We often receive questions relating to individual retirement account (IRA) regular contribution eligibility for minors and older individuals. In order for these individuals, or anyone interested in making an IRA regular contribution, the paramount question is “does the individual have compensation?”
Compensation, or earned income, is required to make a traditional and/or Roth IRA regular contribution. Generally, compensation is the amount an individual earns from working. This article will explain what compensation is and is not for IRA regular contribution eligibility purposes.
Internal Revenue Service (IRS) Regulation 1.219-1(c) defines compensation as “wages, salaries, professional fees, or other amounts derived from or received for personal service actually rendered (including, but not limited to, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, and bonuses) and includes earned income from self-employment, as defined in IRC Section 401(c)(2), but does not include amounts derived from or received as earnings or profits from property (including, but not limited to, interest and dividends) or amounts not includable in gross income”. Compensation does not include amounts received as deferred compensation, pension or annuity payments (including IRA distributions and social security benefits), nor does it include amounts excluded from income such as foreign earned income. Compensation also includes taxable alimony and separate maintenance payments as well as any nontaxable combat pay, (reported in box 12 of Form W-2 with code Q). Additionally, scholarship and fellowship payments are compensation for IRA contribution purposes (if shown in box 1 of form W-2).
What does this mean?
The most important phrase in the above definition of compensation is “amounts derived from or received for personal service actually rendered”. For most of us, this means serving as an employee and receiving a W-2 for our wages. Per IRS Revenue Procedure 91-8 and supported by IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), the IRS treats as compensation any amount properly reported in box 1 (Wages, tips, other compensation) of form W-2, Wage and Tax Statement, provided that amount is reduced by any amount properly shown in box 11 (Nonqualified plans).
Example: Amelia, age 16, worked at Burger Shack for the summer and as a result received a W-2 with $3,500 shown in Box 1 as wages. Amelia could establish an IRA and make a contribution of up to $3,500.
A self-employed individual must consider profits and losses from all businesses when determining “net earnings” as defined in IRC Section 401(c)(2). Net earnings implies a profit situation. A net loss from a self-employed individual’s business is viewed as no compensation for IRA purposes. However, a net loss is not subtracted from salaries or wages when figuring total compensation.
To determine compensation for IRA regular contribution eligibility purposes, a self-employed person must first determine whether his/her services are a material income producing factor in the business and if so, must also reduce the net profits by any contributions to a retirement plan, as well as the deduction allowed for the deductible part of self-employment taxes.
Example: Carla and Suzy formed an equally-owned partnership to sell flower arrangements to restaurants. Anticipating a successful business, they purchased equipment and materials to meet the demand. But the demand was not there and the business showed a net loss for the first year of operation. As self-employed individuals, Carla and Suzy each reported 50 percent of the total partnership loss on their tax return. In 2017, their first year in business, neither Carla nor Suzy had another source of compensation, therefore they were unable to make an IRA regular contribution for 2017.
As the result of a great advertising campaign and a flower fad during 2018, their second year in business, the partnership had a profit of $8,800 (determined after reducing their net profits by any other retirement plan contributions and reductions for self-employment taxes). Carla and Suzy each reported 50 percent of the total partnership net income on their tax return allowing each of them to contribute up to $4,400 for 2018.
What other amounts are not considered compensation?
It is more complicated to explain what is not considered compensation compared to what is compensation. To add to the amounts listed above, any amount “derived from or received as earnings or profits from property” heads the list of income not recognized as compensation for IRA purposes. This includes interest, dividends on stock, rental income, royalties, or gains received when property is sold (long- or short-term capital gains). These sources and others like them are considered passive sources of income. In other words, there is no active or personal service rendered by the income recipient. Because of the complexities that often surrounds these income sources, it is best to consult with a tax professional for clarification.
Example: Tom is a retired farmer. As an income supplement, he rents out some acreage to local farmers. Because he does not materially participate in the farming operation, and renting farmland is not Tom’s official business, the income is passive and though it might be taxable, it is not considered compensation for IRA purposes.
Compensation does not include “amounts not includable in gross income”. Amounts earned by an employee but contributed to a 457 plan, a 403(b) tax-sheltered annuity, or a 401(k) cash or deferred arrangement under a salary reduction arrangement that are not includable as gross income are exclusions from income prior to filing the tax return.
Additionally, Conservation Reserve Program (CRP) payments reported on Schedule SE (Form 1040), line 1b are not compensation.
Finally, unemployment compensation does not qualify as compensation for IRA purposes.
Spousal contribution rule
It is possible to not have compensation but yet be eligible to make an IRA regular contribution. The Kay Bailey Hutchison spousal IRA contribution rules allow a noncompensated individual to use his/her working spouses’ compensation when determining IRA regular contribution eligibility. The spousal rules require that a noncompensated individual is married at the end of the year for which the contribution is made and files a joint federal income tax return with his/her spouse. Each spouse can contribute up to the maximum amount, as long as the working spouse’s compensation, or the couple’s combined compensation, is equal to or greater than the aggregate amount contributed by the married couple.
Example: George, age 67, is retired, and married to Kris, age 64. They file a joint federal income tax return. Kris is working and has compensation of $20,000. George and Kris can each make a $6,500 traditional or Roth IRA contribution for 2018 (i.e., standard contribution limit of $5,500 plus catch up of $1,000). This is because the combined contribution amounts do not exceed Kris’ compensation for the year. Considering George and Kris again file a joint federal income tax return for 2019 which includes compensation of at least $14,000 in 2019, they will each be able to contribute $7,000 for 2019 (i.e., the standard contribution limit increased to $6,000 for 2019 plus catch up of $1,000).
Ultimately, it is the taxpayer who must prove to the IRS the existence of compensation or “earned income” for IRA contribution purposes. Being aware of what is or what is not considered compensation is helpful in answering general inquiries by your customer. However, if an individual is unsure of what qualifies as compensation, or has a unique tax situation, he/she should seek professional tax advice.