IRA Phase-Out Rules: What You Need to Know

Individual Retirement Accounts (IRAs) are an essential component of many Americans’ retirement strategies. However, the tax advantages of IRAs can be limited by phase-out rules tied to income levels. Understanding these rules is crucial for optimizing retirement savings and maintaining compliance with IRS regulations.

Phase-out rules vary based on filing status and whether contributions are made to a Traditional or Roth IRA. Familiarity with these thresholds enables individuals to make better decisions about their retirement planning.

Phase-Out Income Thresholds

Phase-out income thresholds dictate how much individuals can contribute to or deduct from their IRAs based on their adjusted gross income (AGI) and filing status.

Single Filers

For single filers in 2023, the deduction for contributions to a Traditional IRA phases out between a modified adjusted gross income (MAGI) of $73,000 and $83,000 if the individual is covered by a workplace retirement plan. Beyond $83,000, no deduction is allowed. For Roth IRAs, the phase-out range is $138,000 to $153,000, with contributions prohibited above $153,000. Taxpayers within these ranges should calculate contributions carefully to maximize benefits and may consider strategies like backdoor Roth conversions if direct contributions are not an option.

Married Filing Jointly

Couples filing jointly face different thresholds. In 2023, for those covered by an employer-sponsored retirement plan, Traditional IRA deductions begin to phase out at a MAGI of $116,000 and end at $136,000. For Roth IRAs, the phase-out range is $218,000 to $228,000. If only one spouse is covered by a workplace plan, the non-covered spouse can make a fully deductible Traditional IRA contribution if the couple’s MAGI is below $218,000. Couples can explore strategies like spousal IRAs or Roth conversions to optimize savings within these limits.

Married Filing Separately

Taxpayers filing separately face stricter thresholds. In 2023, if either spouse is covered by a workplace retirement plan, the deduction for Traditional IRA contributions phases out between a MAGI of $0 and $10,000. For Roth IRAs, the phase-out range is also $0 to $10,000. This effectively eliminates the ability to contribute or deduct in most cases, making alternative savings strategies, such as health savings accounts (HSAs) or taxable investment accounts, more viable options.

Traditional vs. Roth Limits

For 2024, the annual contribution limit for both Traditional and Roth IRAs is $7,000, with an additional $1,000 allowed for those aged 50 and older. These limits apply to the total contributions across all IRAs in a given tax year.

Traditional IRAs offer tax-deferred growth, with contributions potentially deductible depending on income and access to other retirement plans. Withdrawals in retirement, however, are taxed as ordinary income. Roth IRAs, funded with after-tax dollars, provide tax-free withdrawals in retirement, making them appealing for those expecting higher future tax rates. Additionally, Roth IRAs do not require minimum distributions (RMDs) during the account holder’s lifetime, offering greater flexibility.

Deduction Restrictions

Deduction restrictions for Traditional IRA contributions depend on filing status, MAGI, and access to employer-sponsored retirement plans. Individuals without access to workplace plans can generally deduct full contributions. Those with access must adhere to IRS-set MAGI thresholds, which are updated annually.

For married couples, deduction eligibility becomes more nuanced when only one spouse is covered by a workplace plan. The non-covered spouse can still claim a full deduction if the couple’s MAGI is below a specified limit. Joint financial planning is crucial to ensure contributions are strategically allocated for maximum tax benefits.

Effects of Exceeding Limits

Exceeding IRA contribution limits results in a 6% excise tax on the excess amount each year it remains in the account. For instance, contributing $1,000 over the $7,000 limit would incur a $60 penalty annually until corrected.

To address excess contributions, taxpayers can withdraw the surplus and any associated earnings before the tax filing deadline or recharacterize the excess to another eligible retirement account. Withdrawn earnings are subject to income tax and may incur a 10% early withdrawal penalty if the account holder is under 59½.

Coordination with Employer Plans

Participation in employer-sponsored retirement plans affects IRA eligibility and deductions. Those covered by workplace plans face income-based restrictions on Traditional IRA deductions. For example, single filers earning above $83,000 in 2023 cannot deduct Traditional IRA contributions. However, individuals not covered by workplace plans—or whose spouses aren’t covered—may still qualify for full deductions.

Roth IRA contributions, by contrast, are unaffected by workplace plan participation and depend solely on income thresholds. For individuals exceeding Traditional IRA deduction limits due to workplace plan participation, Roth IRAs or employer-sponsored Roth 401(k)s may provide attractive alternatives with higher contribution limits.

Penalties for Ineligible Contributions

Making ineligible IRA contributions can result in penalties that diminish the account’s benefits. The most common penalty is the 6% excise tax on excess contributions, which applies annually until corrected. For example, a $1,000 excess contribution left unaddressed for three years would result in $180 in penalties, excluding taxes on earnings.

To avoid penalties, taxpayers can withdraw excess contributions and associated earnings before the tax filing deadline or recharacterize contributions to another eligible IRA. Timely corrective actions are essential to mitigate financial consequences, and consulting a tax professional can help ensure compliance with IRS rules.