IRA Rules Made (Somewhat) Simple

Dear Friends —
I thought I’d head off the perennial IRA questions before I get deluged with frantic emails I can’t answer in time for you to make the April 15 contribution deadline. So here they are: 1) How much can I contribute?; 2) “Can I Deduct it?”; and 3) “Can I do a Roth?”

First, you can only contribute to an IRA if you have “earned” income. This is income from work. If all you have is investment income, you do not qualify.

Regardless what type of Individual Retirement Account you choose, the maximum you can contribute for 2004 is either 100 percent of your earned income or $3,000 — whichever is less. For instance, say you’re a student and from a part-time job last summer you earned $2,800. In this case, since $2,800 is less than $3,000, the most you can put into an IRA is $2,800.

This year the base contribution for an IRA increases to $4,000. If you earn at least that amount from a job, you can contribute the full $4,000 to your 2005 IRA. By the way, you don’t have to wait until next year to do this. If you’ve maxed out your 2004 IRA and have all or some of the money (save that tax refund!) now, you can contribute to your 2005 IRA today. The earlier you can get the money working for you, the better. (See “Attention Mom & Dad” below.)

There is one exception to the above rule: if you are age 50 or older, you can contribute an additional $500 -- over the base amount- to your 2004 and 2005 IRAs. This is the so-called “catch-up” provision aimed at helping folks who were unable to contribute the full amount in previous years make up for lost time.

I’ve said it before and I’ll say it until they change the rules: I’m a big fan of Roth IRAs. If you qualify, you should probably opt for a Roth over a Traditional IRA. Sure, you don’t get to deduct your annual contribution, but your money grows tax-free as opposed to tax-deferred. Unfortunately, not everyone is eligible for a Roth because of the income caps. (Dear Cynics: Even if Congress changed the taxation of Roth withdrawals, it’s likely there would be some provision to “grandfather” the tax-free status of contributions made before the rule change.)

There are also income caps that affect traditional IRAs, but in a different way.

When it comes to IRAs, the number you need to know is your “Modified Adjusted Gross Income” (MAGI). Your MAGI is calculated by taking your Adjusted Gross Income found on Line 36 of tax return Form 1040 and adding back some deductions you were allowed, such as those for tuition and fees, student loan interest, foreign housing, and employer-paid adoption expenses.

For most folks this won’t be a major issue. However, if you’re close to the cut-off level, you’ll want to double-check. There’s a MAGI worksheet in IRS Publication 590 which you can read or download from

Traditional IRA: Your money grows tax-deferred

As long as you were younger than age 70 ½ last year and had earned income, you can have a traditional IRA. The question is whether or not your contribution is deductible.

If you are single and are not covered by a company sponsored retirement plan, your IRA contribution is fully deductible- no matter how much money you make. This is also true if you are married and neither of you has a retirement plan through work.

However, if you participate in a company retirement plan, then your income comes into play to determine if you get to deduct your IRA contribution.

Here are the 2004 income limits for making tax-deductible IRA contributions:

Tax Filing Status MAGI less than Phased out at MAGI of:

Tax Filing Status MAGI less than Phased out at MAGI of
Single/Head of Household $45,000 $55,000
Married, filing Joint $65,000 $75,000
(each spouse covered by a company retirement plan)
Married, filing Separate $10,000 $10,000
(each spouse covered by a company retirement plan)

There’s one more piece to this puzzle: What if you’re married and only one spouse participates in an employer-sponsored retirement plan? This would also apply if one of you is a stay-at-home parent.

In this case, for the spouse who has a plan through work, apply the income limits above to see if his/her IRA contribution is deductible.

However, Bill Wagner, an associate editor with the National Underwriter Company and the author of The Ultimate IRA Resource says a different limit applies to the spouse not covered by a company-sponsored retirement plan. For this spouse the joint income limit becomes $150,000 and phases out by $160,000.

For example, say your joint income is $80,000. Wife has a 401(k), but husband has no retirement plan through his job.

The wife — the spouse with the company plan — cannot deduct her IRA contribution because the couple’s joint income exceeds the 2004 top threshold of $75,000.

However, because their joint income is below $150,000, the husband- who has no plan at work- can deduct his contribution to his IRA.

If you’re wondering why you might want to contribute to a traditional IRA even though your income is too high to give you a tax deduction, see the question from “Gary” below.

Roth IRA: Your money grows tax-free

You do not get to deduct a Roth IRA contribution from your 2004 tax return. The trade-off is that you do not pay income tax when you withdraw your money in retirement. Another important difference is there is no age limit for a Roth. If you’re a senior citizen who is working you can qualify for a Roth even if you’re over age 70 1/2.

Tax Filing Status MAGI less than Phased out at MAGI of:

Tax Filing Status MAGI less than Phased out at MAGI of
Single/Head of Household $95,000 $110,000
Married, filing Joint $150,000 $160,000
Married, filing Separate:
a) and you lived with your spouse for one or more days last year $10,000 $10,000
b) and you did not live with your spouse for a single day last year $95,000 $110,000

Keep in mind that the income limits above are for 2004 IRA contributions. Those associated with traditional IRAs are slightly higher for 2005.

Hope this helps!


Attention Mom and Dad: If you can afford it, consider rewarding an industrious child by making her annual IRA contribution yourself. Nothing in the law says the person who earned the money has to make the contribution. If you can’t afford to contribute the full amount, offer to “match” whatever she sets aside.
First of all, if you choose a traditional, tax-deductible IRA, you’ll save your child a bundle on income tax. The refund alone would make a nice down payment on her 2005 IRA, assuming she’s going to have another job this year.
And, let’s face it, how many students actually save any of the money they earn? Generally, it’s spent on clothes, school, CDs, nose rings… “Retirement” isn’t even on the radar screen of a teenager. This is a way for you to jump-start your child’s retirement security and teach her an important lesson about the magic of compounding.
Starting early is the key. A 20-year old who invests $3,000 in an IRA that earns an average annual return of 8 percent a year, will have $111,696 when he retires at age 67. Waiting until age 30 — just ten years — means that amount will be cut by more than half. Given the same annual return, he’ll end up with $51,737. Hard to believe.
If you’re afraid he’ll be tempted to dip into the money, go with a traditional IRA. There’s no guarantee he won’t raid the account, but that 10% penalty should make him think twice. If you trust his judgment and think it’s better to the income tax now rather than later, a Roth makes sense.

Hi, Gail,

I’m single. If I have income over $150,000 and put $3,000 into a 2004 IRA, would the entire amount including the $3,000 be taxed as income at 59 1/2/ or would only the gain be taxed?



Dear Gary —

As a single person, your income is too high for you to be able to either deduct your contribution to a traditional IRA or make any contribution to a Roth IRA. Your only option for 2004, which you clearly understand, is a non-deductible contribution of $3,000 to a traditional IRA.

Another way to look at this is that the $3,000 contribution comes from “after-tax” money.

You will not be taxed twice on this.

The IRA rules are ridiculously complex and confusing and there are lots of different ages at which certain events can or must occur. However, regardless of your age, money in a traditional IRA is not taxed until withdrawn. Age 59 1/2 only comes into play in terms of the extra 10 percent “early withdrawal” penalty. Provided you do not take any money from your IRA until you are at least 59 1/2, you will avoid this.

When you do take a withdrawal, you will not have to pay income tax on the entire amount. It will be reduced by a fraction that represents the after-tax portion of your IRA. For instance, let’s say for the rest of your career you only qualify to make non-deductible contributions to your IRA. You do this for 20 years, contributing a total of $60,000.

After age 59 1/2 you start taking withdrawals from your IRA which is now worth $240,000. It consists of: 1) tax-deductible contributions you made when your income was lower; 2) $60,000 in after-tax contributions you made when you hit the big time; and 3) earnings on all of your annual contributions.

You have not paid income tax on your deductible contributions or any of the earnings in your IRA. However, you paid income tax on 25 percent of your IRA (60,000/240,000). As a result, 25 percent of each withdrawal, will not be taxed. On a $6,000 withdrawal, you would pay income tax on $4,500.

Be sure to save your tax returns for each year you make a non-deductible contribution in case you need to prove that this amount should not be taxed again.

You’re smart to make an IRA contribution even though it’s not deductible because the earnings on this can still be sheltered from taxation for as long as they are in the account.

Best wishes,


Dear Gail,

Enjoy your articles. I have a question regarding a Roth IRA.

In 1998 I converted some of the money from a traditional IRA to a Roth by paying the taxes due. Last year (2004) I converted an additional amount to the Roth. I’ve read that the IRS looks at the original conversion date (1998 in my case) when applying the 5-year rule to withdrawals. So I believe I can withdraw both the amounts converted in 1998 and 2004 without incurring a penalty.

I can’t fine anyone who can answer this for me, including several other “experts” on the internet. Can you please help? I’m 46 years old.



Dear Scott —

STOP! You are not correct. You are confusing your “5-year” rules. It would take another column — or two! — to explain the ins and outs of Roth IRA conversions, so let me just stick to your particular issue.

Regular, annual Roth IRA “contributions” can be withdrawn at any time and at any age without owing income tax or a penalty. You can take the money out the day after you put it in without any adverse consequences.

However, a different rule applies to amounts that are “converted” from a traditional IRA to a Roth. Like annual Roth IRA contributions, converted amounts can be withdrawn at any time without owing income tax. Why? Because you already paid when you made the conversion!

But even if you escape income tax on this amount, you might still be hit with a 10-percent penalty if the converted money has not been in your Roth IRA for at least 5 years.

Here’s the important thing to remember: there is a separate 5-year waiting period for each conversion.

Once converted amounts have been in a Roth for 5 years, they are essentially re-classified as “contributions” and can be withdrawn without income tax or a penalty. Your 1998 conversion clearly meets this test.

However, your 2004 conversion does not. If converted assets are withdrawn from a Roth before the 5-year waiting period is up, you will be assessed a 10% penalty unless once of the following is true:

— You are at least age 59 1/2

— You’re dead and your beneficiary is taking out the money

— You are disabled

— You are using the money to buy a “first time” home

— You are using the money to pay for medical expenses that exceed 7.5 percent of your adjusted gross income

— You are paying qualified college expenses for yourself, your spouse or your child

— You are taking the money out as “substantially equal periodic payments”

The good news is you’re not dead. But you’re also not 59 1/2. And unless one of the other exceptions applies in your case, your withdrawal will get tagged with the penalty.

I’m sorry you had a tough time getting an answer, but I’m not surprised. At the riskof repeating myself, I have to say that the rules governing IRAs are mind-numbing in their complexity. Regardless what you think of the mechanics of his plan, I applaud President Bush for trying to simplify the rules regarding company and individual retirement accounts.

Take care,


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