Rules for Individual Retirement Accounts (IRAs) are complex and widely misunderstood. Errors can be costly, sometimes in cash, and other times in lost opportunities. First and foremost is the eligibility to contribute, which now is only circumstantially related to age. Contributions were formerly limited to people under age 70-1/2. That restriction was eliminated in 2020, following the COVID-19 outbreak.
On the age scale, there is no statutory age limit for contributions, but there is a practical limit, based on income eligibility. At the earliest ages, unless you are one of the most beautiful babies ever (think: Gerber Baby), there is no legitimate way for infants to earn qualified income on which to base a contribution. Eligible income is a broad topic, and not widely understood.
In financial discussions, it is sometimes illustrative to begin with the negative; in this case, what is not considered eligible (earned) income is vitally important. Here are some examples:
- Social Security income is not considered earned income
- Annuity payments, including Traditional Pension Plan payments, are ineligible for IRA contributions
- Investment income, including interest, dividends, and capital gains, are unearned, and therefore are ineligible
- Sub-S Corporation dividend income is considered unearned, as are some partnership payments. (Note that wages and salaries from S-Corps and Partnerships are earned, payroll taxes are due on those earnings, and IRA contributions are allowed.)
- Life insurance proceeds are ineligible (and non-taxable)
- Disability payments and unemployment income, although taxable, are disallowed
- Alimony and Child Support payments that are not taxable are ineligible
- Income from rental properties is unearned, unless real estate is the taxpayer’s official business, and are ineligible
- Gifts received are not qualified
Qualified income (for IRA contributions) takes several forms, most of which are obvious, but a few may catch you by surprise. Wages, Salaries, and Tips, etc. is a line item from the 1040 Form. Items that make their way into that category are IRA qualified. A few other items are generally acceptable, including income from a business you operate (self-employment), taxable alimony and/or maintenance received, and fees for serving jury duty and as directors of organizations.
Other qualified income sources are considerably more obscure, including:
- Combat pay (even if no income tax applies)
- Vacation pay accrued (even if paid in a different year)
- Scholarships, if included in Box 1 of a W-2 (Box 1 includes wages, tips, and other compensation)
- Non-tuition payments for fellowships or stipends
- Difficulty of Care payments (received for caring for an individual who has a handicap, though these payments are generally excluded from taxable income)
Perhaps the most often missed opportunity happens when a married couple has only one breadwinner. In these cases, the non-working spouse can contribute based on the worker’s income, subject to all general rules and restrictions. This is called a “spousal contribution” into a “Spousal IRA.”
All IRA contributions are subject to annual limitations, currently $6,000 ($7,000 for ages 50 and up). Contributions are also capped by eligible income, and cannot exceed that total amount (whether single or married, including spousal contributions).
Knowing the rules may enable contributions from people who otherwise have no qualified source of income. Knowing the rules may also save a taxpayer from making an ineligible contribution, which leads to penalties.
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