The traditional individual retirement account (IRA) is designed to be a tax-deductible investment in your future. But there are limits. If neither you nor your spouse actively participate in an employer-sponsored plan, such as a 401(k)you can claim the full deduction up to the maximum contribution allowed for the year.
However, if you or your spouse actively participate in another plan, your eligibility to deduct your contribution is determined by your tax situation and the modified adjusted gross income (MAGI) that you declare in your income taxes.
This can be tricky because the rules vary for each type of employer-sponsored pension plan.
Active Status Determination
If you are considered an active member, your employer must indicate this on your Form W-2 by ticking the “retirement” box. Administrative errors happen, so this box is sometimes not checked when it should be. It’s helpful for you to understand the rules so you don’t have to rely on your employer’s record keeping.
Here are the rules regarding active member status for different types of employer-sponsored pension plans.
Defined benefit plan
If you are eligible to participate in a defined benefit plan for the tax year, you are considered an active member for that year. This is so even if you refuse to participate in the plan, fail to make required contributions to the plan or fail to perform the minimum service required to accrue a benefit under the plan for the year.
Defined contribution pension plan and target benefit plan
For defined contribution pension and target benefit plans, you are considered an active member for the year in which your contributions to these plans apply. This is true regardless of when your contribution is actually deposited into your account.
For example, suppose your employer sponsors a contract to purchase silver retirement plan and is required to contribute 10% of eligible earnings to the plan each year. Your employer has until the tax filing deadline, including any extensions, to file contributions for a given year. Thus, if a 2020 contribution was made in 2021, you are considered an active member for the 2020 tax year, the year to which the contribution applies.
Incentive Plans and SEP IRAs
These schemes are defined by the discretionary nature of contributions. Employees are considered active for the year in which the contributions are actually deposited into the employee’s accounts, even if the contributions apply to the previous year. The reason for this rule is that it is generally impossible for employers to guarantee contributions to these plans for a given year.
As a demonstration, suppose your employer sponsors a profit-sharing plan to which it contributes 10% of qualifying earnings for the 2019 tax year. But contributions are filed in 2020. Employees are considered active participants for 2020, the year in which the contributions are actually deposited in their accounts.
401(k) and 403(b) plans
If you are eligible to make salary deferral contributions but choose not to, you are not considered an active participant that year.
Voluntary or compulsory contributions
You are considered an active member for any year in which you make voluntary or compulsory contributions to a qualifying employer pension plan.
Acquisition status does not affect status
Depending on the terms of the plan, you may not be immediately vested in the year’s contributions that you receive from your employer. But your devolution the status does not change if you are an active participant. Even if you leave that employer at a later date and forfeit this unearned contribution, you are still considered an active member for the applicable year.
For example, Company ABC contributes 10% of its employees’ compensation to its defined contribution pension plan for the 2019 taxation year. Under the provisions of the ABC defined contribution pension plan, employee contributions are acquired at 100% after three years of work. No acquisition takes place before this date.
Let’s say Jane leaves ABC Company for a new venture after two years of employment. Since Jane leaves before she has accrued a vested balance, she must forfeit the contributions that have been made to her defined contribution pension account at ABC Company. However, Jane is still considered an active member for the 2019 tax year because a mandatory contribution was made to her defined contribution pension account.
Contribution age changes due to the SECURE law
In early January 2020, former President Trump signed the Every Community Establishment for Retirement Enhancement Act (SECURE). Prior to the Secure Act, you could not contribute to a traditional IRA for the year in which you turned 70½ or any subsequent year.
Now, for tax years beginning in 2020, you can contribute after you reach age 70.5, meaning there’s no longer an age limit for contributing to traditional IRAs. The law does not change the age limit on Roth IRA contributions because there is no such restriction.
If you and/or your spouse are active members for a given year, you may need to perform a calculation to determine if you are able to deduct your IRA contributions for that year. If you are unable to deduct the full amount, you may be able to deduct a portion, depending on your MAGI.
This formula is explained in IRS Publication 590. Ultimately, you may want to consult with your tax professional to help you determine if your IRA contribution is deductible.