How Much Can I Deduct?

Generally, you can deduct the lesser of:

1. The contributions to your traditional IRA for the year, or
2. The general limit (or the spousal IRA limit, if applicable) explained earlier under How Much Can Be Contributed.

However, if you or your spouse was covered by an employer retirement plan, you may not be able to deduct this amount. See Limit If Covered By Employer Plan, later.

Trustees' fees. Trustees' administrative fees that are billed separately and paid in connection with your traditional IRA are not deductible as IRA contributions. However, they may be deductible as a miscellaneous itemized deduction on Schedule A (Form 1040). For information about miscellaneous itemized deductions, see Publication 529, Miscellaneous Deductions.

Brokers' commissions. These commissions are part of your IRA contribution and, as such, are deductible subject to the limits.

Full deduction. If neither you nor your spouse was covered for any part of the year by an employer retirement plan, you can take a deduction for total contributions to one or more of your traditional IRAs of up to the lesser of:

1. $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if you are 50 or older), or
2. 100% of your compensation.

This limit is reduced by any contributions made to a 501(c)(18) plan on your behalf.

Spousal IRA. In the case of a married couple with unequal compensation who file a joint return, the deduction for contributions to the traditional IRA of the spouse with less compensation is limited to the lesser of:

1. $2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if 50 or older), or
2. The total compensation includible in the gross income of both spouses for the year reduced by the following two amounts.
1. The IRA deduction for the year of the spouse with the greater compensation.
2. Any contributions for the year to a Roth IRA on behalf of the spouse with the greater compensation.

This limit is reduced by any contributions to a section 501(c)(18) plan on behalf of the spouse with less compensation.

Note. If you were divorced or legally separated (and did not remarry) before the end of the year, you cannot deduct any contributions to your spouse's IRA. After a divorce or legal separation, you can deduct only the contributions to your own IRA and your deductions are subject to the rules for single individuals.

Covered by an employer retirement plan. If you or your spouse was covered by an employer retirement plan at any time during the year for which contributions were made, your deduction may be further limited. This is discussed later under Limit If Covered By Employer Plan. Limits on the amount you can deduct do not affect the amount that can be contributed.

Are You Covered by an Employer Plan?

The Form W-2 you receive from your employer has a box used to indicate whether you were covered for the year. The "Retirement Plan" box should be checked if you were covered.

Reservists and volunteer firefighters should also see Situations in Which You Are Not Covered, later.

If you are not certain whether you were covered by your employer's retirement plan, you should ask your employer.

Federal judges. For purposes of the IRA deduction, federal judges are covered by an employer plan.

For Which Year(s) Are You Covered?

Special rules apply to determine the tax years for which you are covered by an employer plan. These rules differ depending on whether the plan is a defined contribution plan or a defined benefit plan.

Tax year. Your tax year is the annual accounting period you use to keep records and report income and expenses on your income tax return. For most people, the tax year is the calendar year.

Defined contribution plan. Generally, you are covered by a defined contribution plan for a tax year if amounts are contributed or allocated to your account for the plan year that ends with or within that tax year. However, also see Situations in Which You Are Not Covered, later.

A defined contribution plan is a plan that provides for a separate account for each person covered by the plan. In a defined contribution plan, the amount to be contributed to each participant's account is spelled out in the plan. The level of benefits actually provided to a participant depends on the total amount contributed to that participant's account and any earnings on those contributions. Types of defined contribution plans include profit-sharing plans, stock bonus plans, and money purchase pension plans.

Example. Company A has a money purchase pension plan. Its plan year is from July 1 to June 30. The plan provides that contributions must be allocated as of June 30. Bob, an employee, leaves Company A on December 31, 2000. The contribution for the plan year ending on June 30, 2001, is made February 15, 2002. Because an amount is contributed to Bob's account for the plan year, Bob is covered by the plan for his 2001 tax year.

No vested interest. If an amount is allocated to your account for a plan year, you are covered by that plan even if you have no vested interest in (legal right to) the account.

Defined benefit plan. If you are eligible to participate in your employer's defined benefit plan for the plan year that ends within your tax year, you are covered by the plan. This rule applies even if you:

• Declined to participate in the plan,
• Did not make a required contribution, or
• Did not perform the minimum service required to accrue a benefit for the year.

A defined benefit plan is any plan that is not a defined contribution plan. In a defined benefit plan, the level of benefits to be provided to each participant is spelled out in the plan. The plan administrator figures the amount needed to provide those benefits and those amounts are contributed to the plan. Defined benefit plans include pension plans and annuity plans.

Example. Nick, an employee of Company B, is eligible to participate in Company B's defined benefit plan, which has a July 1 to June 30 plan year. Nick leaves Company B on December 31, 2000. Since Nick is eligible to participate in the plan for its year ending June 30, 2001, he is covered by the plan for his 2001 tax year.

No vested interest. If you accrue a benefit for a plan year, you are covered by that plan even if you have no vested interest in (legal right to) the accrual.

Situations in Which You Are Not Covered

Unless you are covered by another employer plan, you are not covered by an employer plan if you are in one of the situations described below.

Social security or railroad retirement. Coverage under social security or railroad retirement is not coverage under an employer retirement plan.

Benefits from previous employer's plan. If you receive retirement benefits from a previous employer's plan, you are not covered by that plan.

Worksheet 1-1. Figuring the Taxable Part of Your IRA Distribution

Reservists. If the only reason you participate in a plan is because you are a member of a reserve unit of the armed forces, you may not be covered by the plan. You are not covered by the plan if both of the following conditions are met.

1. The plan you participate in is established for its employees by:
1. The United States,
2. A state or political subdivision of a state, or
3. An instrumentality of either (a) or (b) above.
2. You did not serve more than 90 days on active duty during the year (not counting duty for training).

Volunteer firefighters. If the only reason you participate in a plan is because you are a volunteer firefighter, you may not be covered by the plan. You are not covered by the plan if both of the following conditions are met.

1. The plan you participate in is established for its employees by:
1. The United States,
2. A state or political subdivision of a state, or
3. An instrumentality of either (a) or (b) above.
2. Your accrued retirement benefits at the beginning of the year will not provide more than $1,800 per year at retirement.

Limit If Covered By Employer Plan

As discussed earlier, the deduction you can take for contributions made to your traditional IRA depends on whether you or your spouse was covered for any part of the year by an employer retirement plan. Your deduction is also affected by how much income you had and by your filing status. Your deduction may also be affected by social security benefits you received.

Reduced or no deduction. If either you or your spouse was covered by an employer retirement plan, you may be entitled to only a partial (reduced) deduction or no deduction at all, depending on your income and your filing status.

Your deduction begins to decrease (phase out) when your income rises above a certain amount and is eliminated altogether when it reaches a higher amount. These amounts vary depending on your filing status.

To determine if your deduction is subject to the phaseout, you must determine your modified adjusted gross income (AGI) and your filing status, as explained under Deduction Phaseout. Once you have determined your modified AGI and your filing status, you can use Table 1-2 or Table 1-3 to determine if the phaseout applies.

Table 1-2. Effect of Modified AGI ¹ on Deduction if Covered by Retirement Plan at Work

If you are covered by a retirement plan at work, use this table to determine if your modified AGI affects the amount of your deduction.

Social Security Recipients

Instead of using Table 1-2 or Table 1-3 and Worksheet 1-3, Figuring Your Reduced IRA Deduction for 2001, later, complete the worksheets in Appendix B of this publication if, for the year, all of the following apply.

• You received social security benefits.
• You received taxable compensation.
• Contributions were made to your traditional IRA.
• You or your spouse was covered by an employer retirement plan.

Use the worksheets in Appendix B to figure your IRA deduction, your nondeductible contribution, and the taxable portion, if any, of your social security benefits. Appendix B includes an example with filled-in worksheets to assist you.

Table 1-3. Effect of Modified AGI ¹ on Deduction if NOT Covered by Retirement Plan at Work

If you are not covered by a retirement plan at work, use this table to determine if your modified AGI affects the amount of your deduction.

Deduction Phaseout

The amount of any reduction in the limit on your IRA deduction (phaseout) depends on whether you or your spouse was covered by an employer retirement plan.

If you were covered. If you were covered by an employer retirement plan and you did not receive any social security retirement benefits, your IRA deduction may be reduced or eliminated depending on your filing status and modified AGI, as shown in Table 1-2.

For 2002, if you are covered by a retirement plan at work, your IRA deduction will not be reduced (phased out) unless your modified AGI is between:

• $34,000 and $44,000 for a single individual (or head of household),
• $54,000 and $64,000 for a married couple filing a joint return (or a qualifying widow(er)), or
• $-0- and $10,000 for a married individual filing a separate return.

For all filing statuses other than married filing a separate return, the upper and lower limits of the phaseout range will increase by $1,000.

If your spouse is covered. If you are not covered by an employer retirement plan, but your spouse is, and you did not receive any social security benefits, your IRA deduction may be reduced or eliminated entirely depending on your filing status and modified AGI as shown in Table 1-3.

Filing status. Your filing status depends primarily on your marital status. For this purpose you need to know if your filing status is single or head of household, married filing jointly or qualifying widow(er), or married filing separately. If you need more information on filing status, see Publication 501, Exemptions, Standard Deduction, and Filing Information.

Lived apart from spouse. If you did not live with your spouse at any time during the year and you file a separate return, your filing status, for this purpose, is single.

Modified adjusted gross income (AGI). You can use Worksheet 1-2 to figure your modified AGI. If you made contributions to your IRA for 2001 and received a distribution from your IRA in 2001, see Both contributions for 2001 and distributions in 2001, later.

Do not assume that your modified AGI is the same as your compensation. Your modified AGI may include income in addition to your compensation such as interest, dividends, and income from IRA distributions.

Form 1040. If you file Form 1040, refigure the amount on the page 1 "adjusted gross income" line without taking into account any of the following amounts.

• IRA deduction.
• Student loan interest deduction.
• Foreign earned income exclusion.
• Foreign housing exclusion or deduction.
• Exclusion of qualified savings bond interest shown on Form 8815.
• Exclusion of employer-paid adoption expenses shown on Form 8839.

This is your modified AGI.

For tax years beginning after December 31, 2001, you also will not take into account any deduction for qualified tuition and related expenses.

Form 1040A. If you file Form 1040A, refigure the amount on the page 1 "adjusted gross income" line without taking into account any of the following amounts.

• IRA deduction.
• Student loan interest deduction.
• Exclusion of qualified bond interest shown on Form 8815.
• Exclusion of employer-paid adoption expenses shown on Form 8839.

This is your modified AGI.

Worksheet 1-2. Figuring Your Modified AGI

Use this worksheet to figure your modified AGI for traditional IRA purposes.

Income from IRA distributions. If you received distributions in 2001 from one or more traditional IRAs and your traditional IRAs include only deductible contributions, the distributions are fully taxable.

Both contributions for 2001 and distributions in 2001. If all three of the following occurred, any IRA distributions you received in 2001 may be partly tax free and partly taxable.

1. You received distributions in 2001 from one or more traditional IRAs, and
2. You made contributions to a traditional IRA for 2001, and
3. Some of those contributions may be nondeductible contributions depending on whether your IRA deduction for 2001 is reduced.

If all three of the above occurred, you must figure the taxable part of the traditional IRA distribution before you can figure your modified AGI. To do this, you can use Worksheet 1-1, Figuring the Taxable Part of Your IRA Distribution.

If at least one of the above did not occur, figure your modified AGI using Worksheet 1-2.

Table 1-4. Table for Use with Worksheet 1-3

How To Figure Your Reduced IRA Deduction

If you or your spouse is covered by an employer retirement plan and you did not receive any social security benefits, you can figure your reduced IRA deduction by using Worksheet 1-3, Figuring Your Reduced IRA Deduction for 2001. The instructions for both Form 1040 and Form 1040A include similar worksheets that you can use instead of the worksheet in this publication.

If you or your spouse is covered by an employer retirement plan, and you received any social security benefits, see Social Security Recipients, earlier.

Note. If you were married and both you and your spouse contributed to IRAs, figure your deduction and your spouse's deduction separately.

Reporting Deductible Contributions

If you file Form 1040, enter your IRA deductions on line 23 of that form. If you file Form 1040A, enter your IRA deductions on line 16 of that form. You cannot deduct IRA contributions on Form 1040EZ.

Self-employed. If you are self-employed (a sole proprietor or partner) and have a SEP-IRA or a SIMPLE IRA, enter your deduction for allowable plan contributions on line 29, Form 1040.

Nondeductible Contributions

Although your deduction for IRA contributions may be reduced or eliminated, contributions can be made to your IRA of up to the general limit ($2,000 for 2001 ($3,000 for 2002 or $3,500 for 2002 if 50 or older) or 100% of compensation, whichever is less) or the spousal IRA limit (if it applies). The difference between your total permitted contributions and your IRA deduction, if any, is your nondeductible contribution.

Example. Sonny Martin is single. In 2001, he was covered by a retirement plan at work. His salary is $52,312. His modified adjusted gross income (modified AGI) is $55,000. Sonny makes a $2,000 IRA contribution for 2001. Because he was covered by a retirement plan and his modified AGI is above $43,000, he cannot deduct his $2,000 IRA contribution. However, he can designate this contribution as a nondeductible contribution by reporting it on Form 8606.

Form 8606. To designate contributions as nondeductible, you must file Form 8606. (See the filled-in Forms 8606 in this chapter.)

You do not have to designate a contribution as nondeductible until you file your tax return. When you file, you can even designate otherwise deductible contributions as nondeductible contributions.

You must file Form 8606 to report nondeductible contributions even if you do not have to file a tax return for the year.

Failure to report nondeductible contributions. If you do not report nondeductible contributions, all of the contributions to your traditional IRA will be treated as deductible. All distributions from your IRA will be taxed unless you can show, with satisfactory evidence, that nondeductible contributions were made.

Penalty for overstatement. If you overstate the amount of nondeductible contributions on your Form 8606 for any tax year, you must pay a penalty of $100 for each overstatement, unless it was due to reasonable cause.

Penalty for failure to file Form 8606. You will have to pay a $50 penalty if you do not file a required Form 8606, unless you can prove that the failure was due to reasonable cause.

Tax on earnings on nondeductible contributions. As long as contributions are within the contribution limits, none of the earnings or gains on those contributions (deductible or nondeductible) will be taxed until they are distributed.

Cost basis. You will have a cost basis in your IRA if there are nondeductible contributions. Your cost basis is the sum of the nondeductible contributions to your IRA minus any withdrawals or distributions of nondeductible contributions.

Commonly, distributions from your traditional IRAs will include both taxable and nontaxable (cost basis) amounts. See Are Distributions Taxable, later, for more information.

Recordkeeping. There is a recordkeeping worksheet, Appendix A, Summary Record of Traditional IRA(s) for 2001, that you can use to keep records of deductible and nondeductible IRA contributions.

Examples -- Worksheet for Reduced IRA Deduction for 2001

The following examples illustrate the use of Worksheet 1-3, Figuring Your Reduced IRA Deduction for 2001.

Example 1. For 2001, Tom and Betty Smith file a joint return on Form 1040. They both work and Tom is covered by his employer's retirement plan. Tom's salary is $40,000 and Betty's is $16,555. They each have a traditional IRA and their combined modified AGI, which includes $2,000 interest and dividend income, is $58,555. Since their modified AGI is between $53,000 and $63,000 and Tom is covered by an employer plan, Tom is subject to the deduction phaseout discussed earlier under Limit If Covered By Employer Plan.

Filled-in Worksheet 1-3. Example 1 of Figuring Your Reduced IRA Deduction

For 2001, Tom contributed $2,000 to his IRA and Betty contributed $2,000 to hers. Even though they file a joint return, they must use separate worksheets to figure the IRA deduction for each of them.

Tom can take a deduction of only $890. He must treat $1,110 ($2,000 - $890) of his contributions as nondeductible.

He can choose to treat the $890 as either deductible or nondeductible contributions. He can either leave the $1,110 of nondeductible contributions in his IRA or withdraw them by April 15, 2002. He decides to treat the $890 as deductible contributions and leave the $1,110 of nondeductible contributions in his IRA.

Filled-in Worksheet 1-3. Example 2 of Figuring Your Reduced IRA Deduction

Using Worksheet 1-3, Figuring Your Reduced IRA Deduction for 2001, Tom figures his deductible and nondeductible amounts as shown on Filled-in Worksheet 1-3, Example 1 of Figuring Your Reduced IRA Deduction for 2001.

Betty figures her IRA deduction as follows. Betty can treat all or part of her contributions as either deductible or nondeductible. This is because her $2,000 contribution for 2001 is not subject to the deduction phaseout discussed earlier under Limit If Covered By Employer Plan. She does not need to use Worksheet 1-3, Figuring Your Reduced IRA Deduction for 2001, since their modified AGI is not within the phaseout range that applies. Betty decides to treat her $2,000 IRA contributions as deductible.

The IRA deductions of $890 and $2,000 on the joint return for Tom and Betty total $2,890.

Example 2. Assume the same facts as in Example 1, except that Tom contributed $2,000 to his Roth IRA and $2,000 to a traditional IRA for Betty (a spousal IRA) because Betty had no compensation for the year and did not contribute to an IRA. Also, their modified AGI, because of capital gains from sales of stock, increased to $156,555. Betty figures her IRA deduction as shown on Filled-in Worksheet 1-3, Example 2 of Figuring Your Reduced IRA Deduction for 2001.

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