We are huge fans of Roth IRAs because they allow investors to grow their money tax-free. Even though there is no deduction for contributions, a Roth IRA provides the dual benefits of tax-free accumulation and tax-free distributions after age 59 1/2. The long-term benefits can be significant.
Roth IRAs also make great emergency funds because at all times and at any age, you can withdraw as much as you have contributed to a Roth IRA without tax or penalty.
Contributions to Roth move assets from your bank account where the interest is taxable to your Roth IRA where it is not. Then, if you need those assets later, you can withdraw the amount you contributed without consequences, leaving any investment gains behind. We refer to this strategy as “Funding Your Roth IRA Even When You Can’t Afford It.”
Roth IRAs can only be funded with earned income (which the IRS calls “taxable compensation”). In the section called “What is Compensation?” of Publication 590 , the IRS lists examples of what is taxable compensation which are reviewed below.
What counts as compensation?
The IRS explains, “Generally, compensation is what you earn from working. For a summary of what compensation does and doesn’t include, see Table 1-1 . Compensation includes all of the items discussed next (even if you have more than one type).”
Those types are:
- Wages, salaries, etc. explained as “The IRS treats as compensation any amount properly shown in box 1 (Wages, tips, other compensation) of Form W-2, Wage and Tax Statement, provided that amount is reduced by any amount properly shown in box 11 (Nonqualified plans).” This notably also includes:
- taxable life insurance benefits, and
- a scholarship or fellowship included in box 1 of your Form W-2.
- Commissions explained as “An amount you receive that is a percentage of profits or sales price is compensation.”
- Self-employment income explained as “the net earnings from your trade or business (provided your personal services are a material income-producing factor) reduced by the total of the deduction for contributions made on your behalf to retirement plans, and the deduction allowed for the deductible part of your self-employment taxes.” The IRS notes that, “If you have a net loss from self-employment, don’t subtract the loss from your salaries or wages when figuring your total compensation.”
- Alimony and separate maintenance explained as “any taxable alimony and separate maintenance payments you receive under a decree of divorce or separate maintenance but only with respect to divorce or separation instruments executed on or before December 31, 2018, that have not been modified to exclude such amounts.”
- Nontaxable combat pay explained as “any nontaxable combat pay you received. This amount should be reported in box 12 of your 2022 Form W-2 with code Q.”
- Graduate or postdoctoral study explained as “taxable non-tuition fellowship and stipend payments made to aid you in the pursuit of graduate or postdoctoral study and included in your gross income under the rules discussed in chapter 1 of Pub. 970, Tax Benefits for Education.”
What does not count as compensation?
Compensation doesn’t include any of the following items:
- Earnings and profits from property, such as rental income, interest income, and dividend income.
- Pension or annuity income.
- Deferred compensation received (compensation payments postponed from a past year).
- Income from a partnership for which you don’t provide services that are a material income-producing factor.
- Conservation Reserve Program (CRP) payments reported on Schedule SE (Form 1040), line 1b.
- Any amounts (other than combat pay) you exclude from income, such as foreign earned income and housing costs.
In our experience, most people benefit from contributing to a Roth IRA. We have written several articles on this topic including “Open a Roth IRA Today or Regret It Later” and “The Role of a Roth IRA in Early Retirement.”
If you and your spouse file a joint tax return, only one of you needs to have compensation in order for both of you to be able to fund a Roth IRA. Therefore, if you or your spouse have earned income, you would likely benefit from fully funding both of your Roth IRAs. However, if you are not sure if you qualify to do so, we recommend consulting a licensed tax professional before making your Roth IRA contributions. This may save you from having to correct excess Roth IRA contributions.
For more on this topic consider reading:
- Can I Fund My Roth With Book Publishing Royalties?
- Can I Contribute To A Roth IRA If I Don’t Have A Job?
- Can I Fund My Roth IRA with Appreciated Stock?
- Can I Contribute to my Roth IRA?
- Can Taxable Life Insurance Benefits Contribute to an IRA?
Photo by Megan Savoie on Unsplash. Image has been cropped.