Accounting

Tax 101: 2021 IRA basics

April calendar on top of 1040 Tax form

Did you contribute the maximum amount allowed to your individual retirement account (IRA) in 2021? If not, there’s still time! The IRS allows taxpayers to make 2021 IRA contributions through April 15, 2022. For tax years 2021 and 2022, taxpayers can contribute the lesser of $6,000 or earned income for the year. The contribution amount increases to $7,000 for taxpayers who are age 50 or older by the end of the tax year.

However, calculating the deduction for contributions to IRAs is tricky, and factors such as the taxpayer’s level of income and whether the taxpayer or the taxpayer’s spouse has an employer-sponsored retirement plan affect the amount of the allowed deduction. There are also three types of IRAs - let’s review the basics!

Types of IRAs

There are three types of IRAs: deductible traditional, nondeductible traditional and Roth. The most important distinction among the three types of IRAs is how contributions and withdrawals are taxed. Traditional deductible IRA contributions are made with pretax dollars, so retirement withdrawals are fully taxed. Contributions to a traditional nondeductible IRA are made after tax, so retirement withdrawals are taxed to the extent of income earned on the contributions. Roth IRA contributions are made with after-tax dollars, and retirement withdrawals of both contributions and earnings that meet certain rules are tax free. In addition, there are layers of rules and limitations that must be considered for each type of IRA.

  1. Deductible traditional IRA
    Contributions to traditional IRAs are tax deductible. Therefore, withdrawals from traditional IRAs are taxed as ordinary income. Taxpayers take the deduction on Form 1040 as an above-the-line deduction. The deduction for a traditional IRA contribution is limited if the taxpayer or the taxpayer’s spouse participates in an employer-sponsored plan. If the taxpayer participates in an employer-sponsored retirement plan, the AGI phaseout ranges for 2021 are as follows:

Filing Status

2021 AGI Phaseout

Unmarried

$66,000-$76,000

Married filing jointly

$105,000-$125,000

 

If a married taxpayer does not participate in an employer’s retirement plan but the taxpayer’s spouse does, then the 2021 phaseout ranges for the spouse who does not participate in an employer’s retirement plan are as follows:

Example:  Phaseout of traditional IRA deduction

Scenario: Lucy, a 40-year-old single taxpayer, is an active participant in her employer’s pension plan. Lucy’s 2021 AGI is $67,000. Calculate Lucy’s maximum IRA deduction.

Solution:  Lucy’s maximum 2021 IRA deduction is $5,400, calculated as follows:

 

2021 AGI

$67,000

Less phaseout threshold

($66,000)

Excess over phaseout threshold

   $1,000

Divided by $10,000 phaseout range

/$10,000

Phaseout percentage

10%

x maximum IRA deduction allowed

$6,000

Phaseout amount

$600

2021 allowed IRA deduction

$5,400

 

Bonus question: What would Lucy’s maximum IRA deduction if she did not participate in an employer-sponsored retirement plan?

Answer: $6,000. Lucy would not be subject to the AGI limitations if she did not participate in an employer-sponsored retirement plan.

 

  1. Nondeductible traditional IRA
    If a taxpayer’s deductible contributions to a traditional IRA are limited, then nondeductible contributions may be made instead. Keep in mind that the overall $6,000 (or $7,000 if over age 50) limit still applies. When the taxpayer receives retirement distributions from the IRA, only the earnings on the contributions are taxed. Because the contributions to the IRA were not deducted, the taxpayer receives this amount in retirement distributions tax free. This concept, called the return of capital principle, runs throughout our tax laws.

 

  1. Roth IRA
    Contributions to a Roth IRA are not tax deductible when made. Distributions of both principal (contributions made to the Roth) and earnings are also tax free if certain rules are met. The ability to contribute to a Roth IRA is limited by modified adjusted gross income (MAGI) for 2021 as follows:

Filing Status

2021 MAGI phaseout

Unmarried

$125,000-$140,000

Married filing jointly

$198,000-$208,000

Married filing separately

$0-$10,000

 

While the return of capital principle dictates that all distributions of Roth IRA contributions are tax free, only qualified distributions of earnings are not taxable. For distributions of earnings from a Roth IRA to be tax free, the distributions must be made at least five years after the first contributions to the Roth IRA and after the taxpayer reaches age 59 1/2.

 

Backdoor Roth IRA conversion

A backdoor Roth IRA refers to when a taxpayer contributes to a traditional IRA or an employer-sponsored plan and then converts to a Roth IRA. While traditional IRAs have no adjusted gross income (AGI) limitation on contributions, Roth IRAs do limit who can participate based on income. This tax planning strategy allows wealthy taxpayers, who otherwise would not be allowed to contribute to a Roth IRA, a back door into a Roth IRA. The Build Back Better Act that was passed by the House in November 2021 proposes an AGI limitation on traditional IRA to Roth IRA conversions and employer-sponsored plan to Roth IRA conversions. While we do not know yet the fate of the Build Back Better Act, we do know that legislators are thinking about limiting this type of Roth IRA conversion. Taxpayers who are considering converting a traditional IRA to a Roth should execute the conversion sooner rather than later.

 

Early distributions

Distributions from all three types of IRAs taken before the age of 59 ½ are subject to a 10% penalty in addition to applicable tax. There are exceptions that allow penalty-free distributions before age 59 ½ for qualifying medical expenses, qualifying higher education expenses and first-time home-buying expenses up to $10,000.

 

In summary…

Now is a great time to review 2021 IRA contributions as a tax planning tool. Taxpayers who have not made the maximum contribution for the 2021 tax year have until April 15, 2022 to do so. It’s a win-win! Taxpayers can reduce tax liability while saving for the future.

Filing Status

2021 MAGI phaseout

Unmarried

$125,000-$140,000

Married filing jointly

$198,000-$208,000

Married filing separately

$0-$10,000

 

The Becker Tax Resource Center is a guide to help you navigate through the tax season. For more tax resources and information, check out our page to explore all of Becker’s tax law resources available to you.

 

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