Some of your clients may not yet have made their contributions to traditional or Roth IRAs for 2004, but plan to make them before filing their 2004 income tax returns. Others may be planning to contribute the maximum amount possible to their IRAs for 2005 as soon as possible.
Accordingly, this article reviews the rules for determining the maximum contributions that may be made to either type of IRA for 2004 and 2005.
* Deductible contributions to traditional IRAs. An individual who is not an active participant in an employer-sponsored qualified plan (including a Keogh plan) may make a deductible contribution of $3,000 to a traditional IRA for 2004 and a deductible contribution of $4,000 for 2005, regardless of what the individual's modified adjusted gross income is.
If the individual is 50 by the end of the tax year (2004 or 2005) for which the contribution is being made, she may make an additional catch-up contribution of $500. The allowable catch-up contribution increases to $1,000 for 2006 and later years.
Thus, an individual 50 or older may make a total deductible contribution of $3,500 in 2004 and $4,500 in 2005. Note, however, that the amount of the contribution may not exceed the individual's compensation income for the tax year.
Example 1: Your client, a single taxpayer, has compensation income of $150,000 and modified adjusted gross income of $200,000 in 2004, but is not an active participant in a qualified plan. He will be 49 in December of 2004. He may make a $3,000 deductible contribution to a traditional IRA for 2004.
For 2005, as long as his compensation income is at least $4,500, and he continues not to be an active participant in a qualified plan, he will be able to make a deductible contribution of $4,500 to a traditional IRA, since he will be 50 by the end of the 2005 tax year.
If an individual is an active participant in a qualified plan, limits are placed on the amount of a contribution to a traditional IRA that is deductible. For single individuals and heads of household, the part of the contribution that is deductible phases out ratably if MAGI is more than $45,000 and less than $55,000 in 2004. In 2005, it phases out ratably if MAGI is more than $50,000 and less than $60,000. However, the amount deductible will be at least $200 if the MAGI is less than the high end of the phase-out range.
Example 2: The same facts apply as in Example 1, except that your client is an active participant in a qualified plan. He will not be able to make any deductible contribution to a traditional IRA in 2004, since his MAGI of $200,000 far exceeds the high end of the phase-out range for deductible contributions by a single individual. Whether he can make a full or partially deductible contribution to a traditional IRA in 2005 will depend on his MAGI for 2005.
Example 3: Your client, a head of household, was 40 at the end of 2004, and was an active participant in a qualified plan. She had compensation income of $40,000 and MAGI of $48,000 in 2004. She can make a deductible contribution of $2,100 to a traditional IRA in 2004 (70 percent of $3,000, since she was 30 percent into the phase-out range of $45,000 to $55,000). If her MAGI is not more than $50,000 in 2005, she will be able to make a deductible contribution of $4,000 to a traditional IRA for that year, as long as her compensation income is at least $4,000.
Example 4: The same facts apply as in Example 3, except that your client's MAGI for 2004 is $54,900, or 99 percent of the way into the phase-out range. Your client can make a deductible contribution of $200 to a traditional IRA in 2004, since her MAGI is under the amount at which a deductible contribution would be completely phased out. This is so even though, under the usual ratable phase-out rules, she would be able to deduct only $30 (1 percent of $3,000).
If your client's modified adjusted gross income is the same in 2005, she will be only 49 percent into the phase-out range of $50,000 to $60,000 for that year, and thus will be able to make a deductible contribution of $2,040 to a traditional IRA for that year (51 percent of $4,000).
For married taxpayers filing joint returns, the phase-out range is between $65,000 and $75,000 in 2004 and between $70,000 and $80,000 in 2005. For married taxpayers filing separate returns, the phase-out range is between $0 and $10,000 in both 2004 and 2005.
If one spouse is an active participant and the other isn't, the non-active participant can make a fully deductible contribution if their MAGI on a joint return is not over $150,000. The amount deductible phases out between $150,000 and $160,000.
Example 5: Your clients are a married couple who file a joint return. The wife is 42 and the husband is 40. Their combined MAGI for 2004 is $140,000. The wife is an active participant in a qualified plan, but the husband is not. Each has compensation income of at least $50,000. The husband can make a deductible contribution of $3,000 to a traditional IRA for 2004, but the wife may not make any deductible contribution to a traditional IRA.
A full contribution can be made to a traditional IRA even if all or part of the contribution is not deductible. However, if only part of the contribution is nondeductible, the individual would be able to contribute the amount that is nondeductible to a Roth IRA, since the limits for making contributions to a Roth IRA exceed the amounts at which a contribution to a traditional IRA is completely nondeductible (see below). Depending on the total MAGI, it may be possible to contribute the full amount to a Roth IRA, even if none of the contribution could be deductible if made to a traditional IRA.
Observation: It's much more advantageous to make a nondeductible contribution to a Roth IRA than to make a nondeductible contribution to a traditional IRA. This is because the income earned on contributions to a Roth IRA will not be taxed when distributed to the Roth IRA owner if certain requirements are met (see below). On the other hand, income earned on nondeductible contributions to traditional IRAs will be included in gross income in the year that it is distributed to the IRA owner.
Example 6: The same facts apply as in Example 3. For 2004, your client may make a contribution to a Roth IRA of the $900 that would not be deductible if contributed to a traditional IRA, since her MAGI is below the $95,000 at which the right to make a contribution to a Roth IRA starts to phase out for single taxpayers and heads of household (see below).
Example 7: The same facts apply as in Example 4. Your client may make a contribution to a Roth IRA of the $2,800 that would not be deductible if contributed to a traditional IRA.
Example 8: The same facts apply as in Example 5. Even though no part of a contribution to a traditional IRA would be deductible by the wife, since the MAGI on your clients' joint return is above the $75,000 high end of the phase-out range for active participants for 2004, the wife would be able to make a contribution of $3,000 to a Roth IRA, since your clients' combined MAGI is below the $150,000 amount at which the right to make contributions to a Roth IRA starts to phase out for married couples filing a joint return (see below).
* Contributions to a Roth IRA. Unlike contributions to a traditional IRA, no part of a contribution to a Roth IRA is deductible. The benefit of a Roth IRA is that income earned by the Roth IRA is not taxable to the owner (or the owner's beneficiary) when withdrawn if certain requirements are met (e.g., the withdrawal was not made until the fifth tax year after the Roth IRA was opened, and the owner was at least 59-1/2 when the withdrawal was made).
The maximum amount that can be contributed to a Roth IRA is the same as the maximum amount that can be contributed to a traditional IRA, i.e., $3,000 in 2004, $4,000 in 2005, plus an additional $500 in 2004 and/or 2005 for taxpayers who are at least 50 by the end of the tax year. However, if an individual makes a contribution to a traditional IRA, the amount that can be contributed to a Roth for any tax year is reduced by the amount contributed.
Example 9: Your client, who is over 50, is eligible to make a contribution of $3,500 to either a traditional IRA or a Roth IRA for 2004. If she contributes $2,000 to a traditional IRA, she may contribute only $1,500 to a Roth IRA.
However, the right to make contributions to a Roth IRA phases out if MAGI exceeds certain specified limits, regardless of whether the individual is an active participant in a qualified plan.
For single taxpayers and heads of household, the contributable amount phases out ratably between $95,000 and $110,000. For married couples filing joint returns, it phases out ratably between $150,000 and $160,000, and for a married individual filing a separate return, it phases out ratably between $0 and $10,000. These phase-out ranges apply for both 2004 and 2005.
A contribution of $200 may be made even if the phase-out would otherwise lower the contributable amount to less than $200 but more than $0.
Example 10: The same facts apply as in Example 8. Both the husband and wife would be able to make $3,000 contributions to a Roth IRA for 2004. Since the husband is also eligible to make a $3,000 deductible contribution to a traditional IRA, he must decide whether he should contribute the full amount to a traditional IRA or to a Roth IRA, or whether to split the contributable amount between the two types of IRAs.
Example 11: The same facts apply as in Example 10, except that your clients' MAGI is $155,000. The wife may make a contribution of $1,500 to a Roth IRA for 2004, since their MAGI is 50 percent into the phase-out range for making Roth IRA contributions by a married couple filing joint returns. The husband could make a $1,500 deductible contribution to a traditional IRA or a $1,500 contribution to a Roth IRA, or he could allocate the $1,500 between the two.
