Earned Income: Why It Matters for IRA Contributions

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Generally, you need to have earned income to contribute to an IRA. If you're working on a full-time basis, then it's likely you'll generate enough earned income to qualify for the full contribution of $6,000 — as long as you meet other requirements. But if you work part-time, then you may not make enough to contribute this amount; however, you may be able to contribute up to the amount of your earned income.

Earned income is money earned while working

What is earned income? It's income earned by actively working as opposed to passive income derived from investments. Generally, someone can make earned income by working for an employer, running a business, or doing freelance work.

Passive income is generated by getting interest, dividends, and capital gains on savings accounts, bonds, and stock investments.

IRA contribution limits are based on earned income and more

When researching this article, I learned several things about earned income and IRA contributions. Contributions to traditional IRAs are limited by certain types of compensation, not earned income. That is, there are several types of income that are eligible for use in determining the IRA contribution amount. Here's the breakdown according to the IRS (from Publication 590-A):

Compensation for the purpose of an IRA

includes:

  • wages, salaries, etc.
  • commissions
  • self-employment income
  • alimony and separate maintenance
  • nontaxable combat pay

excludes:

  • earnings and profits from property
  • interest and dividend income
  • pension or annuity income
  • deferred compensation
  • income from certain partnerships
  • any amounts you exclude from income

Please see the Internal Revenue Service's website to get full information on earned income and compensation relevant to IRA contributions. Also, consult your tax adviser to apply tax regulations to your personal situation.

Contributions to an IRA don't have to flow directly from earnings to the retirement account

There are a few reasons that I bring up the topic of earned income or more precisely “compensation for the purpose of an IRA” relating to IRA contributions.

First, it's a reminder that compensation can limit the amount of your IRA contribution. For example, if you're working a part-time job while attending college, you could start funding a retirement account. But if you earn just $5,000 in a year, then you can contribute $5,000 only — not the $6,000 maximum.

Second, IRA contribution limits relating to compensation do not require you to channel your paycheck directly to an IRA. The general rule is that you need to match your earnings to the contribution cap.

For example, let's say you're a college student who made $2,000 working at the library last year but you spent the money on rent, books, food, or utilities. Then, over the holidays, you received $500 in cash from your relatives for spending money. You could use that extra cash to make an IRA contribution. Just because the source of money for the contribution didn't come directly from earnings or other form of compensation doesn't mean that you can't use that cash to fund the IRA. Again the stipulation is that you have certain types of compensation, not that you immediately directed funds from your paycheck to an IRA.

Third, certain types of compensation are eligible for IRA purposes that may not fit “earned” income and vice versa.

Lastly, Spousal IRA contributions can be based on your spouse's earnings. According to the IRS, “the amount of your combined contributions can’t be more than the taxable compensation reported on your joint return.” But you can share compensation for the purpose of fulfilling guidelines.

If you make too much money or have a plan at work, a certain portion of your contributions to your Traditional IRA may not be tax deductible. Further, you may make too much to contribute to a Roth IRA. Still, the general rules pertaining to IRA-related compensation ares useful to know.

Earned income and compensation matter when considering potential contributions to a tax-advantaged retirement account (such as an IRA).

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