Untangling the IRA rules.

• Author: Boes, Richard F.
• Position: Individual retirement accounts

The Code's individual retirement account (IRA) provisions were enacted by the Employee Retirement Income Security Act of 1974 (ERISA) to encourage individuals to save for retirement. According to a study by the National Institute on Aging,(1) however, many eligible taxpayers are not using IRAs and will have no retirement income other than social security. These individuals should be made aware of the tax benefits of IRAs and encouraged to fund such accounts, if possible.

IRAs were first permitted in 1975. Initially, they were available only to individuals who were not active participants in employer-provided retirement plans. The Economic Recovery Tax Act of 1981 (ERTA) removed the restriction on active participants, making such accounts available to all individuals. This change was made to increase the level of personal retirement savings and allow uniform discretionary retirement savings arrangements. By 1986, however, Congress decided that the expanded IRA provisions were not meeting their intended purposes, since the level of personal savings had not increased appreciably since 1981. Additionally, IRA investment was lowest among taxpayers with adjusted gross income (AGI) under $30,000 and highest among those with AGI in excess of $50,000. Consequently, the Senate Report to the Tax Reform Act of 1986 (TRA) recommended reinstating the pre-ERTA rules limiting IRA deductions to individuals not covered by employer-provided retirement plans.(2) This recommendation, as well as Congress's desire to maintain a tax incentive for discretionary retirement savings by providing for nondeductible IRA contributions, were included in the TRA.

This article will review the basic rules of IRA contributions and distributions and discuss tax planning opportunities.

Contributions

Current law governing the deductibility of IRA contributions was established by the TRA. The TRA's broad revisions to the deductibility of IRA contributions have generally made saving for retirement more complicated, thereby making contributing to IRAs less attractive for many taxpayers. Flowchart I on pages 502-503 illustrates the general rules governing annual IRA contributions. The discussion that follows is based on this flowchart.

Except for rollovers, IRA contributions must be (1) in the form of cash and (2) made only by taxpayers under age 701/2 before the close of the tax year.(3) Contributions made after age 701/2 are excess contributions subject to a penalty (to be discussed later).

* Contributions for nonactive participants

Individuals who are not "active participants" (as defined in Sec. 219(g)(5)) in an employer-maintained retirement plan can make deductible IRA contributions. Individuals covered by any of the following during any part of a plan year ending with or within the individual's tax year are "active participants": (1) a qualified pension, profit-sharing or stock bonus plan described in Sec. 401(a); (2) a qualified annuity plan described in Sec. 403(a); (3) an annuity contract under Sec. 403(b); (4) a simplified employee pension plan under Sec. 408(k); (5) a Federal or state government employee retirement plan; or (6) a trust under Sec. 501(c)(18).(4) Deductible contributions are generally limited to the lesser of $2,000 or 100% of taxable compensation for the year.(5) "Taxable compensation" includes disability pay, unemployment compensation, accrued annual leave, sick leave, alimony, incentive awards, termination pay, wages, salaries, bonuses, tips and commissions. For a partner or sole proprietor, compensation is generally the partner's distributive share of partnership income or the proprietor's net business earnings if the partner or proprietor renders material income-producing personal services to the business. Compensation does not include income from pensions, annuities and other forms of deferred compensation.(6)

Married individuals qualify for the full deduction only if both spouses are not active participants in an employer-maintained retirement plan. Each spouse may then claim the maximum $2,000 IRA contribution deduction ($4,000 total) if they otherwise qualify under the rules described above. Additionally, a married taxpayer filing a joint return with a noncompensated spouse may, under certain conditions, deduct contributions to an IRA established for the spouse's benefit ("spousal IRA"). If neither spouse is an active participant in an employer-sponsored retirement plan during the year, the contributions to a spousal IRA are deductible to the extent of the lesser of $2,250 or the contributing spouse's compensation. The spouses may divide the contribution between them as they choose, as long as neither spouse's contribution exceeds $2,000.(7) A spouse can also elect to be treated as having no compensation if the spouse earns a small amount of income (presumably, less than $2501 during the year.(8)

* Contributions for active participants

Active participants in certain employer-sponsored retirement plans are not allowed IRA deductions if they have AGI of at least $35,000 (single) or $50,000 (married filing jointly).(9) AGI for this purpose is figured under Sec. 219(g)(3)(A) before IRA deductions and without regard to the allowable exclusions under Sec. 135 (higher education expenses financed with qualified U.S. savings bonds) and Sec. 911 (foreign earned income), but after application of Sec. 86 (taxability of social security) and Sec. 469 (passive losses). Deductions for single taxpayers with AGI between $25,000 and $35,000 and married taxpayers filing jointly with AGI between $40,000 and $50,000 are ratably phased out, by reducing the potential $2,000 deduction by an amount that bears the same ratio to $2,000 as the individual's AGI in excess of the applicable dollar amount ($25,000 or $40,000) bears to $10,000. If the reduction amount is not a multiple of $10, it is rounded to the next highest multiple of $10. If the computation yields a deduction that is less than $200, $200 may be claimed.(10)

Example 1: T, a taxpayer, is an active participant in an employer-sponsored retirement plan. He has AGI of $33,500 before the IRA deduction. The portion of the IRA deduction disallowed is $1,700 [$2,000 x ($8,500 / $10,000)]. Thus, Tis allowed a maximum $300 IRA deduction ($2,000 - $1,700).

Note: The phaseout amounts are not indexed for inflation. Consequently, active participants in employer-sponsored plans may experience a complete loss of IRA deductions over time.

* Nondeductible contributions

Nondeductible IRA contributions are allowed to the extent that deductible contributions are disallowed. Annual contributions to any IRA cannot exceed the lesser of $2,000 ($2,250 with a spousal IRA) or 100% of taxable compensation. Income earned on nondeductible contributions is not taxed until distributed to the owner. An election to treat normally deductible contributions as nondeductible should be made if a taxpayer has no taxable income after other deductions. This would prevent the contribution from being considered taxable income when distributed in the future. Taxpayers who make nondeductible contributions must file Form 8606, Nondeductible...