Disallowed IRA Deduction
My 39 year old married daughter received a tax assessment in 2008 for a $4,000 IRA deduction claimed on her 2006 return. She had income of $38,000 from her employer that did not provide a pension plan, however she worked three days as a substitute teacher for a school where there was a pension plan and earned about $400. Because of the $400 of earnings, her entire $4,000 IRA contribution was disallowed. One would think that the IRS would allow a contribution based upon the percentage of earnings from the employer who did not have a pension plan. The interest and possible additional penalties wipe out the earnings as a substitute teacher. This hardly seems fair, but is that how the regulations should be interpreted? She paid the assessment, but I feel it should be challenged if the regulations permit it. Otherwise, I assume she should take a distribution of it less the losses because of the stock market crash in order to avoid the 6% penalty.
Permalink Submitted by Anonymous (not verified) on Thu, 2009-02-19 23:20
Individuals covered by an employer’s plan cannot make deductible IRA contributions unless their modified adjusted gross income is $85,000 or less if married filing jointly, or $53,000 or less if single or head of household. A partial contribution is allowed for modified adjusted gross income higher than the figures cited above. Married persons filing separate returns have a reduced contribution when modified adjusted gross income is in the range of $0 to $10,000.
She could file a late Form 8606 to treat it as a nondeductible IRA or remove it as you describe.
There have been tax court cases where the individuals earned less than $400 and tried to get a contribution deduction and did not prevail. There’s no wiggle room.
Permalink Submitted by Anonymous (not verified) on Thu, 2009-02-19 23:54
Mary, thank you very much for your advise; much appreciated.
Permalink Submitted by Anonymous (not verified) on Fri, 2009-02-20 03:34
[quote=”Mary Kay Foss CPA”]Individuals covered by an employer’s plan cannot make deductible IRA contributions unless their modified adjusted gross income is $85,000 or less if married filing jointly, or $53,000 or less if single or head of household. A partial contribution is allowed for modified adjusted gross income higher than the figures cited above. Married persons filing separate returns have a reduced contribution when modified adjusted gross income is in the range of $0 to $10,000.
She could file a late Form 8606 to treat it as a nondeductible IRA or remove it as you describe.
There have been tax court cases where the individuals earned less than $400 and tried to get a contribution deduction and did not prevail. There’s no wiggle room.[/quote]
What am I missing here? As a substitue teacher working only 3 days earning $400, I doubt the writer was covered by the school pension plan. Moreover, if the lady earned $38,000 plus the $400, her income is $38,400, well below the $53,000 cited above to be eligible to make a deductible IRA.
Permalink Submitted by Anonymous (not verified) on Sat, 2009-02-21 01:22
Either she was covered by a DB plan which would be reflected by a retirement plan box being checked on the W2 OR perhaps her spouse earned enough to elevate their joint modified AGI past the upper threshold. If that happened she could not take a deduction even if she was NOT covered by a plan.
However, she cannot remove the contribution tax free because the deadline has passed for return of contributions and this is NOT an excess contribution, it is just not deductible. Therefore, Form 8606 should be filed to report the basis. There is no reason or benefit to taking a distribution now, and no way to avoid the higher tax bill for 2006 due to loss of the deduction. Filing the 8606 will at least prevent double taxation of future distributions.
Permalink Submitted by Anonymous (not verified) on Sat, 2009-02-21 01:28
It’s worth a shot to see if this is the situation: 1) Is the school retirement plan operated on a fiscal year basis, say with a May or June plan year end? 2) If that’s the case and if the employee worked those 4 days in Sept-December of 2006, then the X should go in the retirement plan box on her 2007 W-2, instead of her 2006 W-2.
Most of the particulars of active participant status are found in Notice 87-16. The status is based on the plan year ending with or within the employee’s tax year. So especially in a smaller school district, they could have made this mistake. And if this is the case, hopefully it wouldn’t mess up any IRA she may have done for 2007.
Permalink Submitted by Anonymous (not verified) on Sat, 2009-02-21 02:17
In my area the schools treat all employees as covered by a plan, even substitutes that work only a few days per year.
You often see this problem when someone works for an employer with a 401k plan and chooses not to participate. IRS considers this as being covered by a plan with a zero deferral percentage – so the retirement plan box is checked and IRAs are disallowed.
Permalink Submitted by Anonymous (not verified) on Sat, 2009-02-21 03:13
Most likely the original question has to do with a defined benefit plan. In a DB plan it’s merely being eligible that causes active participant status to kick in. Often state teacher plans make a person eligible from day one. The employee may never get any benefit out of the plan except his own contributions back. These are usually mandatory contributions under 414(h). But even with no employee contribution or even refusal to be in the plan, the active participant designation remains.
In a defined contribution plan such as a 401(k), on the other hand, there must be an allocation of an employer contribution or an employee contribution or a forfeiture for the year, in order to attain the active participant status. Earnings don’t count. If a person didn’t receive any such allocation, she counts for purposes of meeting the plan’s coverage requirements and is sometimes included in the nondiscrimination testing. But this person is not an active participant.
Permalink Submitted by Anonymous (not verified) on Sat, 2009-02-21 17:33
My thanks to everyone for helping me understand my daughter’s problem. To further clarify her situation, she filed a joint return with her husband who was not covered by a retirement plan and their joint MAGI exceeded $85,000. Like the school district in Mary Kay Foss’s area, my daughter’s school district treats all teachers as being under a retirement plan even if they only worked a few hours. Had she have known the ramification of working those three days in 2006, she would not have worked them.