What Counts as Compensation (Earnings) for IRA Contributions?

Retirement is an important phase of life, and regardless of your current net worth, financial planning for your retirement years is necessary. Planning for your golden years is just like planning for any other important long-term goal. It requires decades of hard work, strong resolution, and a mindset to build a sizeable corpus which would allow you to enjoy your old age.

So, when accumulating cash for your retirement, it is crucial that you know all the necessary details before opting for any financial instrument. Since you are putting your life’s savings in these tools, it is crucial that you trust them to function properly. Every savings account has its unique stipulations. If you don’t fill any of the required details correctly or don’t meet the eligibility criteria, you could end up losing all your savings.

Introduced in the mid-70s, an individual retirement account (IRA) is a useful tax-advantaged investing tool that individuals use to set aside funds for their retirement. Depending on your employment status, you can choose amongst various IRA options available such as Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. But, when it comes to contributing to your IRA, there are certain income restrictions. To regularly contribute towards an IRA, one must have a qualifying source of income, without which you cannot contribute towards the account. The IRA rules change every year, thereby, making it complicated for the contributors to comprehend whether their funds are qualifying income or non-qualifying income.

What is qualifying (earned) income?

As per the IRA, qualified (earned) income for the purpose of qualifying for IRA contributions can be defined as the income generated from wages, salaries, tips, incentives, or any other forms of taxable pay when working for someone. Further, it includes income generated from self-employment. Benefits derived from a union strike and long-term disability payments can also be considered as qualified (earned) income, only when received before the retirement age.

Here is a detailed list of all the sources of qualified income that can be considered for IRA contributions.

When it comes to qualifying income, the IRA has divided income into three categories. They are income earned as an employee, income generated from self-employment, and alimony income. As per the prevailing IRS rules, one can only contribute up to $6000 per year towards the IRA. In case the individual is at least 50 years old by the end of the year, the individual can contribute an additional $1000 towards the IRA, which is known as the catch-up contribution. 

Compensation earned as an employee

Income earned as an employee such as wages, salaries, tips, bonuses, incentives, and commissions is considered as qualifying income when contributing to an IRA.

Income generated from self-employment

Qualified income also includes income generated from self-employment or net income from self-employment in trade or business, professional services, or as an independent contractor. Income generated from self-employment would only qualify as a qualified income when the activities performed by you contributes towards business income generation, and only after the income is subjected to deductions for contributions to an employer plan and self-employment tax adjustments. 

For an independent contractor such as a consultant, or a technician, or a driver, or any other service provider, income generated from the different services provided is considered as qualifying income. For a professional such as a doctor, lawyer, or chartered accountant, the income generated from one’s professional practice is considered as qualified income.

In case you have your own business, or if you are the sole proprietor, business income reported under Schedule C of Form 1040 after adjustments for deductions is considered as qualified income. If you are a member of a partnership or a limited liability company, then income reported in your name under Schedule K-1 would be considered as your self-employment qualified income.

However, there are some restrictions on self-employment income. For instance, if you are an investor in a business and you get a share of the profit in proportion to your investment, then it will not be considered as self-employment income. Only when you are actively associated with the business, and your activity generates income, then you can include the funds in your qualifying income. Furthermore, if you are investing in any stock, the returns or earnings generated from the same cannot be regarded as qualified income.

Income from alimony

According to the special IRA rule, income generated from alimony payments after deduction of tax would be considered as qualifying income for the purpose of IRA contributions. This special rule is only applicable to taxable alimony income which is derived under the divorce decree or separation agreement entered into after 2018. So, even if you do not work and are only dependent on alimony, it can be considered as qualified income as long as it is taxable alimony. However, you can’t include non-taxable revenue streams such as child support for the purpose of IRA contributions.

Combat pay

The only nontaxable income that is considered as qualified income for the purpose of IRA contribution is combat pay. If you have served the U.S. armed forces and have been posted in a combat zone or have been provided with qualifying services outside the combat zone, then you are eligible for combat pay. Combat pay is nontaxable for most of the service members.  

Income sources that don’t get considered as qualified or earned income for the purpose of IRA contributions are retirement pensions, Social Security payments, interest income, annuity benefits, dividend income, unemployment benefits, nontaxable alimony, and child support.

To sum it up

If you are planning for retirement, an IRA can prove to be a very good option, but only when you are eligible to make contributions to it. So, whenever you plan to save for your retirement with an IRA, you should ensure that you meet all the requirements, and the compensation you receive is eligible.  

It is best to take professional help when in a dilemma of whether you are eligible for an IRA or not. To safeguard your retirement with an IRA, you can reach out to financial advisors and seek professional guidance.