Your contribution must also come from “earned income.” In fact, the annual maximum contribution limit is the lesser of:
- The indexed amount (for 2017 and 2018: $5,500 plus a $1,000 catch-up contribution if age 50 or older); or
- Your earned income for the year.
We often get the question about whether something can be considered earned income. So, what does the Tax Code say?
Any amount that is shown in box 1 of Form W-2 is going to count as earned income – this includes wages, salaries, commissions, professional fees, bonuses, and other amounts received for personal services. Most individuals derive income from W-2 sources.
For the self-employed, your earned income is the net employment income earned from the business. This takes into account the profits and losses for the year, meaning a net loss is not considered compensation. However, if you pay yourself a salary, a net loss is not subtracted from this amount when figuring total compensation. Thus, you could still be eligible to make a deductible contribution. Additionally, your net employment income is reduced by contributions you make to employer plans related to your self-employment and the self-employment tax deduction. Keep in mind that net employment income can count as earned income, even if it is not subject to the self-employment tax. This last category would include clergy members or even professional investment traders.
Other sources of earned income include taxable alimony or maintenance payments, combat pay (even though it may be excluded from federal income tax), accrued vacation pay, director’s fees, jury fees, and scholarship or fellowship payments (if included in Box 1 of Form W-2). Any of these forms of income can be used to make an IRA contribution. Additionally, you can combine these sources to determine your earned income for the taxable year.
Alternatively, there are other sources of income that do not count as earned income. Pension and annuity payments are not considered earned income. This includes payments from IRAs (both traditional and Roth), company retirement plans (both qualified and nonqualified), and social security benefits. Similarly, passive sources of income, such as royalties, interest income, capital gain income, life insurance proceeds, disability and unemployment payments, and child support also do not count as “earned income.” Also, unless the taxpayer is in the business of renting property, rental income is also excluded.
Fortunately, for married couples, there is one way to contribute to an IRA if one person doesn’t have earned income – the spousal IRA. Under the Tax Code, if you are married filing jointly, you can contribute the maximum into an IRA for each spouse, even if one person has no earned income. The key is the working spouse must have enough earned income to cover both contributions ($13,000 or $6,500 per person for 2017).
In the end, it is the taxpayer who must prove to the IRS the existence of “earned income” for IRA contribution purposes. This article should give you a general idea of what is and what is not considered compensation. As always, things may get compliacted and if you are not sure or are in a unique tax situation, you should seek the advice of a professional advisor.