Is Your IRA Really Non-deductible?

Barry Picker, CPA/PFS, CFP


A big issue that is constantly coming up is whether an IRA contribution is deductible. For anyone not covered by a qualified plan at work, the answer is that it IS deductible, regardless of the income level. However, for someone who is covered by a plan at work, the deductibility will be determined by the level of adjusted gross income.

As a practitioner, we determine if a client is covered by whether the pension or deferred compensation box is checked on the W-2. If it is, we know they are covered by a plan, and we prepare the return accordingly. After all, this is what the Internal Revenue Service looks at when they get the return. But how do we know the W-2 is prepared correctly? And if it isn't, how does an employee get it corrected, preferably without losing his or her job in the process?

Far and away, the two biggest areas of confusion involve the 401(k) (or 403(b)) plans, and profit sharing plans. Keep in mind that while the rules are confusing even for professionals, the decision to put that little X on your w-2 is being made by a clerical person in the personnel department.

A Sec 401(k) plan (as well as a Sec 403(b) plan or a SIMPLE plan) is a salary reduction plan. The employee is given the option of taking their salary currently, or deferring it to a later date. If the salary is deferred, the salary is not currently taxed, and the income earned by the deferred salary is likewise not currently taxed. Taxes will be paid when the amounts are ultimately withdrawn. Many employers have a waiting period until the new hired employee is eligible to participate in the plan. As far as the IRA rules are concerned, anyone participating for as little as one day during the year is considered as a participant in the plan for the entire year, and the deductibility of the IRA contribution will therefore depend upon the adjusted gross income.

But what constitutes "participation"? In the case of salary reduction plans, participation means having an actual dollar amount of salary deferred. It does not mean eligibility to participate. Therefore is Sam Jones needs to work for the XYZ Corp. for six months in order to participate in the XYZ Corp. Sec 401(k) plan, Sam is not automatically a participant at that six month anniversary date. His W-2 should not be marked, unless and until Sam actually elects to participate and has an amount of salary deferred. In fact, if Sam becomes eligible towards the end of the calendar year, Sam might be better off holding off having any salary deferred until the beginning of the following year, since any amount deferred in the earlier year could render his IRA contribution non-deductible in that year.

The profit sharing plan likewise causes a lot of confusion. In the case of a profit sharing plan, an individual is considered a participant only in a year in which a contribution is made to the individual's account, or a forfeiture is allocated. The key here is that the individual is a participant in the year a contribution is made, even if the contribution is for an earlier year. To illustrate, let's take the case of Sam Jones and XYZ Corp. Since we are now talking about a profit sharing plan, we will assume there is no Sec 401(k), or any other, plan in effect.

Let's assume that Sam was hired by XYZ in June, 1998, and there was a one year waiting period before Sam became eligible to participate in the profit sharing plan of XYZ. Sam therefore became eligible to participate in the profit sharing plan as of June, 1999. But the company did not decide until January of 2000 to make a contribution to the company profit sharing plan for 1999. XYZ then made the contribution, including Sam's allocated portion, in March, 2000.

Sam was not a participant in 1999, because no money was contributed in 1999. Sam WILL be a participant in 2000 To take this one step further, let's assume that in January, 2001, the company decides NOT to make a contribution for the 2000 year. If no contribution is made to the plan during calendar year 2001, and no forfeitures are allocated to Sam, Sam will not be a participant in the profit sharing plan for 2001, and his W-2 (assuming no other plans involved) should not have the pension box checked.

Now that we've discussed the rules for when the pension box on the W-2 should be checked, what happens if you get a W-2 with the box incorrectly checked? The first thing is to make sure that it is, in fact, incorrectly checked. Make sure that there isn't another reason for it being checked, like the existence of a defined benefit plan. But assuming the W-2 is actually wrong, you have a few options.

The first option is, of course, to do nothing and forget about deducting your IRA. Treat it as a non-deductible IRA contribution, remembering to file form 8606, or, better than a non-deductible IRA, make your IRA contribution to a Roth IRA. However, if you want the current deduction, you have to deal with this differently.

The best option if you wish to retain the deduction is to get the employer to correct the W-2. Unfortunately this requires the payroll department to (a) acknowledge that an error was made (show them this article) and then, (b) get them to actually go through the motions to correct it. No one ever wants to go through the hassle of amending W-2's. Alternatively, a letter from the employer stating that the W-2 had the pension box erroneously checked may be sufficient for the Internal Revenue Service.

The last option is to file your return claiming the deduction for the IRA contribution, and take up the fight with the IRS. The IRS can no longer accept the employer's filing of the W-2 as gospel, and so the IRS will get involved with the employer to get it straightened out. This surely will not ingratiate you with the employer, so this is clearly not the recommended way to go.

The bottom line is to be aware that errors are made, and you should not automatically accept a W-2 as correct.