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Retirement Perspectives

Understanding what being an "active participant" means may surprise you—and help your nest egg.

With tax time fast approaching, I often encounter confusion about what can and cannot be done with traditional IRAs and defined contribution [DC] plans in different scenarios. So, here are some pointers that might help you juggle the two.

The traditional individual retirement account (IRA) was created in 1974 through the passage of Employee Retirement Income Security Act (ERISA) thus making traditional IRAs the oldest and most common type of IRA. In mid-2017, for example, 35.1 million (27.8%) U.S. households owned traditional IRAs, according to the Investment Company Institute.

Traditional IRA rules, including eligibility, have changed through their 40-plus-year history. Originally, they could accept annual contributions not exceeding the lesser of $1,500 or 15% of earned income—but only from employees who were not covered by an employer’s qualified plan. Then, in 1981, Congress loosened the rules to let anyone deduct an IRA contribution, whether covered by an employer plan or not and increased the contribution limit to $2,000. The deductibility rules were tightened in by the Tax Reform Act of 1986, while also creating nondeductible (aftertax) contributions for the first time.

Each tax year, an eligible investor may contribute up to a certain limit, which, for both 2017 and 2018 is $5,500, plus $1,000 catch-up for those investors age 50-plus. The aforementioned limits are in addition to employer plan salary deferrals (e.g., 401(k), 403(b), 457, and SIMPLE IRA), if any. In addition, tax law allows taxpayers to fund their IRAs for the prior tax year until their tax-filing deadline.

By way of example, a taxpayer can make a 2017 IRA contribution until April 17, 2017 (due to the fact that the regular date of April 15 falls on a Sunday this year, and on the following business day, Monday, April 16, Emancipation Day is being observed in Washington, D.C.)

Deducting Your Traditional IRA Contributions
This (tax season) is traditionally the time of the year when a majority of IRA contributions are made. Contributions to a traditional IRA can be made with pretax and/or aftertax dollars, which leads to the inevitable question of what determines the deductibility of traditional IRA contributions.

If you are covered by an employer-sponsored plan and your household income exceeds certain government-imposed limit then you are not eligible to deduct your IRA contributions. However, if you, or if married your spouse are not an active participant (in an employer plan), then you can deduct your IRA contribution, regardless of household income.

When is an individual considered an “active participant” in an employer-sponsored plan for determining IRA deductibility? What kinds of plans are considered employer-sponsored plans? Before exploring those questions, it should be noted that the IRS phase “covered by a retirement plan” may be synonymous with active participant for determining traditional IRA deductibility.

An active participant generally is considered an individual in an employer-sponsored retirement plan if he/she receives a contribution under a defined contribution (DC) plan, or is not excluded from participation from a defined benefit plan. For this purpose, DC plans include SEP, SIMPLE, and SAR SEP; 403(b); certain government plans; 401(k)s; profit sharing; stock bonus; money purchase; ESOP; and target benefit plans. The final determination of whether individuals are deemed active participants depends on the type of plan sponsored by their employer.

Generally, if on your W-2 form you check box 13 “Retirement Plan,” you will be considered an active participant for the purpose of making a deductible IRA contributions. The IRS also cautions that special limits may apply to the amount of traditional IRA contributions you may deduct. See IRS publication 590-A, “Contributions to Individual Retirement Arrangements (IRAs).”

The table below outlines more specifics.

 

Table 1. How to Tell Whether You Are Covered by an Employer Plan


Source: Denise Appleby, www.retirementdictionary.com

 

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

125 Plan.  A cafeteria plan is a separate written plan maintained by an employer for employees that meets the specific requirements of and regulations of section 125 of the Internal Revenue Code. It provides participants an opportunity to receive certain benefits on a pretax basis. Participants in a cafeteria plan must be permitted to choose among at least one taxable benefit (such as cash) and one qualified benefit.

A qualified benefit is a benefit that does not defer compensation and is excludable from an employee’s gross income under a specific provision of the Code, without being subject to the principles of constructive receipt. Qualified benefits include the following: accident and health benefits (but not Archer medical savings accounts or long-term care insurance); adoption assistance; dependent care assistance; group-term life insurance coverage; and health savings accounts, including distributions to pay long-term care services.

qualified HSA funding distributions (QHFD) is a distribution from a traditional IRA or a Roth IRA , that is made to the individual’s Health Savings Account (HSA) as a contribution. This is a one-time contribution, which must be made in a direct trustee-to-trustee transfer. 

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