With the advent of the Roth IRA and the continued legislative manipulation of the regular IRA qualifications, it seems that many people are still unsure about the regular IRA rules and deduction limitations. For many of you, the recent deductibility change is massive and will allow you a deductible IRA in future years that may not have been allowed in the past. So, let's take a few minutes to understand the changes to the deductible IRA limitations.

The rules limiting deductible contributions to Individual Retirement Accounts (IRAs) were recently eased by the Taxpayer Relief Act of 1997 ('97 Tax Act). The new limits apply to taxpayers who are active participants in employer-sponsored retirement plans.

In general, you can make up to $2,000 a year in deductible IRA contributions, as long as you have compensation (earned income) of at least $2,000. For married couples filing jointly, up to $4,000 can be contributed, as long as their combined compensation (earned income) is at least $4,000. But, if you were an active participant in an employer-sponsored retirement plan — such as a 401(k) — the rules got a bit sticky.

Old Rules

The deduction limitations applied to you if you were an active participant in an employer-sponsored retirement or deferred-compensation plan. Under pre-'97 Tax Act law, if you participated in such a plan, the amount that you could deduct for an IRA contribution was limited (or completely eliminated) depending on your adjusted gross income (AGI).

For single taxpayers, no deduction was allowed if AGI was $35,000 or more. If AGI was between $25,000 and $35,000, the $2,000 maximum deduction was reduced (also known as "phased-out" in tax lingo) on a pro-rata basis. When AGI exceeded $35,000, the deduction was lost completely.

For married taxpayers filing jointly, the same approach was taken, but the figures were a bit different: no deduction was available if combined AGI was $50,000 or more, and the deduction was phased out for combined AGI between $40,000 and $50,000. Additionally, and more importantly, even if only one spouse participated in an employer-sponsored retirement or deferred-compensation plan, the limitation applied to both spouses.

To the extent that the deduction limitation applied, the $2,000 maximum IRA contribution could still be made — it just was not fully deductible (or deductible at all, depending on AGI) for tax purposes. In effect, one spouse's participation in an employer-sponsored pension, profit-sharing, or deferred-compensation plan would taint the other spouse's ability to deduct an IRA contribution he or she would otherwise have been entitled to deduct.

New Rules

Beginning in 1998, the '97 Tax Act eased these rules in two respects. First, for married couples filing jointly, if only one spouse participates in an employer-sponsored retirement plan, the limitation applies only to that spouse. However, the maximum deductible IRA contribution for an individual who is not an active participant, but whose spouse is, is phased out for taxpayers with AGI between $150,000 and $160,000.

Second, the amounts triggering the limitations were increased for both single taxpayers and married couples filing jointly. For single taxpayers, the limitation range is increased to:

$32,000-$42,000  for  2000
$33,000-$43,000  for  2001
$34,000-$44,000  for  2002
$40,000-$50,000  for  2003
$45,000-$55,000  for  2004
$50,000-$60,000  for  2005 and later years

(NOTE: the maximum IRA deduction is reduced if AGI exceeds the first number for each year, and is zero if it reaches or exceeds the higher number.)

For married couples filing jointly for 2000, the maximum IRA deduction starts to be reduced at an AGI of $52,000, but only reaches zero for AGI of $62,000 or more. That is, for married couples the "phase-out range" is lengthened to $10,000 so, as AGI increases above $52,000 (to $62,000), the maximum allowable IRA deduction is reduced more slowly. After 2000, the ranges for married couples filing jointly are:

$53,000-$63,000  for  2001
$54,000-$64,000  for  2002
$60,000-$70,000  for  2003
$65,000-$75,000  for  2004
$70,000-$80,000  for  2005
$75,000-$85,000  for  2006
$80,000-$100,000 for  2007 and later years

As you can see, the ranges for married-joint filers climb higher, faster, and for a longer time period when compared to the single ranges. But you should also note that for married couples filing separately, the phase-out range remains at zero to $10,000, as under pre-'97 Act law.

An Example

Jack and Jill file jointly in 2000. Jack has earned income of $25,000 and Jill has earned income of $50,000, giving them a combined joint AGI of $75,000. Jack is an active participant in his employer's 401(k) plan, but Jill is not.

Under the old rules, neither Jack nor Jill could make a deductible IRA contribution. But, under the new rules, only Jack's IRA deduction is limited. Jill can deduct up to $2,000 in IRA contributions.

Why is Jack's deduction limited? Because Jack is a participant in his employer's retirement plan, and their joint AGI is greater than $62,000. But Jill, who does not participate in her employer's retirement plan, can make a deductible $2,000 IRA contribution because their joint AGI is less than $150,000. Jill's ability to deduct her IRA contribution is no longer "tainted" by Jack's participation in his employer's retirement plan.

In this example, if their joint AGI were $57,000 instead of $75,000, Jack would be able to deduct up to $1,000 in IRA contributions. Since their AGI is only halfway between the $52,000-$62,000 range, the deduction limitation would only be reduced 50%: from $2,000 to $1,000. Jill would still be able to deduct her entire $2,000 contribution, since their joint AGI would still be less than the $150,000 limitation.

An Alternative

So, what should Jack do? With an AGI of $75,000 and retirement plan coverage by his employer, his IRA is clearly not deductible under the new rules. Does that mean Jack can't make any type of IRA contribution? Certainly not. Jack is still able to make an IRA contribution, but the contribution would be non-deductible. Jack doesn't lose the opportunity to make an IRA contribution, just the ability to deduct that contribution on his taxes.

But, does Jack really want to make a non-deductible regular IRA contribution? Likely not. Instead, Jack should consider making a $2,000 Roth IRA contribution. Since Jack isn't going to receive any current tax deduction for his $2,000 contribution, why make a traditional IRA contribution and pay taxes on any future earnings when distributions are taken from the traditional IRA? Instead, since there is no tax deduction anyway, and since Jack and Jill's combined AGI is below the Roth IRA limitations, a Roth IRA contribution would allow for tax-free earnings on a $2,000 Roth IRA contribution. It's one of the few no-brainers in tax issues: When faced with a non-deductible traditional IRA or a Roth IRA, the Roth IRA will always provide the more tax-favored future benefits.

But, the moral of the story is to understand that, even if your IRA contribution is not deductible, it doesn't mean that a traditional IRA or Roth IRA contribution can't be made.

The other moral is to remember that the deductible IRA limits have been raised substantially, and will continue to rise in the future for folks who participate in employer-sponsored retirement plans. These limits are especially beneficial for married folks where one spouse participates in an employer plan, and the other does not.

So, make sure that you're familiar with the rules. Don't leave a possible deductible IRA contribution on the table just because you're not familiar with the new limitation rules and AGI ranges.

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