This is the time of the year that most individual retirement account contributions are being made, but they may or may not be deductible. If you are active in a company plan, and your income exceeds certain amounts, then you cannot deduct your IRA contribution. If you are not an active participant, then you can deduct your IRA contribution regardless of your income.
This is the time of the year that most individual retirement account contributions are being made, but they may or may not be deductible. If you are active in a company plan, and your income exceeds certain amounts, then you cannot deduct your IRA contribution. If you are not an active participant, then you can deduct your IRA contribution regardless of your income.
This sounds simple, but a U.S. Tax Court case ruling last November will change what you thought you knew about the active-participation rules. The case highlights a situation where an employee was not eligible to make a contribution to the company plan for 15 years but still was considered an active participant and thus was denied a tax deduction for the IRA contribution.
This is the story of Patricia Marie Colombell, who was denied a tax deduction on her 2002 tax return for her $3,500 IRA contribution, even though she was not permitted to participate in her employer’s plan and did not ever participate in the plan — or so she thought.
After the IRS denied her tax deduction, she went to Tax Court to fight her case, but she lost when the court sided with the agency. The court held that she was an “active participant” in a plan.
When inactive is active
She lost her case because the tax law definition of an active participant in a company plan actually can include employees who are not active in the plan.
This is something that all advisers need to be aware of before any client attempts to claim a tax deduction for their IRA contribution.
If you are considered to be an active participant in a company plan, and your income is above certain limits, then you cannot take a tax deduction for your traditional IRA contribution. Here are the current limits:
For tax year 2006 — married/ joint, $75,000 to $85,000; single or head of household, $50,000 to $60,000.
For tax year 2007 — married/ joint, $83,000 to $103,000; single or head of household, $52,000 to $62,000.
This phaseout only applies to those who are active in a company retirement plan.
If you are not covered by a company plan, but your spouse is covered, the phaseout range for you is $150,000 to $160,000 for 2006 and $156,000 to $166,000 for 2007. If you file married-separate, your phaseout range is $0 to $10,000.
This applies only to traditional IRAs. There is no tax deduction available for Roth IRA contributions. If a tax deduction cannot be claimed, then the contribution still can be made, regardless of income, but it will be a non-deductible IRA contribution.
That will create basis in the IRA, which eventually can be withdrawn tax free under the pro-rata rule where every dollar withdrawn will be part tax free and part taxable, based on the percentage of all non-deductible IRA contributions made over the entire balance in all traditional IRAs (including simplified employee pension plans and savings incentive match plans for employees).
Here are the particulars of the Tax Court case, William Edward Colombell, et ux., v. Commissioner: Mrs. Colombell worked part time as an emergency-room nurse for Fairfax, Va.-based Inova Health System for 15 years. The company had a cash balance plan (a type of defined benefit plan), and participation in the plan was both automatic and mandatory, but employees would receive pension credit only for years they worked at least 1,000 hours.
Mr. and Mrs. Colombell’s joint 2002 adjusted gross income exceeded that year’s limits for taking a tax deduction for those who are active participants in a company plan. They each made $3,500 IRA contributions for the year, but Mr. Colombell’s IRA deduction was not an issue, because their joint income did not exceed $150,000 for that year and because he did not participate in any company plan for the year, so this case involved only Mrs. Colombell’s plan participation.
A balance of zero
During the year in question (2002), Mrs. Colombell worked only 511 hours. In fact, at no time during her 15 years of employment did she ever work more than 1,000 hours in a year, and her pension balance was zero at all times.
She was ineligible for any benefit under the company plan. Neither Mrs. Colombell nor the plan ever put any money into the plan. Because of her limited work time, she was not entitled to health benefits, sick leave or vacation time.
Her W-2 form indicated that she was an active participant in the plan, and the IRS disallowed her $3,500 IRA tax deduction. Mrs. Colombell went to tax court, where she probably thought she would win, hands down, and, incredibly, lost her case.
Mrs. Colombell brought out a dictionary to show the definitions of the words “active” and “participant.” The court pointed out that words are subject to two kinds of definitions. One definition is from the dictionary, and that is what the word actually means. The other definition is from the tax code, and that can mean anything and usually means something completely different than the real meaning, as in the case of the words “active” and “participant.”
According to tax law, being active in a plan really means “not being excluded.” The court stated that the regulations “provide that an individual is an active participant in a defined benefit plan simply by not being excluded from the plan. See Sec. 1.219-2(h), Example (1), Income Tax Regs. No actual behavior on anyone’s part is required. In fact, actual knowledge of the plan’s existence is not even required.”
“Because Inova’s plan was mandatory for all employees,” the court ruled, “Mrs. Colombell was not excluded. Even if she never met the dictionary’s definition of what it would mean to be an ‘active participant,’ the regulations make it clear that she was an active participant in Inova’s retirement plan for the year in issue … Here we have a taxpayer with a zero balance in her account. During the 15 years petitioner worked for Inova, she never once met the threshold for pension credit contributions, nor was her job designed such that it would be realistically possible to do so. Despite the fact that Mrs. Colombell received no tax benefit whatsoever from her ‘participation’ in Inova’s retirement plan, the court is not free to rewrite the law … We must conclude that petitioner was, for Internal Revenue Code purposes, an active participant in Inova’s retirement plan in 2002.”
The Court even mentioned a case where a “de minimis” contribution of only $84.89 to the taxpayer’s company plan was enough to make him an active participant, even though he was “unlikely to ever receive benefits under the plan.” But in Mrs. Colombell’s case, the plan contribution was zero, yet the court still ruled that she was an active participant in the company plan and denied her tax deduction.
What the court basically was saying was, “We feel bad for you, but that’s the way it is.” The court stated that “the result in this case is harsh, and unfortunately, the court can appreciate why petitioners will regard it as such. The regulation in its current form, the validity of which has not been called into question, dictates the result.” The court may not “revise the language of the statute, as interpreted by the Treasury, to achieve what might be perceived to be better tax policy. Rather, we must apply the language of the relevant provisions, as written.”
The court noted that Mrs. Colombell would be entitled to recover her $3,500 basis since she never received a tax deduction. Big deal!
The court pointed out that if the plan had an earnings threshold rather than an hours-worked limit, then under Regulation Section 1.219-2(b)(1), she “might not have been an active participant.” If the company plan said that any employee who made less than a certain amount of money is excluded from the plan rather than saying anyone who works less than a certain amount of hours is excluded, then Mrs. Colombell would not be an active participant. This defies all logic.
Just because an individual does not actually participate in the company plan and may even have a zero plan balance does not mean they did not participate in the company plan under the tax code definition of “active participant.” Both the IRS and the tax court have a much broader interpretation of “active participation,” and this case proves it.
The Roth IRA generally is a better option than the non-deductible IRA if you can qualify for a Roth IRA contribution under the income limits, which for 2007 are $156,000 to $166,000 (married/joint) and $99,000 to $114,000 (single or head of household). In this case, a Roth IRA would have been a better choice than getting stuck with basis in a traditional (non-deductible) IRA and having to account for it as long as there is a balance in the traditional IRA.
Mrs. Colombell should have recharacterized this contribution as a Roth IRA contribution (and have all future earnings compound tax free). But by the time the court case was decided, the deadline to recharacterize the traditional IRA contribution as a Roth IRA contribution had passed. The IRS has allowed late recharacterizations in private-letter rulings, but that would not be cost effective here. Mrs. Colombell would have to pay a $9,000 IRS ruling fee, plus thousands more in professional fees to change a $3,500 IRA contribution to a Roth IRA contribution.
Repeal needed
Repealing these rules now will generate more future tax revenues and not trip up unsuspecting taxpayers who cannot possibly understand how these rules work in cases like this one.
This case clearly defies all logic and cannot be what Congress intended. This law needs to be changed so taxpayers do not have to go through all of this only to lose a tax deduction for their IRA contribution.
These active-participation rules always were a problem, and now they are out of date. Congress now is trying to encourage retirement plan participation with every new tax law.
Keeping these active-participant rules serves only to discourage contributions to plans and IRAs by adding unnecessary hurdles. The government should want people to take tax deductions for their IRA contributions, because in the end, distributions from deductible IRAs generate tax revenues. These active-participation rules should be repealed now.
Ed Slott, a certified public accountant in Rockville Centre, N.Y., has created The IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group to help financial advisers and insurance companies become recognized leaders in the IRA marketplace. He can be reached at irahelp.com.
