What is Eligible Compensation When Making an IRA Contribution?
By Natasha Pratts, CIP
In today’s rapidly changing workforce, people are finding alternative ways to earn income. Many businesses arose from the new wave of freelance work and side hustles propelled by the coronavirus pandemic. And members of Generation Z (those born from 1997-2012, also called “iGen”) are much more likely to choose less traditional work structures. Educating these clients on available savings vehicles—and on what makes them eligible to contribute—has become critically important. While many have discovered new avenues to earn income with increased flexibility, these opportunities often lack retirement education and employee benefits. So part-time and self-employed workers are increasingly on their own when it comes to retirement savings.
Why contribute to an IRA?
Most people invest in an IRA to save for retirement. But there are other reasons, as well. Many people will continue to earn income well after traditional “retirement age.” They may use an IRA to build wealth to leave to family, friends, or charity. And some individuals will use their IRAs to help purchase their first home, to reduce their taxable income, or as extra income in case they become disabled.
What’s age got to do with IRA contributions?
Nothing anymore. With the passage of the SECURE Act in 2020, there are no longer age limits to contribute to a Traditional or Roth IRA. Previously, individuals age 70½ and older could not contribute to a Traditional IRA. Today, to be eligible to make a Traditional IRA contribution, an IRA owner (or spouse) needs only to have eligible compensation. Roth IRA contributions may be limited by the modified adjusted gross income (MAGI) of the individual or couple.
What is “Eligible Compensation”?
In most cases, eligible compensation is income a person earns from working. The most obvious eligible compensation is W-2 income, or wages, salaries, tips, professional fees, bonuses, commissions, or any fee-for-service amounts. Other eligible compensation includes
self-employment compensation,
nontaxable combat pay,
certain non-tuition fellowship and stipend payments, and
taxable alimony paid under a divorce or separation agreement.
What is NOT “Eligible compensation”?
Passive income—including most retirement income—is not considered eligible compensation. The following are not considered eligible compensation.
Social Security payments, pensions, or annuity payments.
Disability payments, workers compensation, child support, and unemployment compensation.
Need-based program such as food stamps, cash assistance, rental assistance, or housing assistance.
Deferred compensation (payments postponed from prior years), and profits from rental income, interest income, and dividends.
Foreign earned income and housing costs.
Income from certain partnerships.
Other contribution limit considerations
Your clients should understand that they must earn enough eligible compensation for the tax year to support their IRA contributions. For example, a part-time pizza delivery person earning $2,000 could make a maximum contribution of $2,000, even though the 2022 annual IRA contribution limit is $6,000 (with a $1,000 catch-up contribution for those 50 years and older).
It is also important to note that a six percent penalty tax applies for each tax year that an ineligible contribution remains in the IRA. Such contributions must be removed as an excess contribution or redesignated for a future year. While it is ultimately the responsibility of the IRA owner to know whether they qualify to make an IRA contribution, directing them to the proper resources beforehand may save them time and money in the long run.
Further information on eligible compensation and IRA contribution eligibility for your clients can be found in IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), or direct them to seek advice from a competent tax professional.
