therefore reduce her AGI.
This was not the case. The client was an “active participant” in an employer pension plan, as evidenced on her W-2 by reference to the type of plan and amount of her contribution in Box 12 and the fact that the “Retirement Plan” box was “x-ed”. Because her AGI exceeded $62,000.00 she could not deduct her IRA contribution.
Her response to me when I advised her of this fact was, “But I thought I could contribute to both”.
That is totally true – you can contribute to both your employer’s plan(s) and a traditional - or if you qualify a ROTH - IRA. However you may not be able to deduct part or all of your contribution to the traditional IRA.
The amount of the contribution that can be deducted is “phased out” for active participants in an employer plan as “modified” AGI goes from $83,000 to $103,000 for married taxpayers filing a joint return and Qualifying Widow(er)s, and from $52,000 to $62,000 for Single and Head of Household filers.
The amount of “participation” in the employer plan does not matter. You can be covered by the plan for only one month. A contribution of $100.00 to an employer plan can keep you from deducting a $5,000 contribution to a traditional IRA.
If one spouse is an active participant in an employer plan but the other spouse is not, the “non-covered spouse” can deduct in full any contributions to his/her traditional IRA if the joint “modified” AGI is under $156,000. The deduction is “phased out” as the “modified” AGI goes from $156,000-$166,000. No deduction is allowed if MAGI exceeds $166,000.
“Modified” AGI in these cases is the Adjusted Gross Income adjusted by adding-back foreign income exclusions, excluded adoption assistance benefits, the “domestic production” deduction, and such educational items as excluded savings bond interest and the "above-the-line" deduction for student loan interest, and tuition and fees.
In both cases if a married couple is filing separate returns the IRA deduction is “phased-out” as MAGI goes from $0.00 to $10,000. Another way the Tax Code tries to keep married taxpayers from filing separately.
In my client’s situation I reported the traditional IRA contribution as non-deductible on Form 8606. This creates a “basis” in her IRA investments so that when she begins to take withdrawals a portion will be treated as a tax-free “return of basis”. A Form 8606 should be filed with each subsequent Form 1040, even if no additional non-deductible contributions are made, to keep track of the IRA basis so that it is not forgotten when withdrawals are ultimately made.
When calculating the amount of tax-free return of basis that applies to a withdrawal all traditional IRAs, regardless of the source of the original contributions (i.e. deductible, non-deductible, roll-over from employer plan) are taken into consideration - and it does not matter from which individual IRA account the withdrawal comes from. One client deposited deductible and non-deductible contributions into separate accounts – but this had absolutely no affect on the taxability of subsequent withdrawals.
I told the client the proper way to reduce her AGI was to increase her “pre-tax” employee contribution to her employer’s plan. This will reduce the amount of federal wages reported on her Form W-2 and therefore her AGI.
If the taxpayer is a participant in a 401(k) plan his/her contributions will most likely also reduce the state taxable wages. However, while “pre-tax” for federal purposes, the contributions of employees of federal, state and local government units and non-profit organizations to a 403(b), 457, 414(h) or similar plan may not be “pre-tax” for state income tax purposes. Such is the case in New Jersey.
The moral in all of the misconception stories is - contact your tax professional before doing anything tax related. If the client discussed above had simply emailed me before making the IRA contribution I would have set her straight.
Any questions?
TTFN
One client, a single parent, needed to keep her Adjusted Gross Income (AGI) under a certain amount to qualify for a specific state program. To this end she made a contribution to a traditional IRA, thinking that it would be fully deductible and therefore reduce her AGI.
This was not the case. The client was an “active participant” in an employer pension plan, as evidenced on her W-2 by reference to the type of plan and amount of her contribution in Box 12 and the fact that the “Retirement Plan” box was “x-ed”. Because her AGI exceeded $62,000.00 she could not deduct her IRA contribution.
Her response to me when I advised her of this fact was, “But I thought I could contribute to both”.
That is totally true – you can contribute to both your employer’s plan(s) and a traditional - or if you qualify a ROTH - IRA. However you may not be able to deduct part or all of your contribution to the traditional IRA.
The amount of the contribution that can be deducted is “phased out” for active participants in an employer plan as “modified” AGI goes from $83,000 to $103,000 for married taxpayers filing a joint return and Qualifying Widow(er)s, and from $52,000 to $62,000 for Single and Head of Household filers.
The amount of “participation” in the employer plan does not matter. You can be covered by the plan for only one month. A contribution of $100.00 to an employer plan can keep you from deducting a $5,000 contribution to a traditional IRA.
If one spouse is an active participant in an employer plan but the other spouse is not, the “non-covered spouse” can deduct in full any contributions to his/her traditional IRA if the joint “modified” AGI is under $156,000. The deduction is “phased out” as the “modified” AGI goes from $156,000-$166,000. No deduction is allowed if MAGI exceeds $166,000.
“Modified” AGI in these cases is the Adjusted Gross Income adjusted by adding-back foreign income exclusions, excluded adoption assistance benefits, the “domestic production” deduction, and such educational items as excluded savings bond interest and the "above-the-line" deduction for student loan interest, and tuition and fees.
In both cases if a married couple is filing separate returns the IRA deduction is “phased-out” as MAGI goes from $0.00 to $10,000. Another way the Tax Code tries to keep married taxpayers from filing separately.
In my client’s situation I reported the traditional IRA contribution as non-deductible on Form 8606. This creates a “basis” in her IRA investments so that when she begins to take withdrawals a portion will be treated as a tax-free “return of basis”. A Form 8606 should be filed with each subsequent Form 1040, even if no additional non-deductible contributions are made, to keep track of the IRA basis so that it is not forgotten when withdrawals are ultimately made.
When calculating the amount of tax-free return of basis that applies to a withdrawal all traditional IRAs, regardless of the source of the original contributions (i.e. deductible, non-deductible, roll-over from employer plan) are taken into consideration - and it does not matter from which individual IRA account the withdrawal comes from. One client deposited deductible and non-deductible contributions into separate accounts – but this had absolutely no affect on the taxability of subsequent withdrawals.
I told the client the proper way to reduce her AGI was to increase her “pre-tax” employee contribution to her employer’s plan. This will reduce the amount of federal wages reported on her Form W-2 and therefore her AGI.
If the taxpayer is a participant in a 401(k) plan his/her contributions will most likely also reduce the state taxable wages. However, while “pre-tax” for federal purposes, the contributions of employees of federal, state and local government units and non-profit organizations to a 403(b), 457, 414(h) or similar plan may not be “pre-tax” for state income tax purposes. Such is the case in New Jersey.
The moral in all of the misconception stories is - contact your tax professional before doing anything tax related. If the client discussed above had simply emailed me before making the IRA contribution I would have set her straight.
Any questions?
TTFN
2 comments:
Several years ago when I was reading up on the rules for contributions to traditional IRAs I came across an article that stated -- if you are covered by a retirement plan at work -- even if you did not or chose not to contribute to it, then you were subject to the income limitations as shown in your article. So if the individual in your example contributed $0 instead of $100, then the individual would still be subject to the income phase-out rules for deductible contributions.
What's your opinion?
Anon-
It depends on the type of plan.
If it is a "defined contribution plan" an employee is an active participant if any amount has been contributed or allocated to his/her account for the plan year.
If it is a "defined benefit plan" an employee is an active participant if he/she is eligible to participate in the plan. This is true, as you say, even if the employee declines to participate, does not make a required contribution, or does not perform the minimum service required to receive a benefit for the year.
Today most plans are defined contribution - like a 401(k) plan.
TWTP
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