Can You Deduct Your IRA Contribution?

You may be participating in a 401(k) or other type of employer-sponsored retirement plan. In addition to this, you may also be putting money away in a Traditional IRA. Although contributing to two retirement savings vehicles at once is commendable, you may actually be costing yourself at least part of the tax deduction you would normally receive by doing so.

When qualified plans were first created, active participants in these plans were prohibited from opening Traditional IRAs. But the Economic Tax Recovery Act of 1981 eased this restriction and allowed virtually all workers not only to participate in IRAs, but also to claim a full deduction for their contributions. Then the Tax Reform Act of 1986 further modified Traditional IRA participation by placing certain restrictions on the amount of contributions that active participants could deduct from their income. This act defines an active participant as any employee who participates in any kind of qualified, government, 403(b), SEP, or SIMPLE plan, even if only for one day out of the calendar year. The contribution restrictions involve a graduated phase-out of deductibility for active participants who also contribute to Traditional IRAs. The following chart breaks down the deductibility of these phase-out thresholds:

2007 Contribution and Deduction Limits for Active Participants in Qualified Plans

As the chart indicates, a qualified plan participant can make a full contribution to a Roth IRA at much higher income levels than with Traditional IRAs. (Chalk up another victory for the Roth IRA over the Traditional IRA.) Of course, as an active participant, you could still make a nondeductible contribution to a Traditional IRA, but there would obviously be absolutely no advantage to doing so instead of contributing to a Roth IRA. Therefore, for participants seeking the maximum available tax deduction, the prudent choice will be to maximize their retirement plan contributions and also contribute to their Traditional IRAs to the extent that they are deductible. Then they could contribute the remainder to a Roth IRA if they are eligible.

If your MAGI falls within the phaseout range, then you are allowed a prorated percentage of the full deductible amount. The amount eligible for deduction can be computed as follows:

1. Subtract the phaseout floor amount (the first number in each range in the table above) from your MAGI.
2. Multiply this amount by 40% if you are under age 50 and 50% if you are 50 or older and single in both cases. If you are MFJ or a Qualifying Widower with dependent child and participate in a qualified plan of any kind, then you will multiply the number in step 1 by 20%, or 25% if you are age 50 or above.
3. Subtract step 2 from $4,000, or $5,000 if you are age 50 or above.
4. Round this number up to the next highest multiple of $10. This number has a $200 floor, so if your initial amount is $75, then your deductible amount will be $200.

Example:Frank Briscoe is single and less than 50 years old at the end of 2007. He contributes to his employer’s 401(k) plan and drew a salary of $55,000 for the year. His MAGI for 2007 is $57,242, which exceeds the phaseout floor by $5,242. 40% of $5,242 is $2,096.80. This number is subtracted from $4,000 to get $1,903.20. Frank will round this number up to $1,910 and deduct this amount for his IRA contribution on his return.This article is intended for general educational purposes only and should not be construed as advice. For more information, visit the IRS website at www.irs.gov or consult your tax advisor.