An individual retirement arrangement (IRA) provides a tax-beneficial way in which an individual can set aside money for his or her retirement years to help pay living expenses and to pay for the things when the individual has the time to do them, such as traveling or learning new skills.
An IRA may be either an “individual retirement account” which the IRA owner establishes with a financial services company—such as a bank, brokerage firm or mutual fund company, or an individual retirement annuity that is available through an insurance company. IRAs can be broken down into two types – a traditional IRA (“deductible” and “nondeductible”) and a Roth IRA.
The one requirement for an individual to contribute to any type of IRA is that the individual (or a spouse if married) must have some type of earned income (compensation). Compensation includes:
(1) Wages or salary; (2) commissions; (3) self-employment income; (4) alimony (but only with respect to divorce and separate instruments executed before January 1, 2019); (5) nontaxable combat pay; and (6) taxable non-tuition fellowship/stipend payments.
Federal employees will receive sometime in January from their agencies their 2021 W-2 statements. The W-2’s shows the amount of compensation (salary) the employee earned during 2021. All employees are therefore eligible to contribute to an IRA for calendar year 2021. The deadline for making 2021 IRA contributions is the 2021 federal income tax filing deadline of April 18, 2022.
This column discusses the rules for federal employees for making 2021 contributions to the three types of IRA, namely a: (1) Traditional “deductible” IRA; (2) Traditional “nondeductible” IRA; and a (3) Roth IRA.
What type of IRA an individual is eligible to contribute to comes down to two questions: (a) Is the individual covered by an employer-sponsored defined benefit plan (such as a CSRS or a FERS annuity) or participating in an employer-sponsored defined contribution plan) (such as a 401(k), 403(b); and (b) the individual’s modified adjusted gross income (MAGI). Since all permanent federal employees are covered by either the Civil Service Retirement System (CSRS) or the Federal Employment Retirement System (FERS), the issue of what type of IRA a federal employee can contribute to for the year 2021 is based on an employee’s 2021 MAGI.
In addition to receiving their 2021 W-2 statements during January, employees will also be receiving other income statements for 2021 (including a 1099-INT, 1099-DIV, 1099-B, 1099-MISC, and 1099-NEC). This means that by early to mid-February most employees will know the amount of their 2021 gross income and therefore will be able to determine their MAGI. At that point they know what type of IRA they will be able to contribute to for the year 2021 and how much they are eligible to contribute.
Traditional “Deductible” IRA
In general, if an individual (or his or her spouse) is covered by and participating in an employer-sponsored retirement plan, the individual may not be able to deduct on their federal income tax return (as an “adjustment to income”) some or all of the amount of their traditional IRA contribution. The deductible amount begins to decrease (“phase out”) when the traditional IRA owner’s MAGI increases above a minimum amount (“lower threshold”) and is eliminated altogether when MAGI reaches a maximum.amount (“upper threshold”).
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Table 1 below summarizes the destructibility of traditional IRA contributions for individuals (or spouses) covered by an employer-sponsored retirement plan during 2021. Note that all permanent federal employees are covered by a retirement plan (either a CSRS annuity pension or a FERS annuity pension, and all employees are eligible to contribute to the Thrift Savings Plan). Table 1 applies to federal employees who are considering making contributions to a traditional IRA for the year 2021. When federal employees receive their 2021 W-2 statement in January, they should note on their W-2 Box 13 “Retirement Plan” box will be checked.
Table 1. Deductibility of IRA Contributions-Individual (or Spouse) Covered by Employer Retirement Plan*
The following example illustrates:
Example 1. Thomas is a federal employee and is married to Julie. They are both 40 years old. Julie is employed part-time in private industry but is not covered by a retirement plan. Their combined MAGI for 2021 is $107,000. Thomas’ salary is $75,000 and he contributed $6,000 to his traditional IRA for 2021. Since Thomas’ and Julie’s MAGI is between $105,000 and $125,000 and Thomas is covered by a retirement plan (FERS), Thomas’ and Julie’s IRA contributions are subject to the deduction phase-out as follows:
Thomas and Julie can each deduct up to $5,400 of their $6,000 traditional IRA contributions. The amount that each cannot deduct ($600) is considered a nondeductible contribution.
Traditional “Nondeductible” IRA
Any individual who has earned income (or married and the individual’s spouse has earned income) is allowed to contribute the full amount to a traditional “nondeductible” IRA. It makes no difference with respect to the individual’s age or MAGI – the individual is allowed to contribute to a traditional nondeductible IRA. This means that all federal employees (and spouses) are allowed to contribute the maximum possible to a traditional “nondeductible” IRA for the year 2021.
Note that as a result of the passage of the SECURE Act in December 2019, effective Jan. 1,2020 all individuals with earned income can contribute to a traditional nondeductible IRA. Prior to Jan. 1, 2020 (pre-SECURE Act), once an individual reached the year he or she becomes age 70.5, the individual could not contribute to a traditional IRA (either a deductible or a nondeductible traditional IRA). Note effective Jan. 1, 2020, there is no age limitation for contributing to a traditional IRA.
Reporting Traditional Nondeductible Contributions
IRS Form 8606 (Nondeductible IRAs) must be filed to designate contributions as nondeductible. Individuals do not have to designate a contribution as nondeductible until they file their tax return. This means that federal employees who make contribution to traditional nondeductible IRAs for the year 2021 must include as part of their 2021 federal income tax return IRA Form 8606) in which they will report the amount of their contribution by reporting their nondeductible contributions on Form 8606, they are establishing a “cost basis” in their traditional IRAs.
In establishing a “cost basis” in their traditional IRA, the IRA owner will not be taxed on the entire amount of the IRA when it is withdrawn. When the traditional nondeductible IRA is withdrawn, only the accrued earnings will be subject to federal and state income taxes. This is because since the contributions were made with after-taxed dollars (as reposted on Form 8606), the contribution will not be taxed again.
Roth IRAs
A Roth IRA is an individual retirement account in which contributions are always nondeductible. Roth IRAs like traditional IRAs accrue earnings. The difference between traditional IRAs and Roth IRAs is with respect to withdrawals. With a traditional IRA, at least the accrued earnings portion of the IRA will be taxable when withdrawn. With a Roth IRA, all qualified withdrawals will be tax-free, including the accrued earnings. A qualified Roth IRA withdrawal means that the Roth IRA owner has fulfilled two requirements, namely: (1) At the time of withdrawal, the Roth IRA owner is at least age 59.5; 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.
The Roth IRA has no minimum or maximum age contribution restrictions. There are no “other retirement plan” participation restrictions or rules. Contribution limits for 2021 are $6,000 for all individuals with earned income and $7,000 for individuals with earned income and who were over age 49 as of Dec. 31, 2021 (individuals born before Jan. 1, 1972). But there are annual modified adjusted gross income (MAGI) limitations for making Roth IRA contributions. The 2021 MAGI limitations are presented in Table 2.
Table 2. Roth IRA Contribution Phase-Out (2021)
1 Individuals Filing Married Filing Separate who did not live with their spouse at any time during the year are treated as single
*Modified AGI for Roth IRA Contribution equals:
Adjusted Gross Income:
₋ Income from Roth IRA conversions
₋ Income from Roth IRA rollovers from employer retirement plans
₊ Deduction from traditional IRA contributions
₊ Student loan interest deduction
₊ Foreign earned income exclusion
₊ Foreign housing exclusion or deduction
₊ Exclusion of qualified Savings Bonds interest used for exclusion
₊ Exclusion of employer-provided adoption benefits
IRS Publication 590-A (Individual Retirement Arrangements – Contributions) (https://www.irs.gov/pub/irs-pdf/p590a.pdf) has a worksheet that allows an individual can determine how much can be contributed to a Roth IRA, given the Roth IRA owner’s Modified AGI.
January and February are Good Months for Employees to Make Their 2021 IRA Contributions
Summary of the Major Differences Among IRAs
The following table presents a summary of the major differences among a traditional deductible IRA, a traditional nondeductible IRA, and a Roth IRA.
Finally, during the period January 1 through February 28,2022 as federal employees are getting prepared to file their 2021 federal income tax returns, this is a suitable time for employees to make their 2021 IRA contributions if they have not already done so. This is because employees will have determined during this period what their 2021 MAGI is and therefore which type of IRA they are eligible to contribute to. The deadline to make their 2021 IRA contributions is April 18, 2022, even if they file for a 2021 federal income tax filing extension. Employees who make their 2021 IRA contributions before April 18,2022 should make sure that they mention to their IRA custodians that their contributions are for calendar year 2021. Otherwise, an IRA custodian could assume that the contributions are calendar year 2022 due to the fact that the contributions are being made during calendar year 2022.