Not All Traditional IRA Contributions Are Deductible
By Agatha Schmidt, CISP, SDIP, CHSP
Our client wants to know if the contribution she made to a Traditional IRA is deductible. How do we help her determine that?
A common misconception is that all contributions to a Traditional IRA can be deducted from taxable income. While that might be true for certain individuals, for others who participate in an employer-sponsored retirement plan, or are married to a participant, only a portion of their IRA contributions may be deductible. Some may get no deduction at all.
Deductibility is based on whether the IRA owner, or the IRA owner’s spouse, is an active participant in an employer-sponsored retirement plan. Generally, individuals who are deferring compensation or receiving some type of benefit from such plans are likely to be considered “active participants.” Individuals who receive an IRS Form W-2, Wage and Tax Statement, can look at Box 13 to confirm their active participation status. More information on defining active participation for IRA deduction purposes can be found in IRS Announcement 86-121, Notice 87-16, and IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs).
A Traditional IRA contribution is fully deductible for anyone who is not an active participant and is not married to one. Active participants, or those married to them, may not be eligible for a deduction, or may only be eligible for a partial deduction. This is based on their marital status, tax filing status, and modified adjusted gross income (MAGI).
The IRS provides MAGI phase-out ranges for active participants and those married to them to determine whether they are eligible to deduct any part of their Traditional IRA contributions. Those whose MAGI falls below the range will generally be able to fully deduct their contributions. Those whose MAGI is above the range will not be able to deduct their contributions. If their MAGI falls within the range, they may be able to partially deduct their contributions using an IRS formula.
IRS Publication 590-A includes examples and worksheets that IRA owners may reference for help in determining their deductible amount.
We have a client who made a Traditional IRA contribution and says that a portion of the contribution is not deductible. What are his options?
IRA owners who are not eligible to fully deduct their contribution may have second thoughts about making the contribution. They generally have three options: leave the contribution in the IRA; recharacterize the contribution; or remove it as an excess.
Option 1: Leave the nondeductible contribution in the IRA.
Doing this creates basis, or after-tax assets, in the IRA. This is allowed, but it does create work for the IRA owner (and possibly their accountant), as they must keep track of basis for all future distributions. This is because any Traditional IRA distribution must consist of a pro rata portion of pretax and nondeductible assets, in all non-Roth IRAs. To keep track, IRA owners must report nondeductible contributions on Form 8606, Nondeductible IRAs.
Option 2: Recharacterize the nondeductible contribution.
If an IRA owner prefers not to keep track of basis in her Traditional IRA, she can recharacterize the nondeductible amount as a Roth IRA contribution, as long as she is eligible to make contributions to a Roth IRA. Roth IRA contributions are not tax-deductible but are not included in calculating return of basis with non-Roth IRA distributions. The deadline to complete a recharacterization generally is the IRA owner’s tax return due date, plus an automatic six-month extension, which, for most individuals, is October 15.
Option 3: Treat the nondeductible contribution as an excess contribution and remove it.
Individuals who are not eligible or who do not wish to make Roth IRA contributions may simply choose to remove the nondeductible portion of the contribution from the IRA. To do so, the nondeductible amount can be treated as a “deemed” excess contribution and removed with the earnings attributable to the nondeductible amount. Removing as a deemed excess is not considered a taxable distribution if it is removed timely; however, the earnings portion (often referred to as net income attributable, or NIA) is taxable and may be assessed a 10 percent early distribution penalty tax if the IRA owner is under age 59½ and does not qualify for a penalty exception. The deadline to remove a deemed excess contribution and its earnings is the IRA owner’s tax return due date, plus an automatic six-month extension, which, for most individuals, is October 15.
Are there special considerations for IRA owners age 70½ or older?
Traditional IRA owners age 70½ and older may contribute to qualified charitable organizations from their IRAs up to $100,000 per year. These “qualified charitable distributions” (QCDs) can generally be excluded from income and, thereby, are tax-free. What’s more, QCDs count toward satisfying their annual required minimum distribution (RMD) obligation.
But if an IRA owner age 70½ or older makes a deductible Traditional IRA contribution (the SECURE Act removed the age 70½ limitation on Traditional IRA contributions, beginning in 2020), the amount she can exclude from income as a QCD is reduced. The IRA owner may not “double dip” in this scenario; she cannot both deduct her IRA contributions and exclude from income the entire QCD amount. Rather, the excludable QCD amount will have to be reduced by all Traditional IRA contributions for which she claimed a deduction since reaching age 70½.
NOTE: IRA owners should be encouraged to seek competent tax advice.
