Traditional IRA Deduction Phaseout

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davy88
Posts: 18
Joined: Tue Jan 21, 2020 4:10 am

Traditional IRA Deduction Phaseout

Post by davy88 »

We're working on wrapping up our extended 2021 tax return. I was working as a full time volunteer in 2021 and had no w-2 income, and our AGI was $184,621 (majority was my wife's w-2 income) after my traditional IRA deduction (she also maxed 401k). Upon review of my return our tax company, I realized that her traditional IRA deduction was disallowed for deduction because we exceeded the income limits of $129k. I now understand the tax rules and realize this is the correct treatment.

We were abroad for my wife's work and had extra "pay" applicable to the move on her W-2 (we were tax equalized for it but it still increased our AGI). At tax time then we have our regular return prepared and they also calculate a hypothetical return and tax equalization (based on if we didn't have the extra income related to the move) and the company pays us back the difference. I was trying to reduce our income low enough to get under the $150k threshold so we'd qualify for reimbursement by her company for the third stimulus and additional child tax credit. On our hypothetical equalization we have an AGI of $155,630, so this would have been a good plan had I fully understood the traditional IRA deduction being disallowed. This was the first time we contributed to traditional as we've always done Roth up until now.

So now my questions:
1. What was the point of contributing to the traditional IRA for her if we don't get any tax benefit?
2. Assuming none, what should we do now? Is there any way to reverse it this late in the game or move her contribution to the Roth?
3. Going forward, I now have a part-time salary of around $55k and her total wages are around $240k (before deductions). Best to just max both 401ks and ignore IRA contributions altogether? Try to get some kind of backdoor Roth set up through her company? Try to reduce our AGI so much through 401k and HSA contributions that we can still sneak under the Roth threshold?

Thanks for the advice.
fabdog
Posts: 2077
Joined: Wed Jan 16, 2013 1:59 pm
Location: Williamsburg VA

Re: Traditional IRA Deduction Phaseout

Post by fabdog »

1. What was the point of contributing to the traditional IRA for her if we don't get any tax benefit?
2. Assuming none, what should we do now? Is there any way to reverse it this late in the game or move her contribution to the Roth?
3. Going forward, I now have a part-time salary of around $55k and her total wages are around $240k (before deductions). Best to just max both 401ks and ignore IRA contributions altogether? Try to get some kind of backdoor Roth set up through her company? Try to reduce our AGI so much through 401k and HSA contributions that we can still sneak under the Roth threshold?
1. To have Non deductible IRA contributions that could be moved to a Roth using the backdoor method

2. You could ask to have the funds returned, but you'll owe taxes on any gains. You can also use those funds (assuming that's the only trad IRA she has) to move the funds to a ROTH using the backdoor method. You'll owe tax on the gains made since she put the funds in. You can do the backdoor if she has other IRA funds, but the pro rata rule will come into play

3. You can both make non deductible contributions and then immediately convert to ROTH using the backdoor method. You can do this each year.
Her company will not be involved unless they allow after tax contributions and the execution of rollovers of those amounts to a ROTH, a tactic known as MEGA backdoor Roth. See the wiki for differences

Mike
fyre4ce
Posts: 2069
Joined: Sun Aug 06, 2017 11:29 am

Re: Traditional IRA Deduction Phaseout

Post by fyre4ce »

davy88 wrote: Thu Sep 22, 2022 9:45 am We're working on wrapping up our extended 2021 tax return. I was working as a full time volunteer in 2021 and had no w-2 income, and our AGI was $184,621 (majority was my wife's w-2 income) after my traditional IRA deduction (she also maxed 401k). Upon review of my return our tax company, I realized that her traditional IRA deduction was disallowed for deduction because we exceeded the income limits of $129k. I now understand the tax rules and realize this is the correct treatment.

We were abroad for my wife's work and had extra "pay" applicable to the move on her W-2 (we were tax equalized for it but it still increased our AGI). At tax time then we have our regular return prepared and they also calculate a hypothetical return and tax equalization (based on if we didn't have the extra income related to the move) and the company pays us back the difference. I was trying to reduce our income low enough to get under the $150k threshold so we'd qualify for reimbursement by her company for the third stimulus and additional child tax credit. On our hypothetical equalization we have an AGI of $155,630, so this would have been a good plan had I fully understood the traditional IRA deduction being disallowed. This was the first time we contributed to traditional as we've always done Roth up until now.

So now my questions:
1. What was the point of contributing to the traditional IRA for her if we don't get any tax benefit?
2. Assuming none, what should we do now? Is there any way to reverse it this late in the game or move her contribution to the Roth?
3. Going forward, I now have a part-time salary of around $55k and her total wages are around $240k (before deductions). Best to just max both 401ks and ignore IRA contributions altogether? Try to get some kind of backdoor Roth set up through her company? Try to reduce our AGI so much through 401k and HSA contributions that we can still sneak under the Roth threshold?

Thanks for the advice.
A few things to sort out.
  • If you did not have access to a retirement account at work (and it sounds like you didn't, if you were volunteering), then the AGI limit for you to deduct a traditional IRA contribution in tax year 2021 is $198k-$208k. So, if you already made the tIRA contribution, you should be able to deduct it on your return. Because your wife is covered by a retirement plan at work, the AGI limit for her to deduct her contribution to a tIRA is $105k-$125k, so it sounds like she can't be eligible in any case. Remember, IRA contributions are individual, so it matters whose IRA is being discussed. You seem to switch between "your" deduction and "her" deduction in the first paragraph, so it's not totally clear what has happened. You can, however, contribute to your own IRA using income earned by your spouse (the so-called "spousal IRA"), as long as the total IRA contributions are not greater than total earned income.
  • For the reasons above, if you already contributed to a tIRA for 2021 (the deadline for which was April 15, 2022) then you should be able to deduct that contribution on your 2021 return. The deadline does not move out with an income tax extension, so if you haven't contributed yet, you lost your chance for 2021. The same deadline would apply to your wife.
  • If your wife already contributed to a tIRA for 2021, you will not be able to deduct that contribution on your 2021 return. You have a few options to deal with this. It sounds like your AGI is low enough for her to contribute to a Roth IRA directly (phase-out for 2021 is $198-208k), so I think she can recharacterize the contribution to a Roth. This has the advantage of avoiding taxes on any gains the investments have had in the meantime. Alternatively, she could convert the entire tIRA to a Roth IRA, and the growth will be taxable income for 2022, not the principal. This maneuver is called the backdoor Roth IRA. Or, you could just leave it in the tIRA as non-deductible. This is not the best mathematically, and will require her to track her tIRA basis to avoid double-taxation later. But, it's the least-hassle option now.
  • You asked why anyone would use a non-deductible traditional IRA. There are usually two reasons. By far the most common is as the first step in the Backdoor Roth IRA, a way to contribute to a Roth IRA while getting around the income limits. Some people can't do the Backdoor Roth IRA because they have a large pre-tax IRA that interferes with the pro-rata calculation in the conversion step, and can't/don't want to get rid of that pre-tax IRA money. In that case, there are certain types of investments (high-yield) that perform better in a non-deductible IRA than in a taxable account. This is really a niche case though, as most investors have tax-protected space in their 401k to put high-yield investments. There's a wiki page on the topic.
  • Going forward, your best bet will probably be deductible 401k contributions for your wife (and you, if you have one) and Backdoor Roth IRA contributions for each of you. As I said, this is a way around the normal income limits for Roth IRA contributions.
Topic Author
davy88
Posts: 18
Joined: Tue Jan 21, 2020 4:10 am

Re: Traditional IRA Deduction Phaseout

Post by davy88 »

Thanks both of you for your replies. For clarity, we both contributed $6k each for 2021 and mine was deductible but hers wasn't, sorry for the confusion. So yes, the tax treatment was correct.

Since we were still under the threshold to contribute to a Roth in 2021, it sounds like my best option is recharacterizing her contribution to a Roth. While I had a traditional IRA previously from rolling an old employer's 401k, we opened one for my wife specifically for the 2021 contribution. So everything in there is related to her 2021 contribution and any subsequent gains/losses (they will be marginal, it's just been in VTI). Anything I need to be aware of to do this, or simply just contact Vanguard and ask them to make the change? Anything needed to change how I report things on my 2021 tax form?

And then yes, going forward I think we will just move toward both maxing our 401ks now that I have a W-2 job again.
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retiredjg
Posts: 49183
Joined: Thu Jan 10, 2008 12:56 pm

Re: Traditional IRA Deduction Phaseout

Post by retiredjg »

If you decide to have it re-characterized, you need to include a statement about that on the tax return. I think it goes on the 2021 return, but it is possible it goes on the 2022 return (when you get the 1099 for the re-characterization). Deadline for getting this done is October 17 I believe.


If, instead, you decide to do a Roth conversion, you need to fill in Form 8606 Part I to document the non-deductible contribution to tIRA. (In fact, this should already be done.) You also need to fill in Form 8606 Part II to document a conversion to Roth IRA. If you do it this way, this will be the backdoor Roth process already mentioned.
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