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Opening an individual retirement accounts (IRA) can help you build wealth for the future while enjoying some tax breaks. One thing you’ll need to contribute to an IRA is earned income. The IRS defines what is considered earned income for IRA contributions, along with other guidelines for eligibility. A financial advisor can help you optimize your retirement savings and investments to minimize your tax liability. IRA BasicsAn IRA is a tax-advantaged retirement savings plan that’s distinct from workplace plans, such as a 401k or 457b. There are different types of IRAs, with the most common being traditional and Roth. A traditional IRA is funded with pre-tax dollars and can allow for deductible contributions. Roth IRAs are funded with after-tax dollars and allow you to withdraw money tax-free in retirement. The IRS limits how much you can contribute to an IRA each year. As of 2022, the IRA contribution limit is $6,000. An additional catch-up contribution of $1,000 is allowed if you’re 50 or older. These limits apply to traditional and Roth IRAs. Self-employed individuals and business owners have additional IRA options. For example, you might open a SEP IRA or Simplified Employee Pension for yourself if you’re an independent contractor or sole proprietor. If you run a small business with employees, you might opt for a SIMPLE IRA instead. These IRAs have different annual contribution limits. While there are differences between traditional, Roth, SEP and SIMPLE IRAs, one thing holds true for all of them. You’ll need to have earned income in order to open and contribute to one of these accounts. What Is Considered Earned Income for IRA Contributions?Generally, earned income for IRA contributions is money earned from employment. Examples of earned include:
If you have any of these types of income for the year, then you could make contributions to an IRA. In certain cases, the IRS can also consider other types of compensation for IRA contributions. For example, if you’re receiving alimony or child support or aid related to graduate or postdoctoral studies, those might qualify as earned income. What Is Not Considered Earned Income for IRA Contributions?There are certain types of income you might receive that may be taxable, but not countable as earned income. The IRS doesn’t allow you to include any of the following as earned income for IRA contributions:
In general, the IRS also excludes welfare benefits, unemployment compensation, worker’s compensation benefits and Social Security benefits from earned income calculations. There is an exception for military members who receive excludable combat zone compensation. Those benefits can be counted as earned income. Income Limits for Making Roth IRA ContributionsAside from having earned income, you also have to be within certain income limits in order to contribute to a Roth IRA. Specifically, the IRS bases eligibility to make Roth IRA contributions on modified adjusted gross income (MAGI) and filing status. For 2022, you can make the full contribution to a Roth IRA if you:
Your ability to contribute to a Roth IRA phases out once your income exceeds the allowed threshold for your filing status. For example, you can’t contribute anything to a Roth IRA if you file single, head of household or married filing separately and didn’t live with your spouse if your MAGI is equal to or greater than $144,000. The phaseout threshold for married couples filing jointly and qualifying widow(er)s is $214,000. If you’re married, file separately, but live with your spouse you can only contribute a reduced amount if your MAGI is below $10,000. Income Limits for Deducting Traditional IRA ContributionsIncome isn’t a deciding factor for whether you can contribute to a traditional IRA. But your income and whether you’re covered by a retirement plan at work do determine how much of those contributions you can deduct. If you’re not covered by a retirement plan at work, your contributions are not limited by income. So you can deduct any amount you contribute, up to the annual limit, regardless of how much you earn. There’s an exception, however, if your spouse is covered by a plan at their job. In that case, you can deduct the full contribution for 2022 only if your modified AGI is $204,000 or less. The deduction phases out once your MAGI exceeds $214,000. This assumes you file a joint return. If you file separate returns, only a partial deduction is allowed if your MAGI is less than $10,000. If you are covered by a retirement plan at work, your income directly affects how much of your traditional IRA contributions you can deduct. For 2022, a full deduction is allowed if you:
Married couples who file separately are only allowed a partial deduction when MAGI is below $10,000. How to Make IRA Contributions If You Have Earned IncomeOnce you determine what is earned income for IRA contributions and you verify that your income fits the IRS definition, you’re ready to start saving. If you don’t have an IRA already, you can open one through a brokerage online. This typically involves completing an application, verifying your identity and linking an external bank account to fund your IRA. After your IRA is open, you can begin making contributions. This can be as simple as logging in to your brokerage account, choosing the investments you want to buy and selecting an amount to transfer from your linked bank account. You can make contributions at different times each month or schedule money to be transferred to your IRA automatically. The most important thing to keep in mind is that you can only contribute amounts up to the allowed limit. Making excess contributions to an IRA can result in a tax penalty. So it’s a good idea to keep track of your contributions as you make them. Bottom LineContributing to an IRA can help you to create a more secure retirement picture. You can save in an IRA in addition to the money you’re adding to a retirement plan at work or in place of a workplace plan if you don’t have one. The key is making sure you have earned income to satisfy IRS requirements. Retirement Planning Tips
Photo credit: ©iStock.com/nathaphat, ©iStock.com/insta_photos, ©iStock.com/Kobus Louw Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
What is not compensation for IRA purposes?Compensation for purposes of contributing to an IRA doesn't include earnings and profits from property, such as rental income, interest and dividend income, or any amount received as pension or annuity income, or as deferred compensation.
Which of the following is not allowed in an IRA?Key Takeaways
Collectibles such as artworks, rugs, antiques, metals, gems, stamps, coins, and alcoholic beverages cannot be held in these accounts.
What is considered compensation for a Roth IRA?Roth IRA Eligibility
That includes commissions, tips, bonuses, and taxable fringe benefits. Both W-2 employees and 1099 contractors would receive earned income. You run your own business or farm, or there are some other types of income that are treated as earned income for purposes of Roth IRA contributions.
What is considered compensation for Simple IRA match?For purposes of the SIMPLE IRA plan rules, a self-employed individual's compensation means net earnings from self-employment determined under Internal Revenue Code Section 1402(a), prior to subtracting any contributions made to the SIMPLE IRA plan for the individual.
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