| Qualifying Incomes for
Roth & Traditional IRA Contributions
(August 22nd, 2009)
In order to make contributions to a Roth IRA
or traditional IRA account, you or your spouse must have qualifying
compensation income, which is the purpose of this article. There
are 3 categories of qualifying income:
i) Employee wages
ii) Self-employment income
iii) Alimony income
a) Amounts earned as an Employee
 For
employees, compensation income generally includes wages, salaries,
tips, sales commissions, bonuses, etc. However, the following types
of income that an employee generally receives do NOT count as compensation
income:
- Pension or annuity payments
- Foreign earned income/dividends
- Deferred compensation
b) Self Employment Income
Self-employment income also counts as qualifying
compensation income earned in any of the following ways:
- You can be a professional with your own practice,
e.g. accountant/dentist/doctor.
- You can be a sole proprietor running your own
un-incorporated business.
- You can be a member of a partnership or a limited
liability company (LLC), examples include law firms. In such a case,
the partnership or LLC will give you a Schedule K-1 each year instructing
you how much income to report for that year and how much of that
income is self-employment wage.
- You can be an independent consultant/contractor
e.g. plumber, electrician, accountant, etc.
In order for your income to be considered self
employment income, your income should be derived from sources only
if your services are "a material income-producing factor”
meaning you must be actively involved in your business generating
income, you can’t merely be an investor (you must participate
in the operations & management of the business).
Even if you are actively involved in a business,
you cannot include the investment income from that business as self-employment
income. For example consider your coffee shop owns some US treasury
bonds as investment on the side that generate interest returns each
year, you cannot include this as self employment income.
Also be aware that your total contributions to
a Roth IRA or traditional IRA from self employment income must be
all incomes less all expenses incurred to generate this income equalling
net self employment income.
Losses from Self Employment Income
When you face a loss from your self-employment
business, do not subtract this loss from any compensation income
you receive as an employee from your part time job on the side.
For example, consider you earned $10,000 this year working part
time for a company, but incurred a $4500 loss from your self-employment
income, your qualifying income for making Roth or Traditional IRA
contributions is still $10,000.
Incomes that do not qualify:
- Investment income including dividends and interest
- Pension & annuity payments
- Compensation deferred from a previous year
- Foreign earned investment income
Rule of Thumb
It can be tricky classifying incomes as qualifying
compensation incomes, and other types of incomes. To make this easy
on Americans, the IRS says you can treat any item as compensation
income if it's included in IRS W-2 form labelled "Wages, tips,
other compensation." IRS
Form W-2 can be downloaded here.
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