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Chapter 6: Business Expenses: 6-3c Retirement Plan Contribution Deductions

Book Title: Concepts in Federal Taxation
Printed By: Yincheng Yan (yxy180035@utdallas.edu)
© 2018 Cengage Learning, Cengage Learning

6-3c Retirement Plan Contribution Deductions

Employees who participate in qualified employer pension plans are allowed to defer
recognition of income paid into and earnings on assets in such plans until they are
withdrawn from the plan. Recall from Chapter 4 that employees’ payments into a qualified
employer-sponsored pension plan are excluded from the employee’s gross income.
Taxpayers who do not have access to an employer-sponsored pension plan have several
options under which they can accumulate assets for retirement in a tax-deferred manner.
(See Chapter 15 for a detailed explanation of these plans.) These retirement plans are
different from employer-provided plans in that the taxpayer makes contributions to the plan
and takes deductions for adjusted gross income for the amounts contributed. As with
employer-sponsored plans, earnings on amounts paid into these plans are deferred until
they are withdrawn. The effect of this arrangement is to reduce adjusted gross income (and
ultimately taxable income) by the amount contributed to the plan, providing the same tax
relief as an employer-sponsored plan. Self-employed taxpayers are allowed to establish
their own separate retirement savings plan (referred to as a Keogh, or H.R. 10, Plan). One
type of plan in which all individuals may participate is an individual retirement account.

Individual Retirement Accounts

An individual retirement account

(IRA) (All taxpayers are allowed to LO 9
contribute up to $5,500 per year of their
earned income to an IRA. A husband Explain the requirements for the deduction of
and wife who both have earned sources contributions to an Individual Retirement
of income may each contribute up to the Account.
$5,500 limit to separate IRA accounts.
An IRA can also be established for a
nonworking spouse. However, the total amount paid into the two IRAs cannot exceed
$11,000, and no one account can receive more than $5,500. If an individual and spouse are
not covered by an employer-sponsored retirement plan, all allowable contributions made to
the plan are deductible for adjusted gross income. The IRA deduction is reduced if one
taxpayer is covered by an employer-provided retirement plan.) is an individual trust account
maintained for the exclusive benefit of an individual or his or her beneficiary. There are three
types of individual retirement accounts: conventional IRAs, Roth IRAs, and Education IRAs.
A conventional IRA can consist of either deductible contributions or nondeductible
contributions. For administrative purposes, a taxpayer who makes both deductible and
nondeductible contributions must maintain a separate IRA account for each type of
contribution. Contributions to Roth IRAs and Education IRAs are nondeductible. Because
the focus of this chapter is on business deductions and deductions for adjusted gross
income, our discussion is limited to the contribution and deduction limits of each IRA. A
more thorough discussion of each IRA is presented in Chapter 15.

Conventional Individual Retirement Account

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All taxpayers are allowed to contribute up to $5,500 (this amount is indexed for inflation) per
year of their earned income to an individual retirement account. In addition, taxpayers who
are at least 50 years old are allowed to make a “catch-up” contribution of $1,000 to their IRA
account. A husband and wife may contribute $11,000 ($5,500 × 2) to two separate IRA
accounts as long as their total earned income exceeds $11,000. The allowance of a
deduction for an IRA contribution that benefits a non-working spouse is referred to as the
Kay Bailey Hutchison spousal IRA. However, the total amount contributed to each account
cannot exceed $5,500.

Example 57

Chong and Ling are married, and each has earned income. Chong makes $19,500
per year, and Ling earns $26,500 per year. What is the maximum amount they can
contribute to their individual retirement accounts?

Discussion: Because both Chong and Ling have earned income, each may
contribute the $5,500 maximum to his or her own account, a total of $11,000.

Example 58

Assume that in example 57, only Ling works and Chong stays home with the
children. What is the maximum amount they can contribute to their individual
retirement accounts?

Discussion: Even though Chong is a nonworking spouse, because their total earned
income exceeds $11,000, they can contribute a total amount of $11,000, with no
more than $5,500 contributed to each account.

Example 59

Assume the same facts as in example 57, except that Chong is 52 years old. What
is the maximum amount Chong and Ling can contribute to their individual retirement
accounts?

Discussion: Because Chong is at least 50 years old, his maximum contribution is

$6,500. Ling’s maximum contribution does not change, and their total contribution
limit is $12,000.

An unmarried taxpayer who is not an active participant in a pension plan is allowed to

deduct his or her entire contribution to an IRA account regardless of the amount of his or her
adjusted gross income. This is also the case for a married taxpayer if both spouses are not
active participants in a pension plan. The effect of the deduction is to reduce a taxpayer’s
earned income by the amount paid into the IRA and provides the taxpayer with the same tax
treatment as an employee who participates in an employer-sponsored contributory pension
plan. Earnings on IRA accounts are deferred until they are withdrawn.

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Example 60

Assume the same facts as in example 57, except that neither Chong nor Ling is
covered by an employer-sponsored pension plan. If they each contribute the
maximum allowable amount to their IRAs, what is their deduction for adjusted gross
income?

Discussion: Because neither Chong nor Ling is covered by an employer-sponsored

pension plan, they may each contribute $5,500 to their plans and deduct $5,500 for
adjusted gross income. This gives them a total deduction of $11,000 for adjusted
gross income. The effect of the deduction is to reduce their individual earned
incomes by the $5,500 contribution. Chong is taxed on only $14,000 ($19,500 −
$5,500) of his earned income, and Ling is taxed on only $21,000 ($26,500 − $5,500)
of her earned income.

Unmarried taxpayers who participate in an employer-sponsored pension plan must reduce

the amount of their IRA deduction proportionately when their adjusted gross income reaches
$63,000 ($62,000 in 2017). The entire deduction must be reduced to zero when adjusted
gross income reaches $73,000 ($72,000 in 2017). For married taxpayers, if both taxpayers
are covered by an employer-sponsored plan, the amount of the IRA deduction must be
reduced when adjusted gross income exceeds $101,000 ($99,000 in 2017) and is reduced
to zero when adjusted gross income reaches $121,000 ($119,000 in 2017). When
adjusted gross income exceeds the top end of the range, no deduction is allowed. A general
formula for calculating the IRA percentage reduction and computing the maximum deduction
for a married couple follows:

Example 61

Assume the same facts as in example 57, except that both Chong and Ling
participate in an employer-sponsored pension plan. Chong and Ling continue to
make the maximum contribution to their IRAs, and they have an adjusted gross
income of $113,000. What is their allowable deduction for the $11,000 they
contribute to their IRAs?

Discussion: Because they both participate in an employer-sponsored pension plan,

Chong and Ling must reduce their $11,000 IRA deduction proportionately for each
dollar of adjusted gross income that exceeds $101,000. The entire deduction is
reduced to zero when adjusted gross income reaches $121,000. Based on the
reduction formula below, Chong and Ling must reduce the amount of their IRA
deduction to $4,400 (i.e., $2,200 each):

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Chong and Ling may still contribute the $11,000 maximum to their IRA accounts. It
is only the amount of the allowable deduction that must be reduced when both
taxpayers are covered by a separate pension plan, not the allowable contribution
amount. The tax benefit of making nondeductible contributions is that the earnings
on the contributions are allowed to accumulate tax-free until they are withdrawn.
Chong and Ling do not have to make the maximum contribution to get the $4,400
deduction. They may choose to contribute only the deductible amount, or they may
contribute another amount less than the $11,000 maximum.

Example 62

Assume the same facts as in example 61, except that Chong and Ling’s adjusted
gross income is $93,000. What is the amount of their IRA deduction?

Discussion: Although they both participate in an employer-sponsored plan, their

adjusted gross income is below the level at which the IRA deduction is reduced.
Therefore, they are allowed to deduct their entire $11,000 contribution.

If only one spouse participates in a qualified pension plan, the other spouse can still receive
a deduction for his or her contribution to an individual retirement account (IRA). However,
the deduction is reduced proportionately when the couple’s adjusted gross income exceeds
$189,000 ($186,000 in 2017) and is reduced to zero when adjusted gross income reaches
$199,000 ($196,000 in 2017).

Example 63

Ling and Chong are married, and each has earned income. Ling participates in an
employer-sponsored pension plan while Chong’s company does not have a pension
plan. Ling and Chong make the maximum contribution to their IRAs and have
adjusted gross income for the year of $130,000. What is their allowable deduction
for the $11,000 they contribute to their IRAs?

Discussion: Because Ling is an active participant in a pension plan and their

adjusted gross income exceeds $121,000, Ling is not allowed a deduction for the
$5,500 contribution to her IRA. However, Chong is allowed a deduction for his
contribution because he is not an active participant in a pension plan and their
adjusted gross income is less than $189,000.

Roth Individual Retirement Account

The major difference between the

nondeductible Roth IRA (Taxpayers are LO 10
allowed to make a $5,500
nondeductible contribution to a Roth Explain the requirements for contributing to a
IRA. Total contributions made to all IRA Roth Individual Retirement Account and a
accounts cannot exceed $5,500 per Coverdell Education Savings Account.

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taxpayer. For an unmarried taxpayer,

the amount that can be contributed to a
Roth IRA is phased out ratably when adjusted gross income exceeds $120,000. No
contribution is allowed when adjusted gross income exceeds $135,000. For married
taxpayers, the amount of the contribution is phased out when adjusted gross income
exceeds $189,000 and is fully phased out when adjusted gross income exceeds $199,000.
The major advantage of a Roth IRA over a conventional nondeductible IRA is that qualified
distributions from a Roth IRA, including the income earned on the IRA assets, are not
included in the taxpayer’s gross income.) and the conventional nondeductible IRA is that
qualified distributions from a Roth IRA, including the income earned on the IRA assets, are
not included in the taxpayer’s gross income. Participation in a qualified pension plan does
not restrict contributions to a Roth IRA. However, the amount contributed to a Roth IRA
must be reduced by any contributions made to a deductible IRA. That is, total contributions
made to all IRA accounts cannot exceed $5,500 per taxpayer. However, as with a
conventional IRA, a taxpayer who is at least 50 years old is allowed an additional “catch-up”
contribution to his or her IRA account. The maximum additional contribution is $1,000.

Example 64

Kathryn and Michael are married and both participate in their employers’ qualified
pension plans. Their adjusted gross income is $80,000, and each contributes
$3,500 to a deductible IRA. What is the maximum amount they each may contribute
to a Roth IRA?

Discussion: The maximum amount they each can contribute to a Roth IRA is
$2,000. Each must reduce her or his maximum Roth IRA contribution amount of
$5,500 by the $3,500 contribution made to the deductible IRA account.

An unmarried taxpayer with adjusted gross income of $120,000 ($118,000 in 2017) or less
is allowed to make a $5,500 nondeductible contribution to a Roth IRA. When the taxpayer’s
adjusted gross income exceeds $120,000 ($118,000 in 2017), the amount that can be
contributed is phased out ratably until no contribution is allowed when adjusted gross
income equals $135,000 ($133,000 in 2017). Married taxpayers with adjusted gross income
of $189,000 ($186,000 in 2017) or less may each contribute $5,500 to a Roth IRA. When a
married couple’s adjusted gross income exceeds $189,000, the amount that can be
contributed is phased out ratably until no contribution is allowed when adjusted gross
income equals $199,000 ($196,000 in 2017). A general formula for calculating the
amount of the allowable Roth IRA contribution for married taxpayers follows:

Example 65

Assume the same facts as in example 64, except that Kathryn and Michael’s
adjusted gross income is $195,000. What is the maximum amount they may

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contribute to their Roth IRAs?

Discussion: Because their adjusted gross income is greater than $121,000, they
cannot make a deductible IRA contribution. They must reduce their $11,000 Roth
IRA contribution proportionately for each dollar of adjusted gross income that
exceeds $189,000. The entire contribution amount is reduced to zero when adjusted
gross income exceeds $199,000. Kathryn and Michael must reduce the amount of
their Roth IRA contribution to $4,400 (i.e., $2,200 each):

Coverdell Education Savings Account

Any taxpayer can make a nondeductible contribution of up to $2,000 to a Coverdell

Education Savings Account (CESA) (A taxpayer can make a nondeductible contribution
of up to $2,000 to a Coverdell Education Savings Account for the benefit of an individual
who is not 18 years of age. The total annual contribution to an individual’s Education
Savings Account is limited to $2,000. The amount an individual can contribute to a Coverdell
Education Savings Account is phased out ratably for married taxpayers filing a joint return
with adjusted gross income between $190,000 and $220,000 and for all other taxpayers
with adjusted gross income between $95,000 and $110,000. The income earned on the
assets accumulates tax-free and is never taxed to the beneficiary if the income is used to
pay qualified education expenses of the beneficiary.) for the benefit of an individual who is
not 18 years of age. However, the total amount contributed to an individual’s CESA is limited
to $2,000. The advantage of establishing a CESA is that the income earned on the IRA
assets will accumulate tax-free and never be taxed to the beneficiary if the income is used
to pay for qualified education expenses. In addition to expenses incurred for higher
education, qualified education expenses include tuition paid for elementary (including
kindergarten) and secondary education at a public, private, or religious school. Qualified
educational expenses also include amounts paid for tutoring, computer technology,
uniforms, transportation, and extended-day programs for a child attending an elementary or
secondary school.

The amount an individual can contribute to a CESA is phased out ratably for married
taxpayers filing a joint return with adjusted gross income between $190,000 and $220,000
and for all other taxpayers with adjusted gross income between $95,000 and $110,000.
A general formula for calculating the allowable CESA contribution for an unmarried taxpayer
follows:

Example 66

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Howard is single, and his adjusted gross income for the year is $98,000. He has two
sons, Jason and Brian, ages 16 and 13, respectively. What amount can Howard
contribute to Coverdell Education Savings Accounts for Jason and Brian?

Discussion: Because Howard’s adjusted gross income exceeds $95,000, the

amount he can contribute to each son’s CESA must be reduced to $1,600:

A comparison of the various types of individual retirement accounts is provided in Table 6-2.

Table 6-2

Comparison of Individual Retirement Accounts

Coverdell Education
Conventional IRA Conventional IRA Roth IRA Savings Account
(deductible) (nondeductible) (nondeductible) (nondeductible)

Unmarried Joint Unmarried Joint Unmarried Joint Unmarried Joint

Maximum $5,500 $11,000 $5,500 $11,000 $5,500 $11,000 Unlimited Unlimited

contribution number of number o
< 50 years beneficiaries beneficia
old at $2,000 at $2,000
each each

Maximum $6,500 $13,000 $6,500 $13,000 $6,500 $13,000 Not Not

contribution applicable applicab
≥ 50 years
old

Phase-out All All All All $120,000 − $189,000 $95,000 − $190,000

ranges for taxpayers taxpayers taxpayers taxpayers $135,000 − $110,000 $220,000
contributions are eligible are eligible are eligible are eligible $199,000

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Coverdell Education
Conventional IRA Conventional IRA Roth IRA Savings Account
(deductible) (nondeductible) (nondeductible) (nondeductible)

Unmarried Joint Unmarried Joint Unmarried Joint Unmarried Joint

Phase-out $63,000 − No limits Not Not Not Not Not Not

ranges for $73,000 applicable applicable applicable applicable applicable applicab
deductibility
$101,000−
$121,000

$189,000−
$199,000

Income tax The entire amount of Only the income earned The entire amount of a The entire amount of a
on any distribution on contributions is qualified distribution qualified distribution
distributions received is taxable taxable when received is tax-free received is tax-free
distribution is received

Chapter 6: Business Expenses: 6-3c Retirement Plan Contribution Deductions

Book Title: Concepts in Federal Taxation
Printed By: Yincheng Yan (yxy180035@utdallas.edu)
© 2018 Cengage Learning, Cengage Learning

© 2019 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means - graphic,
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