With the end of the year in sight and tax season around the corner, I’ve been brushing up on the rules for IRA contributions and deductions. Remember IRA contributions can be made for the 2019 contribution year until April 15, 2020. Most large IRA custodians make it easy to designate your contribution for the appropriate year, but if you use an independent broker and make a 2019 contribution next year, make sure they record the contribution properly or you might get an angry letter from the IRS for exceeding your contribution limit in 2020. Today I got to thinking about how and when spousal IRA’s can be maximized, particularly when you fall into what I call the “spousal IRA deduction gap.”
How spousal IRA’s (are supposed to) work
Technically an IRA should only be referred to as “spousal” if one spouse in a married-filing-jointly couple has earned income in excess of the individual contribution limit and the other has earned income less than the individual contribution limit. In this case, contributions can be made to an IRA in the non-earning spouse’s name, based on the excess earnings of the earning spouse.
That’s a complicated way of saying that if the total earnings of a married-filing-jointly couple are at least $12,000 (in 2019), then each spouse’s IRA is eligible for the maximum $6,000 contribution, regardless of the distribution of the earnings between the spouses. If the couple’s total earnings are less than $12,000, then the amount of earnings can be split arbitrarily; there’s no requirement to “fill up” the earning spouse’s IRA before contributing to the spousal IRA.
I don’t know what the original rationale was for this scheme, but it functions as a kind of “breadwinner bonus:” if a worker marries a non-worker, they get to use the non-worker’s IRA deduction, a kind of annual tax stipend for bourgeois family values.
Of course, most low-income people don’t contribute to IRA’s, and most married couples consist of two earners, so this intended use case is negligible in the real world. There’s one nuance to the spousal IRA rules, however, that has a very real impact: the spousal IRA deduction gap.
Why does the spousal IRA deduction gap occur?
The spousal IRA deduction gap arises because while total contributions for married-filing-jointly couples are limited to the greater of the couple’s joint earnings or the annual per-spouse contribution limit, the deductibility of contributions is determined based on the combination of the couple’s joint modified adjusted gross income (adjusted gross income after adding back in certain deductions) and each spouse’s workplace retirement plan coverage.
This is spelled out on page 13 of IRS publication 590-A. Table 1-2 shows that a married-filing-jointly spouse covered by a workplace retirement plan can deduct a traditional IRA contribution if their MAGI is $101,000 or less. Table 1-3 shows that a married-filing-jointly spouse whose spouse is covered by a workplace retirement plan can deduct a traditional IRA contribution if their MAGI is $189,000 or less.
That creates an $88,000 gap, where contributions to the non-covered spouse’s IRA is still fully deductible, whether or not they have any earnings.
Maximizing the value of the spousal IRA deduction gap
Ideally you’ll be maximizing your traditional, Roth, or backdoor Roth IRA contributions each year, but obviously not everyone can, and not everyone who can, will. The spousal IRA deduction gap means that for couples that fall into the gap and aren’t able or willing to maximize contributions to both spouse’s IRA’s, it may be more tax-advantageous to fill up the non-covered spouse’s IRA before making contributions to the covered spouse’s Roth IRA.
Planning around the spousal IRA deduction gap
Everything above has discussed the deductible IRA rules on the assumption that a couple is already married. However, there’s a second payout tucked in Table 1-2: the increased MAGI limit for covered employees when they get married.
A single filer covered by a workplace retirement plan with a MAGI of $73,000 is ineligible for any traditional IRA deduction, while a married-filing-jointly filer is eligible for a full deduction up to $101,000 in MAGI.
That means the same filer, upon marriage to a non-covered person earning $28,000 or less, will see their taxes fall by $4,987, from $9,235 to $4,248, assuming a maximum traditional IRA contribution of $6,000 (the spouse’s taxes, if any, will also fall due to the expanded married-filing-jointly tax brackets, so the total taxes paid by the couple will fall by more than either individual’s under most circumstances).
Most high-income workers are covered by one or more workplace retirement plans, and those plans are almost always more generous than the IRA deduction. The $19,000 employee 401(k) and 403(b) contribution limit, for example, is so much higher than the maximum IRA contribution that it wouldn’t usually make sense financially to choose, between two other-wise identical jobs, the one without a retirement plan purely to maintain eligibility for the IRA deduction.
However, few jobs are identical! There’s naturally some breakeven point where an increased salary more than makes up for the lack of a workplace retirement plan; that exercise is left to the reader. Furthermore, people are motivated by more than money: a dream job that leaves you eligible for the IRA deduction might, in total, be more attractive than endless drudgery with a nice retirement package.
The final important planning situation arises in the case of self-employment. It’s tempting to open an individual 401(k) account soon after starting a small business, since they cost virtually nothing to set up and administer, and allow you to manage your taxes through deductible employer and employee contributions, and Roth employee contributions. That’s good advice, but in some cases you might consider waiting until you’re generating more (or any) income from the business: if you and your spouse are currently not covered by workplace retirement plans, and if you plan to continue working at a non-covered job while you work on your small business.
That’s because opening an individual 401(k) may trigger the MAGI limits on your joint income, completing eliminating the traditional IRA deduction if your MAGI exceeds $189,000 or thrusting you into the spousal IRA deduction gap. Of course, if you know your MAGI will remain below $101,000, then there’s no harm done, since contributions to both spouse’s IRA’s will remain fully deductible.
The same logic applies once a small business has stopped generating income. While closing a 401(k) may seem like too much trouble, keeping it open may cause you to be considered “covered” and limit your IRA deduction. In that case, once you know you won’t be making any further contributions, you may be better off simply rolling the balance into traditional and Roth IRA accounts.
These corner cases can become extremely complex very quickly; only a fee-only, fiduciary financial advisor can provide advice tailored to your situation.