By Kelly Greene
What counts as “compensation” that you can contribute to an IRA?
The answer is trickier than you might think, especially if you’re semi-retired or unemployed.
The Tax Court recently ruled that a 68-year-old taxpayer did not qualify as a professional investor/trader, as he claimed on his 2005 tax return, when he contributed $4,500 in dividends and interest income to his individual retirement account, according to a March 17 memorandum in the case of Robert Kobell v. Commissioner of Internal Revenue.
Dividends and interest are only considered compensation if the taxpayer is a dealer. Although the taxpayer had worked in New York early in his career as a trader, he had made only three stock transactions in 2005, did not have customers and did not operate “from an established place of business,” the memo says.
The Tax Court concluded that the $4,500 was not considered compensation, which meant it could not be deducted as an IRA contribution.
Ed Slott, an IRA consultant in Rockville Centre, N.Y., points out that the Tax Court ruled on whether the IRA contribution was deductible, because this was what the Internal Revenue Service had challenged. But the taxpayer wasn’t eligible to make an IRA contribution at all, regardless of whether he deducted it, because he didn’t have compensation.
This points up an important, and potentially costly, lesson for taxpayers in transition: When you make an IRA contribution but have no compensation, or less compensation than your total IRA and Roth IRA contributions, it’s considered an “excess contribution.” Excess contributions are subject to a 6% excise tax for each year they remain in the IRA.
So, what does count as compensation? For most people, it’s pretty simple: Earned income, mainly your paycheck.
But other times it isn’t so easy to determine. You might be getting your retirement income from an annuity or pension – but that doesn’t count as compensation. Alimony and maintenance payments do count – but not child support.
Unemployment income – despite being referred to as “unemployment compensation” in an IRS publication, doesn’t count as compensation for IRA purposes, Mr. Slott says.
To keep track of what counts as compensation for IRA purposes, he put together the following:
- Any amount shown in box 1 of Form W-2: Wages, salaries, commissions, professional fees, bonuses, other amounts received for personal services
- Net self-employment income (reduced by contributions to employer plans and the deduction for self-employment taxes)
- Net self-employment income from personal services (e.g., clergy, professional traders) even if it is not subject to self-employment tax (reduced by contributions to employer plans and the deduction for self-employment taxes)
- Taxable alimony and/or maintenance payments
- Combat pay (even though it may be excluded from federal income tax)
- Accrued vacation pay
- Director’s fees, jury fees
- Scholarship or fellowship payments if included in Box 1 of a W-2
Compensation does not include:
- Pension and annuity income: IRA, Roth IRA, company plan distributions and non-qualified annuity distributions, Social Security benefits
- Rental income (unless it is the taxpayer’s business)
- Interest income, dividend income, capital gain income, certain income from partnerships, S-Corp income, amounts excluded from income (other than combat pay)
- Child support
- Life insurance proceeds
- Deferred compensation
- Severance pay
- Disability payments and unemployment insurance