While anyone with earned income can participate in a Traditional IRA, the ability to deduct those contributions from your taxable income are dependent on many factors. I was recently discussing retirement plans with a friend and they explained how they were not going to participate in their employer’s 401(k) because they didn’t like the selection of funds. Instead, they planned on contributing money into an IRA instead. Sounds reasonable right?
At first glance nothing seems wrong with this picture, but unfortunately for this person that could be an unwise decision. While generally speaking if you do not participate in a retirement plan through your employer you can take advantage of the deductible IRA contributions. What this person did not realize is that since their employer offers a defined benefit plan (pension) that qualifies as being covered under the IRS rules. Publication 590 states:
If you are eligible to participate in your employer’s defined benefit plan for the plan year that ends within your tax year, you are covered by the plan.
This applies even if:
- You declined to participate in the plan
- Did not make any contributions
- Did not perform the minimum amount of service to receive a benefit
So, while you may elect not to take part in your employer’s 401(k) or other defined contribution plan this doesn’t not automatically mean you qualify to take full deductions of your IRA contributions. If your employer offers any sort of pension, profit sharing, stock bonus or money purchase plans even if you opt-out you are considered a participant.
What happens if this affects you? You may still have the potential to deduct all or a portion of your IRA contributions, but you must meet some guidelines. For 2007 these guidelines are:
- Your Adjusted Gross Income is no more than $50,000
- You are under age 70 1/2
- You may make a tax-deductible contribution to an IRA of up to $4,000 ($5,000 if age 50 or older)
- Partial deductible contributions may be made for those earning between $50,000 and $59,999 AGI.
Married Filing Jointly
- Your combined Adjusted Gross Income is no more than $80,000
- You are under age 70 1/2
- You may make full deductible IRA contributions
- Partial deductible contributions can be made for those earning between $80,000 and $99,999 AGI
There are also other factors that can limit the amount of deductible IRA contributions in situations where a married couple has only one in the household is covered by a retirement plan. Details on those situations can again be found in IRS Publication 590.
The main thing I wanted to bring to attention is that simply assuming you can make deductible IRA contributions because you don’t participate in your company’s 401(k) is not entirely accurate. Before deciding to go with an IRA over your employer’s plan be sure you understand what if any defined benefit plans you are eligible for and then take into account your AGI as stated above. It doesn’t take a whole lot of income to cross the threshold of non-deductible contributions. Worst-case is if you choose not to participate in your employer’s plan and make too much money you are faced with no pre-tax retirement savings.
So in my friend’s case, their AGI was over $50,000 and since his employer offered a pension plan, by not participating in the company 401(k) plan he has no pre-tax contributions available. The options are to either enroll in the 401(k) or make after-tax contributions, preferably in a Roth IRA.
As always, this is simplified overview. Be sure to check with your tax advisor or accountant in regards to your specific situation to determine what the best course of action is for you. More detailed information can be found in IRS Publication 590.
Author: Jeremy Vohwinkle
My name is Jeremy Vohwinkle, and I’ve spent a number of years working in the finance industry providing financial advice to regular investors and those participating in employer-sponsored retirement plans.