YOUR TAXES: A SPECIAL REPORT : BEWILDERED BY IRAs : Retirement Plan Coverage, Income Level Key to Determining Deductibility
Judging from the tax returns trickling into Internal Revenue Service offices and the questions pouring into tax advisers, one of the main sources of confusion over the new tax law is the restriction on deductions for individual retirement accounts.
Thousands of people are mistakenly claiming deductions for contributions to these still-popular retirement accounts, IRS officials say. And millions more understand that tax reform eliminated their deduction but are unclear about the wisdom of making contributions anyway, say money managers who are fielding an onslaught of taxpayer calls.
Little wonder. Not even the nation’s tax experts can agree whether taxpayers who have lost their IRA tax deductions should continue making annual contributions. And the General Accounting Office has found that IRS agents are sometimes contributing to the confusion by providing erroneous information on the new IRA rules.
But don’t despair. The eligibility rules are actually quite straightforward once you have determined if you are covered by a retirement plan at work. And the answer to that question is supplied by your employer--in Box 5 on the W-2 wage form that you should already have received.
If you think your company does offer a pension plan but the box isn’t checked, contact your employer’s personnel or employee benefits department. Tax advisers caution that, because this is a new form, some employers may mistakenly omit checking the box, and it is the employee’s responsibility to submit the correct information to the IRS.
Whether to make non-deductible contributions is a tougher call. To help you decide, tax advisers suggest that you ask yourself these questions:
- Can you substitute contributions to your employer’s 401(k) retirement plan, which many financial planners have long favored over the IRA anyway?
- Can you abide by the rigorous record-keeping demands required of taxpayers making non-deductible contributions?
- If you get out of the habit of contributing to an IRA, will you discipline yourself to switch to another tax-deferred or tax-free investment or will you just stop saving for your retirement altogether?
Until this tax-filing season, taxpayers haven’t had to worry about which IRA contributions were deductible and which weren’t. Anyone who worked for a living could contribute up to $2,000 of his income for the year to an IRA, take a tax deduction for the full amount and also defer until retirement all taxes on the interest those contributions earned.
Tax reform changed that. Many middle- and upper-income taxpayers covered by a retirement plan at work can still contribute to an IRA and defer the tax on the interest that accumulates. But they are no longer eligible to take a tax deduction for their annual contribution.
Here’s how you determine whether you’re still eligible. If you aren’t covered by a plan at work, you’re still eligible for a deduction--regardless of your income. The only exception is if you file a joint return with your spouse and he or she is covered by a retirement plan at work. In that case, the two of you are treated as a unit and, if you exceed certain income levels, neither of you can claim an IRA deduction.
Under current law, you could get around that restriction by filing separate returns. But keep in mind that filing separate returns often results in higher taxes for couples, and that Congress is considering legislation to close this loophole.
If you fail the first test, you move on to the second: income level. Couples with adjusted gross incomes below $40,000 and single people with adjusted gross incomes below $25,000 can claim a full IRA deduction even if they are covered by a retirement plan at work.
At the other extreme, couples with adjusted gross incomes of $50,000 or more--and single individuals with $35,000 or more--lose the right to a deduction if they are covered by a plan at work.
For those with incomes between those two extremes, there are still partial deductions. To figure the allowance, which decreases as the taxpayer’s salary rises, the IRS provides a work sheet.
At first blush, the work sheet appears long and complicated. But part of it is devoted to calculating IRA deductions and allowed non-deductible contributions for non-working spouses.
To determine your partial deduction, you simply subtract your adjusted gross income from the $50,000 ceiling and multiply the difference by 20%. Hence, someone with an adjusted gross income of $45,000 may still contribute up to $2,000 but is entitled to a tax deduction of only $1,000.
Once you determine the size of your allowable deduction, enter that number on line 24a of your 1040 Form. (On Form 1040A, the line is 11a.) Taxpayers filing joint returns also enter their spouse’s IRA deduction on Line 24b. And for sole proprietors, farmers and partners claiming deductions to a Simplified Employee Pension Plan (SEP) instead of to an IRA, the deduction should be entered on Line 26.
For the vast majority of taxpayers, that’s all there is to it. The Investment Company Institute--a mutual fund trade group--estimates that fully 78 million of America’s 87 million households, or almost 90% of Americans, are still eligible for a full or partial IRA deduction.
If you aren’t one of the lucky ones, you’ll have to decide first whether to contribute anyway--hence, taking advantage of tax-free growth on your interest earnings. Remember the three questions posed earlier.
Tax advisers say that if you were able to make up for the lost IRA deduction by contributing to your employer’s 401(k) last year, the record-keeping hassles of a non-deductible IRA may be more trouble than they’re worth. Even with tax reform’s changes, employees still can save up to $7,000 a year in a 401(k) plan and deduct the full amount as well as the interest that money earns. An added benefit is that many employers match those contributions.
The new IRA record-keeping requirements shouldn’t be taken lightly. First, you have to file a new one-page form--Form 8606--every year that you make a non-deductible contribution. Then, you must keep careful track of which of your contributions are deductible and which aren’t because they all get thrown into the same pot when it comes time to withdraw them for retirement and you don’t want to pay double tax. (One way to simplify record keeping would be to open a separate IRA for non-deductible contributions.)
For record-keeping purposes, you should keep copies of all applicable 1040s and W-2 wage and salary forms, every Form 8606 that you file and every Form 5498 that you receive from your IRA trustees--and keep them not just for a few years but until all of your IRA funds have been withdrawn.
Making a mistake could be costly. The IRS can assess a $100 penalty each time you overstate the amount of your non-deductible contributions.
The last question to ask yourself concerns discipline. If you won’t go to the trouble to investigate other tax-advantaged investments but you already are in the habit of contributing regularly to an IRA, then you should keep contributing.
Before making your decision, you also might consider the withdrawal penalties. Some tax-free or tax-deferred investments don’t have withdrawal restrictions, but IRAs do. In fact, there are more withdrawal rules now than ever.
Generally, any amounts that you withdraw before you turn age 59 1/2 will be subject to a 10% penalty. The tax reformers did relax that rule slightly. To accommodate people who retire before age 59 1/2, lawmakers decided that a taxpayer can make an IRA withdrawal at any age without penalty if the distributions are structured as a series of equal payments over the taxpayer’s expected lifetime. The IRS has actuarial charts to help guide someone trying to set up such a withdrawal plan.
Again, there is a premium on good record keeping. Only contributions for which you have claimed a tax deduction can be penalized. Non-deductible contributions cannot--regardless of when you withdraw them. (Earnings on non-deductible contributions are, however, subject to early withdrawal penalties.)
There also is a new 15% penalty on excessively large withdrawals. Generally, you needn’t worry about this rule unless you withdraw more than $112,500 from an IRA in a single year.
If, after weighing all these factors, you decide to make a non-deductible IRA contribution, complete the same work sheet discussed earlier and enter the appropriate line onto the new Form 8606. If you and your spouse both claim non-deductible contributions, each must complete a Form 8606 and attach it to your Form 1040.
The form isn’t difficult. You simply provide the name of the institution handling your non-deductible IRA and the amount of your contribution. If you made no IRA withdrawals during 1987, you do nothing more. You don’t even have to carry this information over to your Form 1040.
If you are self-employed and choose to contribute to a Keogh or SEP plan rather than an IRA, you have nothing new to learn. Tax reform didn’t tamper with the deduction for either of these IRA-like plans.
