Informed Investor: Now is a good time to make deductible traditional IRA contributions

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All federal employees born after June 30, 1943, are eligible to make contributions to a traditional IRA for the year 2013. Traditional IRA contributions are either deductible or nondeductible, depending on the employee’s 2013 modified adjusted gross income (MAGI). This column discusses which employees are eligible to contribute to a deductible traditional IRA for 2013.

It is important to first review some basic rules regarding traditional IRA contributions.

When contributions can be made. Contributions can be made to a traditional IRA for any year in which the IRA account owner receives compensation. Compensation includes “earned income” – salary/wages and self-employment income. The “proof” of earned income in the form of salary/wages is an employer-issued W2. Since every federal employee who worked during 2013 will be receiving a W2 this month from their agency, every employee younger than age 70.5 during 2013 is eligible to contribute to a traditional IRA for 2013. For married employees, only one spouse has to have compensation to allow each spouse to contribute to their individual traditional IRAs.

Deadline for making contributions. Contributions can be made to a traditional IRA for a particular year at any time during that calendar year or by the due date (not including extensions) for filing the tax return for that year. This means that IRA contributions for the year 2013 must be made no later than April 15, 2014.

Amount of IRA contributions. For 2013, the maximum contribution (not counting rollovers) to a traditional IRA is the smaller of: (1) $5,500 ($6,500 if born before Jan. 1, 1964) or (2) the IRA owner’s compensation during calendar year 2013. Compensation includes wages/salaries, lump-sum payment for unused annual leave, commissions and self-employment income.

Amount of contributions to a traditional IRA that are deductible. If an individual or, if married,  his or her spouse is participating in an employer retirement plan—all employees who participate in employer-sponsored retirement plans have their W2 marked as such—the amount of the traditional IRA contribution that is deductible may be limited. The deductible amount begins to decrease (“phase out”) when an individual’s MAGI rises above a certain amount and is eliminated altogether when it reaches a higher amount. MAGI is defined as an individual’s AGI plus student loan interest and tuition and fees deductions, U.S. Savings Bonds interest exclusion, and any foreign earned income exclusion. The following table summarizes by tax filing status and MAGI how much of an individual’s traditional IRA contribution is deductible for 2013:

Employees whose MAGI is within the phase-out (partial deduction) range should use an IRS worksheet (“Figuring Your Reduced IRA Deduction for 2013”) for determining how much of their traditional IRA contribution is deductible. This worksheet may be found in IRS Publication 590 (Individual Retirement Arrangements) which can be downloaded from www.irs.gov. In preparing their 2013 income tax returns, employees who contributed to traditional IRAs for 2013 should note that some, or all, of their contributions may not be deductible on Form 1040, line 32 as an “adjustment to income.” Nondeductible contributions must be reported on IRS Form 8606.

Note the following: (1) Full-time and part-time federal employees are considered participants in a pension plan; (2) for employees filing as married filing separately, the phase-out is the same regardless of whether the employee or spouse is covered by an employer retirement plan; and (3) an employee’s spouse who is receiving retirement benefits from a previous employer’s plan does not classify the spouse as a retirement plan participant. The following example illustrates the partial deduction of traditional IRA contributions:

Wilson, a federal employee, and his wife Carol who was unemployed during 2013, both age 35, will file joint tax returns for 2013. Their combined MAGI for 2013 is $97,555. Wilson earned $62,000 during 2013. Both Wilson and Carol contribute $5,500 to their traditional IRAs for 2013. Since their MAGI is between $95,000 and $115,000 and Wilson is covered by a retirement plan, Wilson’s and Carol’s contributions are partially deductible, calculated as follows:

(1) End of Wilson’s and Carol’s phase-out threshold ………….……………… $115,000
(2) Less: Wilson’s and Carol’s MAGI ………………………………………………...…(97,555)
(3) Unused threshold…………………………………………………….…………………..…17,445
(4) Multiplied (3) by 27.5 percent ($5,500 maximum deduction
     divided by $20,000 phase-out range) rounded to the next
     multiple of 10)………..………………………………………..………………………………4,800
(5) Wilson’s 2013 compensation…………………………….…....……………………... 62,000
(6) Limit of Wilson’s and Carol’s 2013 traditional IRA
     contribution deductions (lesser of line 4 or 5)....……….……………………….$4,800

Wilson and Carol can deduct $4,800 of their $5,500 contributions. The amount that they cannot deduct—$700—is a nondeductible traditional IRA contribution and must be reported on IRS Form 8606.