Contrary to rumor, individual retirement accounts are still available and still offer both tax deductions and long-term tax incentives for saving.
The rules concerning IRAs were changed a few years ago to prevent some taxpayers from claiming a deduction for their contributions. However, every working taxpayer can still make a contribution, and more than 75% of these taxpayers can still claim at least a partial deduction.
The deduction limits generally apply only to individuals who are "active participants" in a qualified retirement plan or who have spouses who participate in such a plan. These include not only plans in which the employer provides the funding but also 401(k) plans in which employees make pretax contributions. Keogh plans, simplified employee pensions, government plans and 403(b) annuities are also considered qualified retirement plans for this purpose.
Who is an active participant? In a defined benefit plan, the employer usually promises the employee a certain annual retirement benefit in the future depending on years of service and wages earned during the working years. For this type of pension plan, an employee is considered an active participant if he or she is covered by the plan.
In a defined contribution plan, the employer usually makes a contribution to an account for each employee based on current salary and years of service; at some future point, the employee gets the amount accumulated in the account. For this type of plan, an employee is considered an active participant if the employer actually makes a contribution during the year or is legally bound to make a contribution for that year.
Employers are required to state on an employee's Form W-2 whether the individual is an active participant in the employer's qualified plan during that year.
Even with this limitation many active participants can still deduct all or part of their IRA contribution. An active participant's deduction is limited only when his or her adjusted gross income reaches $25,000 for the year ($40,000 for a married couple filing a joint return). The $2,000 deductibility limit (but not the contribution limit) is reduced proportionately as an individual's adjusted gross income increases from $25,000 to $35,000 (or $40,000 to $50,000 for a married couple on a joint return).
Thus, an unmarried active participant with $30,000 of adjusted gross income could make a $2,000 IRA contribution and still deduct $1,000. The full $2,000 would gather interest tax free as long as it is in the account. If this is the only IRA contribution the individual ever makes, and the IRA eventually grows to $10,000 before the withdrawal is made, a tenth of the withdrawal would be tax free (the $1,000 non-deductible contribution divided by the $10,000 in the IRA).
Generally, an IRA contribution cannot exceed the taxpayer's earned income. This includes self-employment income as well as wages. A married couple is allowed to make contributions of up to $2,250 of their combined earned income even if one spouse has little or no earned income for that year. The IRA contribution can be divided between them as they please, though neither can be treated as contributing more than $2,000 of the $2,250. Of course, each spouse could contribute up to $2,000 of his or her own earned income.
About the Author Adam Starchild has been writing on tax planning and wealth preservation for over 20 years.
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