It’s no wonder that Americans are clamoring for tax simplification. You need to look no further than the rules pertaining to deductibility of IRA contributions to appreciate this.
I wrote a RetireMentors article, The Tax Rules That Limit the Deductibility of Your IRA Contributions, which was published December 9 in MarketWatch. The article discussed three sets of rules that determine whether your IRA contribution is deductible.
The common theme of all of the rules is whether you or your spouse is covered by a retirement plan at work. While none of the rules make sense due to the low maximum IRA contribution limit, i.e., $5,500 or $6,500 if you’re 50 or older, one of them defies logic and is furthermore discriminatory in my opinion.
IRA Marriage Penalty
Let’s suppose that you don’t have a retirement plan at work. You should be allowed to make a maximum deductible IRA contribution of up to $5,500 or $6,500, depending on your age, without any further restrictions, right?
Unfortunately the answer to this question is, “not necessarily.” You can make a deductible IRA contribution if you don’t have a retirement plan at work and you’re single. If you’re married and your spouse is covered by a retirement plan, your ability to deduct a portion or all of your contribution is subject to an income test.
To begin with, you need to be familiar with, and calculate, “modified adjusted gross income,” or “MAGI.” MAGI is “adjusted gross income,” or “AGI,” increased by certain sources of nontaxable income and various otherwise allowable deductions. While MAGI is often the same as AGI, this isn’t always the case.
Even if you’re not covered by a retirement plan at work and your spouse is, your ability to deduct your IRA contribution is threatened once your MAGI exceeds $183,000. There’s a narrow $10,000 band between $183,000 and $193,000 where a portion of your contribution is deductible. None of your contribution is deductible, however, once your MAGI exceeds $193,000.
Why should the deductibility of your IRA contribution when you’re not covered by any retirement plan at work be endangered if (a) you’re married, (b) your spouse has a retirement plan at work, and (c) your income exceeds a certain level? Why shouldn’t you be entitled to an income tax deduction for your contribution just like your spouse assuming he/she is contributing to a traditional 401(k) plan?
To add insult to injury, the amount of your maximum contribution and potential deduction is 30% of what your spouse can contribute to his/her retirement plan — $5,500 vs. $18,000. Furthermore, the limit decreases to 27% if you’re both over 50 – $6,500 vs. $24,000.
The fact of the matter is that we’re motivated by income tax deductions and many individuals won’t make an IRA contribution unless it’s deductible. Often times, if they don’t make an IRA contribution, they also won’t invest the funds elsewhere.
Ignoring potential increases in contribution limits, the 401(k) plan spouse can save and deduct up to $360,000 to $480,000, depending on age, over 20 years. The spouse who doesn’t have any retirement plan is limited to making contributions to an IRA totaling $110,000 to $130,000, depending on age, over the same period. Once again, the annual IRA contributions may or may not be deductible depending upon income.
When you get together with family this holiday season and the topic of income tax simplification comes up, which it will since tax time is just around the corner, please keep this blog post in mind. It’s as good a place as any to start a discussion about this popular topic.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.