MAGI, IRA, tax alphabet soup: What am I missing about deducting contributions?
Q. Hi Dan. I’m looking at making an IRA contribution for 2023 for my wife. We are both in our 40s. I save in a 401(k) but my tax software is saying I can’t deduct any of the contribution for her. I see a phaseout range of $218,000-$228,000 for our situation (she’s a stay-at-home mom) but my salary isn’t over $228,000, so I think I should be able to deduct a partial contribution. I must be missing something. What might that be? — Bob in Cocoa Beach
A. Hi, Bob. The $218,000 to $228,000 phaseout range applies when one spouse is not covered under an employer retirement plan as would be the case if your wife did not work in 2023. If both spouses are covered by an employer plan, a lower phaseout range applies. My guess is you or your wife have other income besides your salary. The deductibility of an IRA contribution depends on “Modified Adjusted Gross Income” (MAGI), not just one’s salary.
The MAGI calculation starts with your Adjusted Gross Income, Line 11 on your Form 1040. This is basically the sum of all income, which commonly can include items like dividends, interest, capital gains, rental income, self-employment income, taxable alimony, Social Security, pensions, annuity income, and a few more things. The AGI is then adjusted or “modified” further to get to the MAGI.
There are several items in the tax code that use MAGI as a trigger. To complicate things, MAGI is not calculated in a uniform manner for all these items. With respect to deductibility of an IRA contribution, you modify the AGI by adding a few items to AGI. See Worksheet 1 of IRS Publication 590-A for these items and the calculation process.
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If that MAGI is over $228,000, you cannot deduct any contribution to an IRA for your wife. If it were between $218,000 and $228,000, you could only deduct a smaller IRA contribution for her.
Say, for instance, your MAGI came in at $223,000, smack-dab in the middle of the phase-out range. You could make a deductible contribution of up to $3,250, half the normal maximum $6,500 contribution. You could then opt to contribute up to an additional $3,250 but that contribution of $3,250 would be non-deductible. The allowable deductible contribution is calculated on Worksheet 2 of IRS Publication 590-A.
Like so many tax issues, whether it is a good idea to make non-deductible contributions to an IRA or not varies. An IRA is a tax deferred account. This can be beneficial if you anticipate your tax bracket will be lower when you withdraw funds as is often the case when people retire.
One downside is a rather infamous provision dubbed the “pro-rata rule.” The pro-rata rule dictates that any distribution is deemed part a return of already taxed contributions and part not yet taxed earnings. This makes a portion of every distribution taxable and another non-taxable. The proportion changes as the balance of the IRA changes and is accounted for on Form 8606 every year until there is no more IRA money.
Filing an 8606 year after year strikes many people as a hassle, particularly households that were only able to make a few non-deductible contributions. For others, it is just another form and not much of a chore. There are ways to get off the 8606 train, but they are not applicable to all taxpayers.
Dan Moisand, CFP®, was the 2023 chairman of CFP Board, the organization that grants and administers the CERTIFIED FINANCIAL PLANNER™ designation for the more than 100,000 CFP® professionals in the U.S., a past national president of the Financial Planning Association, and has been featured as one of America’s top financial planners by at least 10 financial planning publications. He can be reached at www.moisandfitzgerald.com or 321-253-5400, ext. 101.
This article originally appeared on Florida Today: I've got taxing questions on our 2023 return: Where do I start?
