Because individual retirement accounts, or IRAs, offer a hefty tax savings, the Internal Revenue Service limits whether a person may contribute, and how much. If you are a high earner, the rules may exclude you from deducting a traditional contribution or making a Roth IRA contribution. Or your income may fall into the phase-out range: you can't take full advantage of an IRA, but you may be eligible for a partial benefit.
To understand how phase-out limits work, it is important to understand contribution limits, as well. Each year, the IRS determines the maximum total amount you may contribute to your Roth and traditional IRAs. As of 2010, that amount is $5,000 if you are under 50, and $6,000 if you are 50 or over. Note that the limit is for total contributions. For instance, you cannot contribute $5,000 to both a Roth IRA and a traditional IRA if you are under 50, but you could contribute $2,500 to each.
Roth IRA Phase-Out Limits
IRA phase-out limits work very differently depending on whether you are contributing to a Roth or traditional IRA. Roth IRA income limits affect how much you can contribute to the account. If your income exceeds a certain amount, you may make a partial contribution. Earn too much, and you are excluded from participating entirely. For instance, if you are married, filing jointly in 2010, you may contribute the maximum limit (either $5,000 or $6,000) if you and your spouse's combined income does not exceed $167,000. If you make up to $177,000, you may make a partial contribution. If your joint income exceeds $177,000, you cannot make a Roth IRA contribution in 2010.
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Traditional IRA Phase-Out Limits
Traditional IRA phase-out limits only apply if you participate in an employer-sponsored retirement plan plan, and even then, they only affect your deduction. For instance, in 2010 if you are married, filing jointly and participate in a 401k at work, you can write off the maximum IRA contribution if you and your spouse earn up to $89,000. If your joint income does not exceed $109,000, you can write off a portion of your traditional IRA contribution. If your joint income exceeds $109,000, you cannot deduct your traditional IRA contribution. However, you are allowed to make a non-deductible traditional IRA contribution regardless of your income or employer retirement plan.
The IRS determines annual Roth and traditional IRA phase-out limits for filers who are married, filing jointly and single or head of the household. There is also a $10,000 income limit for filers who are married, filing separately. There is no phase-out range in this category. The limit applies to single filers who lived with their spouse at some point during the year and is intended to stop people from filing separately just to skirt IRA phase-out limits for joint filers.
IRA phase-out limits are based on your modified adjusted gross income, or MAGI, which is slightly different from your adjusted gross income. To calculate yours, see Worksheet 1-1 in IRS Publication 590. If your MAGI falls in the phase-out range, use Worksheet 2-2 to calculate your reduced Roth IRA contribution, and Worksheet 1-2 to calculate your reduced traditional IRA deduction.