To contribute to an individual retirement account (IRA) — either traditional or Roth — you first must have earned income. But it can't be just any old income. The Internal Revenue Service has specific rules for what it allows under its "taxable compensation" umbrella. Understanding those rules will let you know whether — and how much — you can contribute to any kind of IRA.
The IRS sets IRA contribution limits annually. For 2012, the annual contribution limit was $5,000 — or the total of your taxable compensation, if it's less than $5,000. If you're over 50, you can contribute an additional $1,000, but only if you have another $1,000 in qualified earned income.
Wages and salaries, plus tips, bonuses and professional fees paid to you, qualify as earned income in determining IRA contribution eligibility. If it's money that's listed in Box 1 of your W-2 form provided by your employer, you can consider it earned income. Allocated tips listed in Box 8 of your W-2 form also qualify.
If you earned commissions from your primary employer, they likely will be listed on your W-2. But if you were paid commissions through referrals or as a finder's fee, or if you received compensation as an independent contractor, you may not be issued either a W-2 or a 1099 detailing your pay. For those commissions or payments to qualify as earned income for IRA contributions, you must report them on your return as taxable income. In addition, any tips not recorded on your W-2 form must be reported as taxable income to count as earned income.
To figure your eligible earned income if you are a sole proprietor or a partner in a business, start with your net earnings and subtract the deduction allowed for self-employment taxes and any deduction made for contributions on your behalf to a retirement plan. However, you do not have to subtract a self-employment loss from other qualified income. For example, if you were paid $8,350 from a part-time job but reported a loss of $9,100 from a self-owned business, you still have $8,350 in IRA-eligible income.
The IRS allows taxable alimony and separate maintenance payments specified in a court decree to count as earned income for IRA purposes.
Although combat pay is not taxed, it qualifies as earned income in figuring IRA contributions.
If you file a joint return, you can claim as your own any qualified income earned by your spouse minus your spouse's IRA contributions. For example, if your spouse got $45,000 in taxable compensation and made a $5,000 Roth IRA contribution, you would be allowed a $5,000 IRA contribution — $6,000 if you're over 50 — even if you earned nothing yourself. In short, the total contributions for you and your spouse cannot exceed the joint earned income reported on your tax return.
You must be paid the money in the calendar year for which the IRA contribution is reported.
It might seem like work to you, but money received from rental property doesn't count as earned income for IRA purposes. Neither do dividend or interest payments. Also out: pension and annuity income; deferred compensation; income from a partnership in which you don't work; and any income except combat pay that carries no tax liability.