When you are laid off from a job with a sizable salary, depending on your state's unemployment benefits limit, the unemployment compensation you collect might leave enough after living expenses to save or invest. However, since the individual retirement arrangement, or IRA, was created for the benefit of working Americans, the Internal Revenue Service rule is that IRAs must be funded with earned income.
While the IRS defines earned income rather broadly, the term does not extend to unemployment compensation. In the case of IRA contributions, the IRS considers wages, salaries, commissions and tip income, in addition to taxable military pay and alimony, as earned income. Like unemployment compensation, Social Security and disability benefits are not considered income. Neither are interest and dividends, pension and annuity income, or severance pay.
Earnings While Unemployed
If during your term of unemployment you happen to earn money -- as a temporary employee, subcontractor or consultant, for example -- you are free to contribute those funds to a traditional or Roth IRA. Of course, during the weeks when you accept paid work, your unemployment benefits are reduced or eliminated.
Monitor Your IRA
While you cannot contribute unemployment benefits to an IRA, you can continue to monitor the account and shift or reallocate your assets as you wish. In fact, careful attention to your IRA investments can take on greater importance during periods of unemployment. Because your cash flow is down, you might want to hedge your bets by adopting less risky strategies, such as bonds or Treasury securities. On the other hand, you might prefer to look into higher-risk investments that may offer higher returns.
If you were laid off from a job where you participated in a 401(k), you might consider rolling your 401(k) into a traditional or Roth IRA. An IRA, particularly at a discount brokerage, might offer lower fees and a broader range of investment choices than a 401(k). If you opt to move the funds into a Roth IRA, you will be able to withdraw them at retirement age tax-free. If you decide to take this route, ask your 401(k) administrator to effect a direct, or trustee-to-trustee, rollover to sidestep the 20 percent withholding that would be required if the trustee made out a check to you.