The Tax-Advantaged Accounts team at Wolters Kluwer often receives questions relating to individual retirement account (IRA) regular contribution eligibility. Though the Setting Every Community Up for Retirement Enhancement Act of 2019 (i.e., the SECURE Act) repealed the age 70½ restriction, which applied to traditional IRA regular contribution eligibility, compensation remains a requirement to make either a traditional IRA or Roth IRA regular contribution.
Compensation, or earned income, is generally 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 based on 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 include amounts excluded from income such as foreign earned income. Compensation also includes taxable alimony and separate maintenance payments, and 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, Wage and Tax Statement, representing 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 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 contribute 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 imply a profit. 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 owns a sole proprietorship selling flower arrangements to restaurants. Anticipating a successful business, Carla purchased equipment and materials to meet the demand. But in 2020, her first year in business, the expected demand was not there, and the business showed a net loss for the year. Carla had no other source of compensation; therefore, she could not make an IRA regular contribution for 2020.
As the result of a great advertising campaign and a flower fad during 2021, Carla’s second year in business, the sole proprietorship had a profit. After reducing her net profit by any other retirement plan contributions and reductions for self-employment taxes, Carla’s net income (earnings) on her tax return amounted to $4,400, allowing her to contribute up to $4,400 for 2021.
What are other amounts that 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 a 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 these income sources' complexities, 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. 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 before filing the tax return.
Additionally, Conservation Reserve Program (CRP) payments reported on Schedule SE (Form 1040), line 1b, are not considered compensation.
Finally, unemployment compensation does not qualify as compensation for IRA purposes.
Spousal contribution rule
It is possible not to have compensation but still be eligible to make an IRA regular contribution. The Kay Bailey Hutchison Spousal IRA contribution rules allow a non-compensated individual to use his/her working spouses' compensation when determining IRA regular contribution eligibility. The spousal rules require that a non-compensated 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 to his/her own IRA, considering 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 $7,000 traditional or Roth IRA contribution for 2021 (i.e., standard contribution limit of $6,000 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 2022, which includes compensation of at least $14,000 in 2022, they will each be able to contribute $7,000 for 2022.
Ultimately, the taxpayer 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 helps answer 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.
For an opportunity to learn more about IRAs and other tax-advantaged accounts, including Health Savings Accounts and Coverdell Education Savings Accounts, consider the Wolters Kluwer IRA Library or on-demand video training offered on a variety of topics. Go here to learn more about training opportunities available to you or call us at 1-800-552-9408.