Deductible vs. Non-Deductible IRA Contribution

A contribution to an IRA is a good thing. A deductible contribution to an IRA is even better. So how do you know if you’re eligible to make a deductible contribution? Today’s post briefly describes the two-fold path to deductibility.

As pointed out in February 4’s post, all you need to be allowed to contribute to an IRA is some earned income—generally compensation or self-employment income; sweat-of-the-brow type income as distinct from sitting-home-and-clipping-coupons type income. Actually, if either you or your spouse has earned income (and you file jointly), then you both can contribute. But being allowed to contribute is not the same as being allowed to deduct.

There are two paths to deductibility. You don’t need to travel down both those paths. Either one will suffice. Let’s call them the No-Plan Path and the Low-Income Path.

No-Plan Path
The first path to a tax deduction is available if neither you nor your spouse is covered by a tax-favored retirement plan at work for the year of your IRA contribution. There’s a simple way of knowing if you are covered by a plan: Your employer is supposed to check a box on your annual W-2 form if you’re covered. (It’s the box labeled “Retirement Plan” in Box 13 on the 2008 form.) Simple enough: Is the box checked? If it’s not checked by any of your or your spouse’s employers, then you get a deduction for your IRA contributions.

One other rule: If you are married filing jointly, and your spouse is covered by a plan but you are not, then you meet the No-Plan Path to deductibility (but your spouse does not) if as a couple you have modest adjusted gross income: Less than $159,000 in 2008 or $166,000 in 2009.

What determines whether or not your employer checks the box? Those rules can get complicated in specific circumstances, but generally they go like this: If your employer contributes anything during the year to a defined contribution plan (that’s a plan where you have an individual account, like a profit sharing plan or a 401(k) plan), then you’re covered. Your own elective deferrals to a 401(k) plan count as employer contributions for this test. Or if your employer is obligated to contribute for the year, but doesn’t get around to doing it until early the next year, you’re covered. In a defined benefit plan (you know, a traditional pension plan), if you are accruing a benefit by virtue of your work for the employer, then you’re considered covered.

Low-Income Path
Let’s say you or your spouse is covered by a plan. All is not lost! The Low-Income Path to a deduction might be open to you.

If your adjusted gross income (AGI) is not too large, then you can deduct your IRA contribution even if you’re covered by a plan. Whoopee! Break out the Champagne and Oreos! Here are the AGI limits for IRA deductibility for 2008 and 2009. They grow each year with cost-of-living increases. And there is a small range above these amounts (of $10,000 - $20,000) where the deductible limit is phased out.

Single:
2008: $53,000
2009: $55,000
Married filing jointly:
2008: $85,000
2009: $89,000
Married filing separately:
2008: $0
2009: $0

If you think all of this is way too complicated then it needs to be, that’s because it is.