All I have are publishing royalties, but I want to fund my Roth IRA. Do publishing royalties count as earned income to the IRS?
Roth IRAs can only be funded with earned income (which the IRS call “compensation”). In the IRS’ guide for IRA Contributions (Publication 590), they say compensation explicitly includes: wages, salaries, commissions, self-employment income, alimony, nontaxable combat pay, and “other amounts you receive for providing personal services”. Meanwhile, the following explicitly do not count as compensation: “earnings and profits from property, such as rental income, interest income, and dividend income,” pensions and annuities, deferred compensation, and any income excluded from your return.
Neither list clearly mentions royalties and therein lies the problem.
To help clarify, the IRS instructions say that any amount in box 1 of your W-2 counts as compensation, but royalty payments are noted on a 1099-MISC, so that guideline is no help.
Most other things paid on a 1099 (like interest, dividends, and royalties from property) are on the list of unearned income and are filed with Schedule E like royalties, which if anything, indicates that the IRS considers them all similar. That seems to be a blow against royalties counting as compensation. On the other hand, if your employer requests that you write the book for which you expect royalties, that seems like a clear example of compensation for work performed for your employer and thus “earned”, despite it being paid on a 1099.
That being said, there is one surefire way to make sure your royalties count as earned: treat your writing like a self-owned business. You would treat your writing like its own taxable entity (a sole proprietorship existing for the purpose of writing this book) that then creates tax liability for you personally. That means you would list your writing income (including royalties) and expenses on Schedule C instead of Schedule E and any profit would count as business income on your 1040. Royalties seem like a clear example of compensation for someone in the business of writing, and if you have clearly documented expenses (perhaps for research), that would support the argument that royalties were earned.
If you do this, treat it like a real business – get a business license and keep good records of what expenses were for and how they clearly apply to the book you’re writing. In 2010, a university professor decided to write a book on the side (counting it as a Schedule C sole-proprietor business) and take research and travel expenses against his book’s earnings. The IRS challenged and denied this because he didn’t have good documentation about whether his expenses were really for his book, for his work (which should then have been reimbursed by his employer, the City University of New York), or for himself personally.
The last caveat is that creating a self-employed business to persuade the IRS that your book royalties are earned income opens up the royalties to self-employment tax. This is an additional 15.3% tax which would not have applied if the royalties were left as Schedule E supplemental income. However, treating your writing career as its own business (in every respect) seems like the only clear path to convincing the IRS your royalties are earned, so you could consider the self-employment tax on your royalties the cost of funding your Roth with those royalties.
All this being said, funding your Roth has tremendous advantages and a lot of savings potential, so it is probably still worth it.
We are not tax professionals so consult your CPA or tax preparer about the practicality of this plan for you. The IRS makes a distinction between “earned” and “unearned” income ostensibly for the benefit of those who work hard for their money and writing is a hard business. It stands to reason that if you can document the effort, your royalties should allow you to contribute to your Roth.
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