What made the original IRA a no-brainer investment was a simple, indisputable fact: Contributions were deductible. Put $4,000 into an IRA, write off $4,000 on your tax return.
In the 25% bracket, that saves $1,000 and delivers instant gratification. But there are some restrictions to prevent some higher-income earners from getting that deduction. There are two tests that determine how much you can deduct if you save within a traditional IRA:
- Company plan test. Are you an active participant in a company retirement plan? You are, as far as the law is concerned, if you are eligible during any part of the year to participate in a pension, profit sharing, or similar plan. (If you are in a profit-sharing plan but no contribution is made to your account for the year, however, you are not considered covered for that year.) Or if you make a contribution to your 401(k) anytime during the tax year.The Form W-2 you receive from your employer should indicate to you -- and the IRS -- whether you're covered.If you are not tripped up by the company-plan test, you can deduct IRA contributions regardless of how high your income is.
- Income test. If you are covered by a plan, you may lose your right to the deduction. The write-off is phased out for active participants in company plans whose adjusted gross income(AGI) -- before subtracting IRA contributions -- exceeds certain levels. See IRS Publication 590 for more information.
You could still contribute up to the annual contribution limit to your account; it simply could not be deducted from your tax bill.
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Do nondeductible contributions make sense?
Before Congress created the Roth IRA, nondeductible contributions to a regular IRA made good financial sense because -- deductible or not -- money inside an IRA grows without annual interruption from the IRS. Now, however, it would be a serious blunder for anyone who qualifies to use a Roth -- and that's almost everyone -- to make nondeductible contributions to a regular IRA.
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