What is Compensation for Making an IRA Contribution? | Ed Slott and Company, LLC

What is Compensation for Making an IRA Contribution?

By Beverly DeVeny, IRA Technical Expert

Follow Me on Twitter: @BevIRAEdSlott

We get this question a lot. I have income from _________(fill in the blank). Can I make an IRA contribution? Sometimes the answer is yes, and sometimes it is no. The general rule is that you must have taxable income in order to make an IRA contribution, but not just any type of taxable income will do. Your income must be considered "compensation" in order to be able to use it to make an IRA contribution.

The following is a list of items that are considered compensation and items that are not considered compensation for the purposes of making an IRA or Roth IRA contribution. The rules for SEP and SIMPLE IRA contributions are different.

Compensation

  • W-2 Income Wages, salary, tips, bonuses, professional fees, amounts received for performing personal services and certain scholarship or fellowship payments. The safe harbor is the amount reported in box 1 of Form W-2 reduced by any amount in box 11.
  • Commissions
  • Self-employment income - Net earnings from self-employment in a trade or business when your activities in the business contribute to the income produced – reduced by the deduction for contributions to an employer plan and reduced by self-employment taxes.
  • Alimony - If you have to pay tax on the alimony you receive, you can use it as a source of compensation for making an IRA contribution.
  • Non-taxable combat pay - This is an exception to the rule that compensation must be taxable.

NOT Compensation


  • Earnings from property Rental income, interest and dividends.
  • Pension and annuity income, Social Security, required distributions from IRAs or employer plans.
  • Deferred compensation distributions from non-qualified deferred compensation plans – income deferred from a prior year. While it would have counted in the year it was earned, it does not count when the receipt of the income is postponed to a later year.
  • Partnership income if your activities do not contribute to the income produced, you cannot use it as a basis for making an IRA contribution.
  • Amounts excluded from income - Amounts such as foreign earned income that are excluded from the U.S. tax return cannot be used as the basis for making an IRA contribution. There is an exception for non-taxable combat pay.
  • Unemployment benefits - Since the definition of compensation is wages, salary or tips, unemployment income clearly is excluded.
  • Disability payments

This list is a good guideline, but it’s not all-inclusive. If you have any questions on whether or not you have compensation, you should consult with a specialist in this area. There is a 6% penalty for making an ineligible contribution. That penalty continues to apply each year the ineligible contribution remains in the IRA.

The penalty is reported on Form 5329, which is filed with your tax return each year. When the form is not filed, the statute of limitations does not start to run. IRS can, and will, go back to the date of the original error and charge the penalty + interest. They can also charge failure to file penalties and, if the amount is large enough, accuracy related penalties.
 

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