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There is much confusion about the definition of an active participant and how it affects an individual’s ability to claim a tax deduction for a contribution to a Traditional IRA.  While some of the requirements for being an active participant are clearly defined, others are not. Consequently, individuals often claim deductions for their contributions when they are not eligible to do so, only for the deduction to be denied by the IRS.

The Effect of Being an Active Participant

An individual is eligible to take full deduction for his traditional IRA contribution if he is not an active participant, or married to an active participant. On the other hand, if the individual is an active participant or married to an active participant, his eligibility for deducting a traditional IRA contribution depends on his modified adjusted gross income (MAGI) and tax filing status.  The MAGI limits as they apply to the different tax filing statuses are as follows:

So...Who is An Active Participant?

The general definition is that an active participant is an individual who receives contributions or benefits under an employer sponsored plan. But it’s not that simple. The rules that define who is an active participant varies among the types of employer sponsored plans, and may depend on when the contributions are made to the participant’s account (under the employer sponsored plan).

• SEP IRA and Profit Sharing Plan: The individual is an active participant for the year the contribution is deposited to the individual’s SEP or profit sharing account. For instance, if the contribution is for last year and deposited last year, then the individual is an active participant for last year. However, if the contribution is for last year, but deposited to the individual’s account this year, then the individual is an active participant for this year. But see "Lesser Know Rules" later, for an exception.
• Money Purchase and Target Benefit Pension Plans: The individual is an active participant for the year for which forfeiture is allocated, or a contribution is made regardless of when it is deposited to the individual’s account. For instance, if the contribution is for last year and deposited last year, then the individual is an active participant for last year. And if the contribution is for last year, but deposited to the individual’s account this year, the individual is an active participant for last year.
• Defined Benefit Plan: The individual is an active participant if he/she is not excluded under the eligibility provisions of the plan for the plan year ending with or within the individual's taxable year. This applies  regardless of whether the individual has elected to decline participation in the plan.
• 401(k), 403(b), Salary deferral SEP, SIMPLE IRA: The individual is an active participant if the individual elects to make salary deferral contributions to the plan. If the individual is eligible to make salary deferral contributions, but declines to do so and no other contributions or forfeitures are made to his/her account for the plan year ending with or within the individual's taxable year, the individual is not an active participant for that year.

These are the better known rules.

Lesser Known Rules

• When profit sharing or SEP IRA contributions for two years are made in one year, the result is 'active participant' status for two years. While the general rule for profit sharing plans and SEP IRAs is that the individual is an active participant for the year in which the contribution is deposited to the profit sharing/SEP account, an exception applies. Under this exception, if contributions for two separate plan years are made in the same year, the contribution for the later year is deemed to be made in the next year. This prevents a participant from unintentionally circumventing the active participant status for one year when contributions for two years are made in the same year.  

Here’s an example to illustrate.

A profit sharing plan has a July 1 to June 30 plan year. As of June 30, 2007, no employee or employer contributions have been made and no amounts have been forfeited for the plan year ending June 30, 2007.

On January 15, 2008, the employer makes a contribution for the plan year ending on June 30, 2007.

On November 30, 2008, the employer makes a contribution for the plan year ending June 30, 2008.

In such a situation, the contributions for the later plan year are deemed to be made in the next taxable year, solely for the purposes of determining active participant status. In the fact pattern described above, the contribution made on November 30, 2008 is deemed to be made in taxable year 2009. Therefore, the individual is an active participant in both the 2008 and 2009 taxable year.

• Even de minimis participation counts: If you are an active participant only for a few weeks in the year, and/or your contribution is only a few dollars, you are still considered an active participant. This is important for someone who knows he/she will be leaving a job shortly after the New Year begins, or an individual who becomes eligible to participate in the plan near the end of the year. Making a salary deferral contribution of $200, even if the employer matches the contribution 100% may not be worth giving up the eligibility to deduct an IRA contribution of $5,000.

• Excess Contribution Removed Does not Negate Active Participant Status: If you make a salary deferral contribution to your 401(k) plan, and removed the amount because it was an excess contribution- as you are required to do with excess contributions- you are still an active participant for the year.

• Did not receive your required contribution? Still an Active participant: Under a money purchase or target benefit pension plan, employers are required to make contributions to your account, as per their agreement. This is unlike a profit sharing plan where contributions can be made on a discretionary basis. Sometimes, these ‘required’ contributions are not made to employees’ accounts for varying reasons, including the employer simply not having the funds to make the contribution. But even if you do not receive this ‘required’ contribution, you are still considered an active participant for the year that it was required to be made.

• You Are Active- Even if You Don’t ‘Own’ the Contributions: Non IRA based plans employer sponsored plans can include a vesting schedule, which requires you to work with the employer for a number of years before you ‘own’ the employer contributions made to your account. If you leave that employment before meeting the service requirement, you forfeit those contributions. Even if those contributions are forfeitable (or have been forfeited), you are still considered an active participant for that year.

Conclusion

Don’t be caught in the active participant confusion trap. Individuals have taken the IRS to court, challenging their position on the individual’s active participant status and they have lost. In one case, the court acknowledged that while the results seemed “harsh”, they simply could not ignore the language of the statutes.  So as much as they sympathized with the petitioner, the gavel had to come down on what seemed to be an inequitable result. You employer is required to check box 13 on your W-2 if you are an active participant for the year. But mistakes can be made. Check with a tax or financial professional who is an expert in the retirement plans field if there is any degree of uncertainty.

Shorter version previously published in Retirement Weekly