"Taxable" vs. "Includible" Compensation?

[ryanf1475]

Hello,

I sure wish the IRS would clarify their language. I just want to confirm something.

Scenario A: I am able to earn a taxable total of $5k for the year, contribute the full $5k to my Traditional IRA, and pay no taxes. Here, my contribution is limited to my "taxable compensation" for the year (https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-ira-contribution-limits).

Scenario B: However, let's say that I have a pre-tax 457 that I want to contribute the $5k to. The rule here says the contribution is limited to "includible compensation" for the year (https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-457b-contribution-limits). Well, yes, the $5k is "able" to be included, but I chose NOT to include it because it went into the 457. Is that allowed, or does the IRS actually mean "included" income, i.e. I would have to include $2.5k if I wanted to contribute $2.5k to the 457?

The confusion: In Scenario A, my "taxable" income was not actually taxed, but it's "taxable" because it WOULD have been taxed if I did not contribute to the IRA. In Scenario B, my "includible" income is "able" to be included, so I should therefore be able to contribute the full $5k to my 457. But I don't think this is what the IRS means, right? I think they mean you can only contribute up to the amount that you actually pay taxes on?

 

[Bali Hai Again]

Scenario A: You are required to pay SS and Medicare tax on the earnings $382.50 (7.65%). If no other deductions, that leaves $4617.50 for your IRA. You can deduct the $382.50 if you put it into your IRA but the $382.50 will need to come from somewhere else and not the $5000 in earnings.

 

[Taxing Matters]

The confusion: In Scenario A, my "taxable" income was not actually taxed, but it's "taxable" because it WOULD have been taxed if I did not contribute to the IRA. In Scenario B, my "includible" income is "able" to be included, so I should therefore be able to contribute the full $5k to my 457. But I don't think this is what the IRS means, right? I think they mean you can only contribute up to the amount that you actually pay taxes on?

The Congress has established different rules and limits for various types of tax preferred plans. While many requirements are similar among the plans the details are important. The IRS has a publication specific to IRAs, Publication 590A. That covers IRA contributions and its limits in great detail. There is no similar publication for § 457(b) plans.

As for the difference in terminology, it is Congress that chose those terms, not the IRS. Looking at the actual Internal Revenue Code (IRC) Includible compensation for the purposes of § 457(b) plans means the same thing as participant's compensation under IRC § 413(c )(3). The basic limit is defined there in paragrah (A) as "The term 'participant's contributions means the compensation of the participant from the employer for that year". For an IRA, on the other hand, what may be contributed is limited by taxable compensation. These contribution limits are determined before taking into account the contribution made.

Note that this means the limit for a § 457 plan contribution is total of taxable and nontaxable compensation paid by the employer, whereas for a traditional IRA, the general limit is just the taxable compensation received by the taxpayer. Publication 590A has a chart of what compensation means for IRAs. Only the compensation that is taxable (taken into account before your contribution) may be contributed to an IRA. That compensation is not limited to just that paid by your employer.

 

[ryanf1475]

The Congress has established different rules and limits for various types of tax preferred plans. While many requirements are similar among the plans the details are important. The IRS has a publication specific to IRAs, Publication 590A. That covers IRA contributions and its limits in great detail. There is no similar publication for § 457(b) plans.

As for the difference in terminology, it is Congress that chose those terms, not the IRS. Looking at the actual Internal Revenue Code (IRC) Includible compensation for the purposes of § 457(b) plans means the same thing as participant's compensation under IRC § 413(c )(3). The basic limit is defined there in paragrah (A) as "The term 'participant's contributions means the compensation of the participant from the employer for that year". For an IRA, on the other hand, what may be contributed is limited by taxable compensation. These contribution limits are determined before taking into account the contribution made.

Note that this means the limit for a § 457 plan contribution is total of taxable and nontaxable compensation paid by the employer, whereas for a traditional IRA, the general limit is just the taxable compensation received by the taxpayer. Publication 590A has a chart of what compensation means for IRAs. Only the compensation that is taxable (taken into account before your contribution) may be contributed to an IRA. That compensation is not limited to just that paid by your employer.

Thank you, but that begs the question of why they choose to call it "includible compensation" rather than just "compensation"? Is it to prevent contributions, for example, that come from income that has been excluded by the Foreign Earned Income Exclusion? Or would such excluded compensation be fair game for 457 contributions?

 

[Taxing Matters]

Thank you, but that begs the question of why they choose to call it "includible compensation" rather than just "compensation"? Is it to prevent contributions, for example, that come from income that has been excluded by the Foreign Earned Income Exclusion? Or would such excluded compensation be fair game for 457 contributions?

It means that both taxable and nontaxable income are allowed to be used for the contribution. Amounts excluded from income, however, are not. So foreign earned income that you exclude from income on your return cannot be used as part of your tax deductible contribution to the plan.

 

[davew9128]

I sure wish the IRS would clarify their language.

Congress writes the statute and language in them, not IRS...

 

[Taxing Matters]

The IRS uses the language Congress writes into the tax code in its publications and forms. That's a deliberate choice to ensure that the information the IRS is providing is an accurate statement of the law. Tax law is one of the few areas in Congress in which there established a joint committee of the House and Senate for review of bills that fall into their subject matter. For tax law, that's the Joint Committee on Taxation. The reason Congress did that was to help the House and Senate actually understand what the tax laws they propose will do, get help in writing them, and provide reports to the House and Senate members explaining the bills so they know what they are voting on. This is necessary because federal tax law taken as a whole is one of the largest and most complex parts of the U.S. Code and the one that changes the most.

So how does that affect the language used? The joint committee is staffed with a number of tax lawyers who provide the technical analysis and help draft the language for the laws members of Congress want to pass. Being a tax lawyer myself, I can tell you that there are a lot of technical terms that they have created to define very specific things, and those terms often end up in a number of Code provisions for accuracy. Lawyers love this stuff and speak the language of law all the time, and they forget that the general public isn't familiar with that kind of writing.

Writing rules in plain English sounds a lot easier than it really is, especially with highly technical areas like tax law. When I worked as an attorney at IRS in the national office part of my work involved drafting and reviewing tax regulations. I always tried, as much as possible, to write them in plain English becuase I had had previous experience dealing with taxpayers every day and saw the frustration they had trying to understand this arcane language. It was more challenging than I had thought before starting that kind of writing, and it took more time to write than a regulation using a lot of tax jargon. And in the end, I couldn't always avoid the use of that jargon. Some tax terms have so specific a meaning that it's difficult to convey any other way. A lot of the lawyers at IRS national office and in Congress never had that kind of field experience nor do they want to take the extra time it takes to write a really clear plain language bill or regulation. The extra time spent doing that would save the IRS, the courts, and Congress a lot more time later on when disputes arise concerning what that law really means. So it really is worth the effort to write them in a way everyone can understand. The best laws are those written so that the people who have to comply with them (taxpayers in the case of tax law) can understand them without a legal (or tax) professional having to explain it to them. Congress in recent years has started a drive to more plain English drafting, mostly by encouraging agencies to do that. They have yet to impose a plain language requirement on themselves.