Maxing Out Your Tax-Deductible IRA

Key Points

  • The tax deductibility of an IRA contribution depends on whether or not you (or your spouse) participate in an employer-sponsored plan.
  • Maximize tax advantages by contributing as much as you can to an IRA or 401(k).
  • If you don’t qualify for a deductible IRA contribution, there are other ways to boost your retirement savings.

Dear Carrie,

How much can a person who is 55 invest yearly in an IRA that is tax-deductible?

—A Reader

Dear Reader,

It seems like such a simple question. But the answer is anything but, thanks to the complex web of rules and regulations surrounding the whole range of retirement investment options. Still, it’s an important question, because the need to build capital for retirement is the most critical financial challenge for most Americans – regardless of their age.

Despite its complexity, the tax code can help you. So you owe it to yourself to take full advantage of what's available. In a nutshell, here’s how IRA deductibility works.

What's tax deductible

Anyone with earned income (i.e., wages or self-employment income) can open an IRA and contribute to it annually based on certain maximums and income limits, which I'll discuss. But whether those contributions are deductible depends on two things: 1) whether you (or your spouse) participate in a company retirement plan; and 2) your income level.

There are essentially three scenarios:

  • If you (and your spouse) are not active participants in a qualified workplace retirement plan such as a 401(k), 403(b) or a traditional defined benefit plan, in both 2015 and 2016 at age 55 you can deduct annual IRA contributions of up to $6,500. That figure includes the basic maximum of $5,500 for people under 50, PLUS a "catch-up" contribution of a $1,000 for those 50 and over.
  • If you are an active participant in a company-sponsored plan, then an IRA is deductible only if your income is below certain thresholds:  in both 2015 and 2016 these numbers are $61,000 to $71,000 for single taxpayers; $98,000 to $118,000 for married filing jointly; $0 to $10,000 if you’re married filing separately. Deductibility is phased out between those limits.
  • If your spouse is an active participant in a plan but you're not, for your 2015 return you can contribute and deduct the full $6,500 if your income is below $183,000. Deductibility gets phased out between $183,000 and $193,000. (These numbers change to $184,000 and $194,000 for 2016.)

Even if you (or your spouse) don't have any earned income, either of you may be able to contribute to what is known as a spousal IRA—provided the other spouse has sufficient earned income. Contributions limits are the same as any other IRA. That contribution may also be tax-deductible, again depending on the above scenarios.

Definition of "active participant"

It may seem obvious that if you're contributing to a 401(k) plan, you’re an "active participant." But there's a bit of nuance that you need to consider because, even if you don’t participate through payroll deductions, you might be an active participant according to IRS rules.

For instance, if your company has a traditional pension plan, you are probably considered an active participant as long as you’re eligible—even if no contributions are being made at the moment. If you’re unsure where you stand, check with your human resources department.

Two steps to maximize financial security

The first step is to determine your status in terms of what you can contribute and what's tax deductible for you.

Step two is to put as much as you can into the right vehicle. A 401(k) plan has much higher annual contribution limits than an IRA, in both 2015 and 2016 up to $18,000 plus an additional $6,000 for those over 50. Since contributions are made with pretax dollars, it’s essentially the same as tax deductibility for an IRA contribution. Contribute the max if you can, but at the very least, contribute enough to get any company match.

If neither you nor your spouse has a 401(k), contribute the maximum to an IRA, including the catch-up contribution. That will shave $6,500 off your income and save you taxes. If you were in the 35 percent tax bracket, you'd reduce your taxes by $2,275.

Beyond a deductible IRA contribution

If you don’t qualify for a deductible IRA contribution, you can still make a non-deductible contribution. But you do have a couple of other options. Alternately, you could:

  • Invest that money in a traditional taxable brokerage account. You give up tax-deferred growth, but in return you’ll be able to take advantage of long-term capital gain rates (withdrawals from traditional IRAs are taxed at ordinary income rates). Plus, taxable accounts are more flexible, with no rules about early withdrawals or minimum distributions.
  • Consider a Roth IRA. Contributions to a Roth IRA aren't tax deductible, but qualified withdrawals of earnings are tax-free (withdrawals of contributions are tax-free at any time). However, there are income limits. For 2015, you can contribute the maximum to a Roth IRA if your adjusted gross income (AGI) is at or below $116,000 for single filers; $183,000 for married filing jointly. You can make a partial contribution if your AGI is between $116,000–$131,000 for singles; $183,000–$193,000 for married filing jointly. (For 2016, those numbers go up to $117,000 to $132,000 and $184,000 to $194,000 respectively.)

At age 55, you probably have 5 to 10 years before you retire, so now may be a great time to sit down with a financial advisor who can help you evaluate your needs. But at the very least, take full advantage of the tax code to sock away as much money as possible. Remember, you have until April 15th of the following tax year to make your contribution.

Next Steps

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