There is still time for federal employees to make their 2020 IRA contributions. Unfortunately, there is a lack of familiarity and some misinformation about IRAs among federal employees.
Among the misinformation: Some employees have concluded that they are not eligible to contribute to an IRA because they contribute to the Thrift Savings Plan (TSP). Nothing can be further from the truth. The fact that a federal employee has earned income in the form of a salary allows the employee to contribute to a traditional IRA and/or to a Roth IRA. This column discusses the contribution rules for IRAs, including the different types of IRAs, contribution limits and contribution deadlines.
There are two types of IRAs that all federal employees are eligible to contribute to for tax year 2020, Traditional IRAs and Roth IRAs. Note that there are other IRAs available for self-employed individuals can contribute to, including SEP-IRAs and SIMPLE IRAs which are not discussed in this column.
Contributory or Traditional IRA (deductible and nondeductible)
To deduct a traditional IRA contribution (on one’s federal income tax return as an adjustment to income) an IRA owner must pass up to three of the following tests:
(1) the “earned income” test;
(2) the “other retirement plan” test; and
(3) the “maximum income” test.
Test (3) applies only if Test (2) is passed. The “age” test (for contributing to a traditional IRA) was repealed under the SECURE Act effective Jan. 1, 2020.
The earned income test requires compensation from “working”. “Working” income includes: W2 wages, self-employment income, combat pay, scholarships. fellowships and stipends (as a result the 2019 SECURE Act passage), and taxable alimony. Note that “working” income does not include rents, interest, dividends, pensions, capital gains and flow-through K-1 income from an S Corporation.
A non-working spouse is eligible to contribute to a traditional IRA based on his or her working spouse’s earned income.
The following example illustrates:
Judy was a full-time college student during 2020. She is married to Howard who is a federal employee whose salary during 2020 was $55,000. Both Howard and Judy can each contribute a maximum $6,000 to their own traditional IRA for tax year 2020.
The “other retirement plan” test applies if an individual’s income falls within certain limits as presented in Table 1 below. If an individual is covered by a qualified pension plan and the individual’s income is above specified income limits, then the individual will be limited with respect to how much of their traditional IRA contribution will be deductible on the federal income tax return. All full-time and part-time permanent federal employees are covered by a defined benefit plan – a CSRS or FERS annuity. Most Federal employees contribute to the Thrift Savings Plan (TSP). This means that Federal employees who contribute to traditional IRAs are subject to the “maximum income” test.
The third test for deducting a contribution to a traditional IRA is the “maximum” income test. This test is the most confusing. If the individual falls under the income limits as shown in Table 1 below and meets the earned income test discussed, the contribution to the traditional IRA will be deductible as an adjustment to income. IF the individual’s income is above the limits shown in the following tab, the deduction is limited or disallowed, but only if the individual is covered by a pension plan, lie federal employees.
On a joint return in which both spouses have earned income but only one spouse is covered by a retirement plan, the non-covered spouse may make a deductible IRA contribution provided the family’s 2020 modified adjusted gross income (MAGI) was less than $206,000. This is presented here in Table 1:
Table 1. Are 2020 Traditional IRA Contributions Deductible?
*Adjusted gross income (before IRA deduction) plus Foreign Earned Income exclusion plus Foreign Housing Exclusion or deduction plus Excluded U.S. Savings Bonds interest shown on Form 8815 and used for education plus Student Loan interest deduction plus Tuition and Fees deduction equals Modified AGI (MAGI)
The following example illustrates the use of Table 1:
Example 1. Sharon and Stuart are married and file their income taxes as married filing joint. Both Sharon and Stuart are federal employees and therefore covered by a pension plan. Their 2020 MAGI is $135,000. Since their 2020 MAGI exceeds $124,000, no deductible traditional contribution is allowed for both Sharon and Stuart.
Example 2. Same background information as in Example 1 except that only Sharon is a federal employee and Stuart works in private industry but is not covered by a pension or retirement plan. Since only one spouse is covered by a pension or retirement plan the “other retirement plan” rules apply (see third row of table above). In this case, Stuart, but not Sharon, would be able to deduct his 2020 traditional IRA contribution because Sharon and Stuart’s 2020 MAGI is less than $196,000.
Traditional nondeductible IRAs
If an individual chooses to make a non-deductible contribution to a traditional IRA, then IRS Form 8606 (Nondeductible IRAs) must be filed for the year in which the contribution was made and subsequently in any year in which another contribution is made or an IRA withdrawal is made.
If the individual does not report the contribution on Form 8606 as a nondeductible contribution, the contribution will be treated as if it is a deductible traditional IRA contribution. The consequences of treating traditional IRA contributions as deductible will be that future IRA contributions will be fully taxable, unless the IRA owner can show with satisfactory evidence a completed Form 8606, that nondeductible contributions were made.
There are no income limitations for contributing to a nondeductible traditional IRA. In fact, the only “test” that an individual must pass in order to contribute to a nondeductible traditional IRA is the “earned income” test. Effective Jan. 1, 2020, there is no longer an “age test” for contributing to a traditional IRA. Prior to Jan. 1, 2020, an individual over age 69 could not contribute to a traditional IRA even, if the individual had earned income.
Assuming an individual who contributes to a nondeductible traditional IRA files Form 8606 whenever a contribution is made, the IRA contributions can be withdrawn income tax and penalty free at any time. But that is not the case if the IRA owner also has deductible traditional IRAs. This is because traditional IRA withdrawals are withdrawn in proportion to the money that was contributed, using Form 8606 to track the “basis” of nondeductible accounts. The following example illustrates:
Jason owns a traditional IRA, currently worth $20,000 and consisting of: (1) $10,000 of deductible contributions; (2) $6,000 nondeductible contributions reported on Form 8606; and (3) $4,000 of accrued earnings. A withdrawal of $5,000 of the nondeductible contributions in Jason’s traditional IRA would be 70 percent taxable (70 percent of $5,000 or $3,500 included in income) as shown below:
Taxable proportion: [$10,000 (pre-taxed contributions) plus $4,000 accrued earnings]/$20,000 = 70 percent
Nontaxable proportion: $6,000 (after-taxed contributions)/$20,000 = 30 percent
Roth IRAs
Roth IRAs are nondeductible upon contributing and nontaxable when distributing, if certain conditions are met, namely: (1) the Roth IRA owner is over age 59.5 or disabled; and (2) it has been at least five years since January 1 of the year the Roth IRA owner made his or her first Roth IRA contribution.
To make a Roth contribution only two tests must be met: (1) the individual must have earned income; and (2) the earned income cannot exceed specified MAGI limits, as presented in Table 2:
Table 2. Can You Make a 2020 Roth IRA Contribution?
*Adjusted gross income less income from Roth IRA conversions less income from Roth IRA rollovers from employer retirement plans plus deduction for Traditional IRA contributions plus Foreign Earned Income exclusion plus Foreign Housing Exclusion or deduction plus Excluded U.S. Savings Bonds interest shown on Form 8815 and used for education plus Student Loan interest deduction plus Tuition and Fees deduction equals Modified AGI (MAGI)
The fact that an individual is in a pension plan has no effect on whether the employee can contribute to a Roth IRA. The only test is the “income” test that is presented above. This means that all federal employees are eligible to contribute to a Roth IRA if their income is below the limit for their tax filing status.
Since Roth IRA contributions are not deductible, the contributions are not reported on a tax return. However, the account must be separately established and maintained as a Roth IRA. Federal employees who contribute to the Roth TSP may be eligible to contribute to Roth IRAs for 2020, depending on their MAGI. There are no income limitations for contributing to the Roth TSP. But even if a Federal employee is not eligible to contribute to a Roth IRA and instead contributes to the Roth TSP, the employee can eventually do a direct transfer of his or her Roth TSP account to a “rollover” Roth IRA with no tax consequences and with no dollar limitation.
2020 IRA Contribution Limits and Filing Deadline
Federal employees younger than age 50 as of Dec. 31, 2020 can contribute a maximum $6,000 to an IRA for the year 2020. Employees over age 49 as of Dec. 31, 2020 can contribute a maximum $7,000 for the year 2020. The deadline for contributing is April 15, 2021.
Employees can contribute to the one, two or three types of IRAs discussed above depending on their MAGI, but their total contributions cannot exceed $6,000 or $7,000, depending on their age. IRAs may be established at a bank, credit union, mutual fund company, brokerage, or an insurance company. Employees who contribute to their IRAs for 2020 between now and April 15, 2021 should notify their IRA custodians that their contributions are for 2020 and not for 2021.
The deduction for tax deductible contributions made to a traditional IRA may be taken on a 2020 federal tax return filed before October 15, 2021, as long as the traditional IRA contributions are made in full no later than April 15, 2021.