How to Know If You Are an Active Participant in a Qualified Retirement Plan to Determine If You Are Entitled to Deduct an IRA Contribution.
What the tax law says may surprise you!
Introduction
If you are determined to be an active participant in a qualified retirement plan, such as a 401(k), 4003(b), or a 457 plan, and your income is above the phase-out ranges for IRA deductibility of a traditional IRA contribution, you cannot deduct the contribution. If you did take a deduction to which you were not entitled, interest and penalties would apply to the tax “savings” you would have to pay back. You would need to consider either the ROTH IRA or a nondeductible IRA. Accordingly, knowing what the tax law is in this area could save you time and money.
Who is an Active Participant per the Tax Law?
The first stop is Internal Revenue Code Section 219(g)(5). It says an active participant is an individual:
(A) who is an active participant in –
(i) a plan described in section 401(a) which includes a trust exempt from tax under section 501(a),
(ii) an annuity plan described in section 403(a),
(iii) a plan established for its employees by the United States, by a State or political subdivision thereof, or by an agency or instrumentality of any of the foregoing,
(iv) an annuity contract described in section 403(b), or
(v) a simplified employee pension (within the meaning of section 408(k)), or
(B) who makes deductible contributions to a trust described in section 501(c )(18).
Well, this hapless definition in the Code doesn’t really help us, does it? So we will look elsewhere.
Publication 590 says that an active participant in a defined contribution plan is someone for whom a contribution or an allocation is credited to the person’s account for the year for which the person wants to take a deduction (my paraphrasing).
Example: John Doe was an employee of ABC Corp. ABC’s tax year end was December 31. John left employment on December 31, 2007. ABC has accrued a contribution for its plan year ending June 30, 2008, and it was known that a contribution would be made as of June 30, 3008, but ABC did not make the payment until January 31, 2009. Regardless of when the contribution is paid by ABC in this situation, John is an active participant for all of 2008.
Publication 590 also says there is a special rule which says that if it is not possible to determine if a contribution or allocation will be made for a particular plan year and no contribution is paid during the plan year, then the employee is not an active participant for that calendar year in which the plan year ends. But if the employer accrues a contribution for the plan year and pays it after the plan year in a subsequent calendar year, then the employee will be an active participant in the subsequent plan year.
Example: Same facts as in the example above except that ABC’s contribution was not obligatory…contributions were discretionary…but on December 31, 2008, ABC decided to accrue a contribution for its plan year which had already ended on June 30, 3008, and ABC did not make the payment until January 31, 2009. John is an active participant in 2009, but not in 2008.
Comment: This is an unusual situation. In most situations the plan year coincides with the tax year.
Publication 590 says that you are an active participant in a defined benefit plan if you are eligible to participate, even if you declined to participate, made no contributions, and did not the minimum service requirements to have a benefit accrued for you.
Comment: Since most of my clients are not in defined benefit plans, this more stringent definition probably will not apply.
The William Edward Colombell et ux. v. Commissioner Case T.C. Summ. Op. 2006-184; No. 23979-04S
This case involved an employee, Patricia Marie Colombell, who worked for Inova Health System for 15 years. The Company had a cash balance plan, which is a type of defined benefit plan. Participation in the plan was mandatory, but employees only received a pension credit if they worked at least 1000 hours for the year. Mrs. Colombell never worked more than 1000 hours in any year. Neither she nor Inova paid any money into the plan. Accordingly, Mrs. Colombell was not permitted to participate in the plan. However, the W2 indicated that she was an active participant.
For the 2002 tax year in question, Mrs. Colombell claimed a $3,500 IRA contribution deduction. After the IRS denied the deduction, Mrs. Colombell decided to go to Tax Court. She lost. The Tax Court stated that “according to the tax law, being active in a plan really means not being excluded. Because Inova’s plan was mandatory for all employees, 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… Had Inova’s plan had an earnings threshold rather than an hours-worked threshold, Mrs. Colombell might not have been an active participant. See sec. 1.219-2(b)(1), Income Tax Regs., explaining that an individual is not an active participant if his or her compensation is ‘less than the minimum amount of compensation needed under the plan to accrue a benefit.’ ”
Comment: It would be more beneficial if Congress would get rid of the active participant rules. But while they are on the books, the alternative IRAs….the ROTH and the nondeductible….are free from subjection to these rules, and the phase-out ranges are either higher (ROTHs) or nonexistent.
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