Are IRAs tax deductible?

The Individual Retirement Account (IRA) was once a popular tax deductible way to save for retirement but lost much of its luster after Congress tightened eligibility requirements in the 1986 tax law. But since the 1997 tax law changes took effect IRAs are worth taking a second look at.

Both you and your spouse can take a tax deduction on your tax return for contributions to a regular IRA of up to $5,000($6,000 if age 50 or over) or 100% (whichever is less) of wage, salary, or self employment taxable earnings if neither of you have retirement plan coverage at work. Taxable alimony is included for the purposes of determining taxable earnings. You have until April 15, 2010 to make your 2009 IRA contributions. You must make your contributions by this deadline even if you get an extension to file your tax return. You can only make contributions for years prior to your attaining age 70½. On a joint tax return, provided you have taxable earnings of at least $10,000, you and your spouse can contribute $5,000 each to an IRA even if only one spouse works.

If either you or your spouse are an "active participant" in an employer retirement plan or self employed retirement plan for any part of the plan year you may not be able to make tax deductible IRA contributions. If you are an employee and you were covered by an employer retirement plan the "Retirement plan" box inside Box 13 of your Form W-2 will be checked.

An employer retirement plan is: 

A qualified pension, profit sharing, or stock bonus plan, including a qualified self employed Keogh plan, SIMPLE IRA, or simplified employee pension (SEP);

A qualified annuity plan;

A tax sheltered annuity; and

A plan established for employees by the United States, a state or political subdivision, or any agency or instrumentality of the United States or a state or political subdivision. Eligible state Section 457 plans are not included as employer retirement plans. 

If the taxpayer or spouse is covered by a retirement plan at work the tax deduction begins to phase out at: 

$55,000 if the taxpayer's filing status is single, head of household, or married filing separately and he lived apart from his spouse for all of 2009; 

$89,000 if the taxpayer's filing status is married filing jointly and both the taxpayer and spouse are active plan participants, or the taxpayer is a qualifying widow or widower; 

$89,000 if the taxpayer's filing status is married filing jointly and the taxpayer is active plan participant but the spouse is not. The spouse uses the $166,000 threshold; 

$166,000 if the taxpayer's filing status is married filing jointly and the taxpayer was not an active plan participant but the spouse was. The spouse uses the $89,000 threshold; and 

$0 if the taxpayer's filing status is married filing separately and he lived with the spouse at any time in 2009.

These limits will rise through 2010. 

Phase-outs

If the phase-out threshold is...

The tax deduction
phases out at...

No tax deduction
is allowed at...

$55,000

$55,001-$65,000

$65,000 +

$89,000

$89,001-$109,000

$109,000 +

$166,000

$166,001-$176,000

$176,000 +

$0

$0-$9,999

$10,000 +

 Roth IRAs

You can make non tax deductible IRA contributions but you are probably better off contributing to a Roth IRA instead. While both plans accumulate earnings tax free until withdrawal the Roth IRA after five (5) years offers completely tax free withdrawals of earnings if you are 59½ or older, disabled, or you withdraw no more than $10,000 for first time home buyer expenses.

Non tax deductible IRAs

These are basically non tax deductible retirement savings accounts for people who don't qualify for the tax deductible or Roth IRA. In these non tax deductible accounts, contributions are taxed but the earnings and interest grow tax deferred. When it comes time to withdraw the money, you pay tax on the earnings.

IRA Distributions

Any distribution that you take from tax deductible contributions or earnings that you do not rollover or redeposit within sixty (60) days is taxable and must be reported on your tax return. You are also subject to a 10% penalty tax unless: 

you are over age 59½; 

you are totally disabled; 

you meet the exceptions below and pay medical costs; 

you receive unemployment compensation for at least 12 consecutive weeks and pay medical insurance premiums with the distribution; 

you pay qualified higher education expenses with the distribution; 

the distribution is $10,000 or less and used for qualified first time home buyer expenses; 

you are a beneficiary receiving the distribution following the death of the owner; or 

you receive annual payments under an annuity schedule.

On or before April 1st of the tax year after the tax year in which you reach age 70½ you must begin taking taxable distributions. A penalty tax of 50% applies to amounts that you were required to take and didn't.

IRA Distributions - Medical expenses

There are penalty-free withdrawals from IRAs to pay for medical expenses that exceed 7.5% of adjusted gross income. You still have to pay regular income tax on this money, however. Also, there are penalty-free withdrawals for unemployed people to pay for health insurance.

IRA Distributions - Higher education expenses

The 10% penalty tax that applies to most withdrawals from IRAs before you reach age 59½  will not apply to withdrawals for your higher education expenses, or those of your spouse, children, or grandchildren. This change applies to distributions after 1997 for expenses paid for academic periods after 1997.

IRA Distributions - First time home buyers

The law also permits a tax penalty free qualified first-time homebuyer distribution, subject to a $10,000 lifetime limit. The tax penalty free distribution must be used to acquire a principal residence of the taxpayer, a spouse, child, grandchild, or ancestor.

IRAs are tricky, and there are tax penalties if you contribute too much, receive too much, or take out money too early.

 


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