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 is an active participant in an employer-sponsored plan, such as a 401(k), you can claim the full deduction up to the maximum allowable contribution for the year.
If, however, either you or your spouse are active participants in another plan, your eligibility to deduct your contribution is determined by your tax-filing status and the modified adjusted gross income (MAGI) you report in your income taxes.
This can be tricky as the rules vary for each type of employer-sponsored retirement plan.
Determining Active Status
If you are considered an active participant, your employer should indicate this on your Form W-2 by checking the "retirement" box. Administrative errors happen, so this box is sometimes not checked even 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-participant status for different types of employer retirement plans.
If you are eligible to participate in a defined-benefit plan for the tax year, you are considered an active participant for that year. This is so even if you decline to participate in the plan, fail to make mandatory contributions to the plan, or fail to perform the minimum service required to accrue a benefit under the plan for the year.
Money-Purchase Pension and Target-Benefit Plan
For money-purchase pension and target-benefit plans, you are considered an active participant for the year during which your contributions to these plans apply. This is true regardless of when your contribution is actually deposited into your account.
For example, say your employer sponsors a money-purchase pension plan and is required to contribute 10% of eligible compensation to the plan each year. Your employer has until its tax-filing deadline, including extensions, to deposit a particular year's contributions. So, if a 2020 contribution was made in 2021, you are considered an active participant for the 2020 tax year, the year to which the contribution applies.
Profit-Sharing Plans and SEP IRAs
These plans are defined by the discretionary nature of the contributions. Employees are considered active for the year in which the contributions are actually deposited to the employees' accounts, even if the contributions apply to the previous year. The reason for this rule is that it is usually impossible for employers to guarantee contributions to these plans for any particular year.
To demonstrate, let's say your employer sponsors a profit-sharing plan, to which it contributes 10% of eligible compensation for the 2019 tax year. But the contributions are deposited in 2020. Employees are considered active participants for 2020, the year in which the contributions are actually deposited to their accounts.
401(k) and 403(b) Plans
If you are eligible to make salary-deferral contributions but elect not to, you are not considered an active participant for that year.
Voluntary or Mandatory Contributions
You are considered an active participant for any year you make voluntary or mandatory contributions to an eligible employer-sponsored retirement plan.
Vesting Status Does Not Affect Status
Depending on the plan provisions, you may not be immediately vested in the year's contributions you receive from your employer. But your vesting status does not alter whether you are an active participant. Even if you leave that employer at a later date and you forfeit that non-vested contribution, you are still considered an active participant for the applicable year.
For example, ABC Company contributes 10% of its employees' compensation to its money-purchase pension plan for the 2019 tax year. Under the provisions of the ABC money-purchase pension plan, employees' contributions are 100% vested after working for three years. No vesting occurs before then.
Let's say that Jane leaves ABC Company for a new firm after two years of employment. Because Jane is leaving before she accrued any vested balance, she must forfeit the contributions that were made to her money-purchase-pension account at ABC Company. However, Jane is still considered an active participant for the 2019 tax year, because a required contribution was made to her money-purchase pension account.
Changes in Contribution Age Due to the SECURE Act
In early January 2020, former President Trump signed the Setting Every Community Up for Retirement Enhancement (SECURE) Act. Before the Secure Act, you could not make contributions to a traditional IRA for the year during which you reached age 70½ or any later year.
Now, for tax years beginning in 2020, you can make contributions after reaching age 70½, meaning there is no longer an age restriction for contributing to traditional IRAs. The act does not change the age restriction on Roth IRA contributions because there is no such restriction.
The Bottom Line
If you and/or your spouse are active participants for a given year, you may need to perform a calculation to determine whether you are able to deduct your IRA contributions for that year. If you are not able 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 for assistance with determining whether your IRA contribution is deductible.