401(k) Participation Wipes Out Taxpayer’s Deduction for IRA Contribution

An employee’s contribution of a little less than $1,400 to a 401(k) offered through her employer proved costly, as that contribution made the employee qualify as an active plan participant for tax purposes and that status, along with the size of her income, made her ineligible to claim a deduction for the $5,000 she also contributed to an IRA during that same year.

In 2008, Rebecca Smackey Hurd worked for two employers. Hurd was not covered by an employee retirement plan at the first job, but was covered at the second job, where she contributed $1,373 to a 401(k). During that same year, Hurd also contributed $5,000 to her IRA. Hurd deducted the $5,000 contribution from her 2008 taxes. The IRS disallowed the deduction and assessed a deficiency.

The US Tax Court agreed with the IRS. While Section 219 of the Tax Code generally permits taxpayers to deduct contributions to an IRA up to a certain limit, the law also imposes further restrictions on that deduction in cases where the “taxpayer is an ‘active participant’ in a qualified pension plan.” The law defines active participants to include any employee makes a voluntary or mandatory contribution to an employer pension plan. Section 219(g) also contains an income phase-out for active plan participants. For single filers like Hurd, the deduction was completely phased out for taxpayers earning more than $63,000. Hurd’s $1,373 contribution to the 401(k) available through the second employer made her an active participant and, because she earned more than $86,000 in 2008, the IRS contribution deduction was completely phased out for her, according to the court.

Hurd attempted unsuccessfully to persuade the court that she was not an active participant since her second employer did not match her $1,373 401(k) contribution and her interest in the 401(k) had not vested. The court pointed out that the regulations implenting Section 219 made clear that an employee’s contribution triggered “active participant” classification, whether or not the employer provided any sort of matching. Futhermore, the language of the statute itself, specifically Subsecion 219(g)(5), stated that vesting status was also immaterial to determining whether or not an employee was an active plan participant.

The taxpayer also failed to persuade the court that it should not deem her an active participant since she did not participate in a plan with her first employer. The court explained that any amount of participation for any portion of the year was enough to trigger “active participant” status. To hammer home this point, the court noted that, in a 2001 decision, an employee who made only an $84 mandatory contribution and who was unlikely to ever receive any plan benefits was still declared to be an active participant.

In the end, Hurd made the contribution, which made her an active participant, regardless of her vesting or the employer’s contribution. Because her income far exceeded to phase-out cap, she was not entitled to the deduction and the IRS’s imposition of the deficiency was proper.

Contributions to retirement plans can provide significant tax advantages if conducted properly. To ensure that you are managing your retirement plans in a manner that is the most tax-advantageous to you, talk to the experienced tax attorneys at Samuel C. Berger, P.C. and CPAs at S.C. Berger, P.C. Their in-depth knowledge and experience can help you get the most from your retirement plan contributions. To consult our attorneys and CPAs, contact us online or call (201) 587-1500 or (212) 380-8117.

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