How Traditional IRA Phase-Out Limits Work

Hey everybody! I wanted to drop some knowledge on you today about phase outs for Traditional IRA contributions based on how much money you make. If you ever plan on making more than ~90k (or $120k if you’re married) then pay attention!  As always, I am not a tax expert and you should always consult one prior to making any investment decisions or tax

First, the concept. Our fabulous friends in Congress decided that us regular ol’ folks needed ways to lower our tax burden when saving for retirement. So, they passed the Tax Reform Act of 1986 to help us out. *How nice* “What does it do”, you ask? Well, they told the suits over at the IRS that you don’t have to pay taxes on money that you put into a Traditional IRA account until you actually take the money out of the account in retirement. Sweet, right?

So, in theory, if you made $50,000 and put $5,000 into your traditional IRA, you would only have to pay tax on $45,000 (super simple example, excluding other items that reduce your taxable income, such as standard deduction and 401k contributions). However, our friends in Congress didn’t want the super-rich-Romney’s of the world taking advantage of this, because they have enough loopholes as it is. Due to this, the amount that you can write-off (the $5k in my example) is reduced once your income gets to a certain level, assuming that you are covered by a retirement plan at work.

All you care about is how much (if any) you can write-off to reduce your tax liability. So, here’s what ya need to do:

  1. Calculate your Modified Adjusted Gross Income (MAGI). This link should help with that calculation.  If you don’t know your AGI (adjusted, without the modification…gotta love the IRS terms), look at Line 37 on your most recent 1040, and that should give you an idea.  If you have a pretty straight forward tax situation (no self-employment, rental properties, adoption expenses, student loan interest, etc) then all you really need to do is take AGI + IRA contribution = MAGI.  Bam, done!  If you’re more complicated, check out the link and meet us at #2.
  2. Next, you need to know your filing status.  Again, check out your old 1040, Boxes 1-5 towards the top of the first page.  Now, you can find out what MAGI amounts start the phase-out.  For 2013 it is as follows:
    Single and Head of Household: $59k – $69k
    Married (and covered at work): $95k – $115k
    Married (and not covered at work): $178k – $188k
    So, if your MAGI is under the first number, you don’t have to phase-out.  Congratulations, you don’t make enough money for Congress to penalize you.  On the other hand, if your MAGI is higher than the second number, you don’t get to write anything off…congrats on being “rich” in the eyes of Congress.
  3. Now, here is the interesting part for the people that fall in between the MAGI range.  You calculate how much you can write-off based on this handy-dandy formula:  (Highest Dollar Limit of MAGI Range – MAGI) * [Contribution Limit/(Highest dollar limit of phase-out range - Lowest dollar limit of phase-out range)]
  4. What? That didn’t make 100% sense reading it for the first time.  Huh, let’s try to break it down:
    Highest Dollar Limit of MAGI Range – This is the $69k, $115k, and $188k from the phase out amounts in #2
    MAGI- Can’t help much here, you gotta calculate this one. 
    Contribution Limit – How much did you put in the account this year (not gains!).  2013 limit is $5,500
    Highest dollar limit of phase-out range – the 2nd number in the ranges in #2
    Lowest dollar limit of phase-out range – the 1st number in the ranges in #1
  5. Whatever that formula gives you is how much you get to write-off to reduce your taxable income.
  6. Ok, fine, fine, I’ll do an example for you.  Here’s the facts:27, f, brown hair and eyes….oh, wait. Wrong screen.  My bad.  Taxes…got it.

AGI $65,000
Single
$5,500 annual contribution

So, here’s how the formula works out:(69k – 65k) * [(5,500/(69k -59k)] = 4k*0.55 = $2,200.  So, our example results in a $2,200 reduction to taxable income.  Not quite as awesome as $5,500, but it’s still nice to have something to help with retirement savings.

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