Find out when IRA contributions don’t reduce your taxes.
A Money Girl fan recently asked me whether or not she should contribute to both a 401(k) and an IRA. This is an important question because there’s a little twist in the rules that can make contributing to an employer retirement plan and an IRA in the same year not such a good idea for some people. In this article we’ll look at when it’s a smart move to contribute to both and when it isn’t.
What is an IRA (Individual Retirement Arrangement)?
If you’re a regular Money Girl reader, you already know that an IRA stands for Individual Retirement Arrangement and is a special type of account you can use to save for retirement that offers money-saving tax benefits. In general, investing through a tax-advantaged account is a smart move because it really stretches your dollar.
When Is It Bad to Contribute to an IRA?
For you to understand why I’d ever say that contributing to an IRA could be a bad idea, you need to understand the special rule that I mentioned. Here’s the deal: If you or your spouse were covered by an employer retirement plan and you also contribute to an IRA, the tax deduction you get for your IRA contributions may be limited. That’s the government’s way of making sure you don’t get too much of a good tax thing.
Let me back up and say that this limitation on deductions only applies to having both a retirement plan at work and a traditional IRA—not a Roth IRA. You get an upfront tax deduction for contributions you make to a traditional IRA but you don’t with a Roth. You always have to pay tax on Roth contributions upfront and all the tax goodness comes in the future when you take tax-free withdrawals during retirement.
IRA Deduction When You’re Covered by an Employer Retirement Plan
So let’s talk about the limitation on traditional IRA deductions if you’re covered by an employer retirement plan. The deduction you get depends on how much you earn and on your tax filing status. The deduction begins to decrease or phase out when your income is above a certain amount and gets completely eliminated when it reaches a higher amount. So you might be entitled to a full deduction, a partial deduction, or no deduction.
IRA Deduction Limits by Tax Filing Status
Here are the allowable IRA deductions for each tax filing status for 2011:
Single and Head of Household: Your phase out range is from $56,000 to $66,000. That means if your modified adjusted gross income (MAGI) is $56,000 or less, you get to take a full IRA deduction when you’re covered by a retirement plan at work. If your income falls somewhere in between $56,000 and $66,000, you get to take a partial deduction. But if your MAGI is $66,000 or more, you’re out of luck and get no tax deduction for traditional IRA contributions.
Married Filing Jointly or Qualifying Widow(er): Your phase out range is from $90,000 to $110,000. So if you have MAGI of $90,000 or less, you get to take a full IRA deduction when you’re covered by a retirement plan at work. If your income is between $90,000 and $110,000, you’re entitled to a partial deduction, and if it’s $110,000 or more you get no deduction.
Married Filing Separately: If your MAGI is less than $10,000, you’re entitled to a partial deduction, and if it’s over $10,000 you get no deduction.
IRA Deduction When Your Spouse Is Covered by an Employer Retirement Plan
Now, in addition to these income limitations, there’s one more rule to know that applies to married folks who file a joint return. If you’re not covered by a retirement plan at work, but your spouse is, the amount you can deduct is also limited. As a couple, your phase out range for 2011 is $169,000 to $179,000.
In other words, if your spouse has an employer retirement plan and your total MAGI is $179,000 or more, you cannot take a deduction for a contribution to a traditional IRA even if you don’t have a retirement plan at work.
What to Do About Non-Deductible IRA Contributions
You might be wondering what happens if you make contributions to a traditional IRA but find out later that you don’t qualify for a full deduction for those contributions? After all, that’s one of the reasons why you might have made traditional IRA contributions to begin with.
If you catch this situation before the end of the year, you could withdraw your traditional IRA contributions (plus any earnings they made) and increase the amount you or your spouse contribute to your employer plan instead. You can withdraw contributions you made during the tax year from your IRA tax free, if you do it by the date of your tax return, or by your extended due date if you file for an extension. However, the cutoff for making workplace retirement contributions is December 31st—so you’d need to up the ante at work before the calendar flips to a new year.
Should You Contribute to Both a 401(k) and an IRA?
Okay, so let’s get back to the big question. Should you contribute to both a 401(k) and an IRA or just to a 401(k)? Well, it depends on your tax filing status and income. Let’s assume Bonnie is a single woman who makes $40,000.
I told you earlier that the threshold for a single taxpayer to get the full IRA deduction is modified adjusted gross income of $56,000 or less. Since she’s under that amount, Bonnie can deduct 100% of any amount she chooses to contribute to a traditional IRA—so I’d recommend that she consider it.
The major advantage that Bonnie would get for branching out beyond her 401(k) into an IRA is more flexibility in her investment choices. The typical workplace retirement plan offers a limited menu of funds. So if she’s unhappy with her choices at work, an IRA would give her total investment freedom for a portion of her retirement money.
A disadvantage to using an IRA is that Bonnie would be responsible for making the contributions—it wouldn’t happen automatically from a payroll deduction, like with her 401(k) contributions. So if she isn’t disciplined with her investing or doesn’t put it on autopilot she might neglect those IRA contributions. In that case, sticking with the 401(k) would insure that the job gets done.
To know if contributing to both a traditional IRA and an employer plan is right for you, first consider whether you make too much money to be eligible for an IRA tax deduction, and then decide whether or not you welcome the idea of having more control over your retirement investing.
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