You’re having a banner year at work and you want to set aside some of your earnings for retirement. Specifically, you want to make a deductible traditional IRA contribution.
Your income was $70,000 in 2014 and will increase to $115,000 in 2015 as a result of a sizable bonus. You got married earlier this year to Ashley and her employment income is $100,000. Ashley has a 401(k) plan while you aren’t covered by any work-related retirement plan. Ashley is 28 and you’re 30.
When you meet with your CPA to do tax planning, she tells you that you don’t qualify for a deductible traditional IRA contribution. This doesn’t make sense. You’ve been able to take deductions for your IRA contributions in prior years when your income wasn’t as high and it wasn’t as easy to fund the contributions. Have the rules changed?
Traditional IRA contribution limit
Before addressing why you’re not eligible to take a deduction for your IRA contribution this year, let’s take a look at the contribution limit. Unlike work-sponsored retirement plans including 401(k) plans where you can contribute up to $18,000 or $24,000 if you’re 50 or older, the limit for traditional IRAs is relatively low.
For 2015 and 2016, contributions cannot exceed the lesser of:
- $5,500 or $6,500 if you’re 50 or older, or
- Taxable compensation
Ashley and you can each contribute up to $5,500 to a traditional IRA.
Do you have a retirement plan at work?
While the IRA contribution limit rules are straightforward, it’s another story when it comes to deductibility. There are three sets of rules for determining if you can take a deduction for a contribution to a traditional IRA account. The focus of the rules is whether you or your spouse is covered by a retirement plan at work.
No retirement plan at work
Life is simple if neither you nor your spouse is covered by a retirement plan at work. Each of you can take a deduction up to the lesser of the contribution limit or taxable compensation. When you were single last year, you were allowed to make a maximum deductible traditional IRA contribution of $5,500 since you had no retirement plan at work.
No retirement plan at work and spouse is covered by a retirement plan
Although you still don’t have a work-related retirement plan, your ability to take a deduction for your IRA contribution changes now that you’re married and Ashley participates in a 401(k) plan. You need to apply an income test to determine how much, if any, of your IRA contribution is deductible. The test is based on modified adjusted gross income (MAGI), which is adjusted gross income increased by certain sources of nontaxable income and various otherwise allowable deductions.
The ability to take a deduction for your IRA contribution phases out when your MAGI exceeds $183,000 and is eliminated when MAGI is greater than $193,000. Ashley and your 2015 MAGI is $215,000 which is the same as your total employment income. Consequently, you will receive no deduction for your IRA contribution since your MAGI exceeds the allowable threshold.
Retirement plan at work
There’s a third set of rules that come into play when you’re covered by a retirement plan at work that affects Ashley’s ability to take a deduction for an IRA contribution. Like the second set, deductible traditional IRA contributions are determined by tax filing status and MAGI.
Single individuals with MAGI less than $61,000 in 2015 can make a deductible traditional IRA contribution up to the contribution limit. Those with MAGI greater than $71,000 aren’t eligible to deduct any portion of their contribution. Reduced deductions are permitted for MAGI between $61,000 and $71,000. The minimum and maximum MAGI thresholds are $98,000 and $118,000, respectively, for married couples who file a joint return.
Since Ashley and your MAGI of $215,000 is greater than the maximum threshold of $118,000, no deduction is allowed for Ashley’s IRA contribution.
Eliminate barriers for making deductible traditional IRA contributions
Given the relatively low historical and current traditional IRA contribution limits and associated tax savings, it isn’t good tax, economic or social policy to limit one’s ability to make a deductible traditional IRA contribution based on participation in a retirement plan at work and income exceeding a specified limit.
Unlike Roth IRA contributions where 100% of distributions permanently escape taxation, deductible traditional IRA contributions, earnings, and appreciation are ultimately taxed, sometimes at a higher tax rate than what was in effect when the deduction was taken.
The current barriers for making deductible IRA contributions often result in individuals foregoing the contribution and investing the funds elsewhere. In a system already strained by the scarcity of private pension plans, this is one more obstacle to the enjoyment of a financially secure retirement. Elimination of the current work-related retirement plan and income barriers would be a small, but meaningful, step toward providing additional incentives for saving for retirement. And let’s not forget about tax simplification.
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.