Whether you are in your 20’s, 30’s or 40’s, it is never too late to start planning for the golden years of your life. Though it is best if you start saving for retirement as early as possible, you need to do your homework and undertake financial planning to best prepare for your present and future financial needs. You must understand that it takes a considerable amount of hard work, long hours and decades of saving money to build a sizable retirement corpus that would allow you to enjoy your retirement years.
So, before investing your money in any financial instrument, do take time to understand the methodology, rate of return, investment options available to you, rules and regulations related to taxation, etc. One of the more popular investment vehicles available to investors is an individual retirement account (IRA). An IRA is a tax-advantaged account used by investors to save for retirement.
First introduced in the mid-1970s, there are a number of different kinds of IRAs you can invest in depending on your employment status - Traditional IRAs, Roth IRAs, SEP IRAs, and SIMPLE IRAs. However, you need to adhere to certain income restrictions such as having a qualifying source of income, without which you cannot contribute towards the account. In addition, the stipulations get updated each year requiring you to stay on top of the changing rules to identify whether your income qualifies for contributing to IRAs or not. To understand more about IRAs and how they can fit in your retirement plans, get in touch with a professional financial advisor.
What is meant by earned income?
Earned income refers to any money received as pay in exchange for carrying out work. This can be in the form of wages, salaries, bonuses, commissions, tips, and in case you are self-employed, net earnings can be deemed as earned income. It also constitutes money received due to long-term disability, union strike benefits and from certain deferred retirement compensation arrangements but only when received before the retirement age.
Let us discuss the different kinds of sources of qualified income that are eligible for IRA contributions:
1. Compensation earned as an employee
If you are working as an employee then income earned in the form of wages, salaries, tips, bonuses, incentives, and commissions is deemed as qualifying income and considered eligible for contribution to an IRA.
2. Income generated from self-employment
If you are self employed then any income generated from self employment or net income from self-employment in trade or business, professional services, or as an independent contractor is deemed as qualifying income. Please note that income from self employment would only qualify as earned income wherein your business activities lead to generation of income. Furthermore, this income must have been subjected to deductions for contributions to an employer plan and self-employment tax adjustments as well.
If you are an independent contractor like a consultant, freelancer, technician, plumber, electrician, driver or any other service provider, any income that you generate due to services provided by you will be deemed as qualifying income. Similarly, if you are a professional such as a chartered accountant, an architect, a doctor, or a lawyer, the income you generate from your professional practice is considered as qualified income.
Further, if you own a business, or you are a sole proprietor, any business income reported under Schedule C of Form 1040 after taking into account adjustments for deductions, is deemed as qualifying income. If you are a member of a partnership firm or a limited liability company, then any income reported in your name under Schedule K-1, is deemed as your self-employment earned income.
With that said, there are certain restrictions on self-employment income. For example, if you have invested in a business and you earn a share in the profits in proportion to your investment, then it will not be considered as self-employment income. Only in cases wherein you actively take part in the running of a business and your activity generates business income, then you can include the money as your earned income. Further, any returns or earnings generated from stock investments made by you cannot be considered as earned income.
SPONSORED WISERADVISOR
Need a financial advisor? Compare vetted advisors matched to your specific requirements.
Choosing the right financial advisor is daunting, especially when there are thousands of financial advisors near you. We make it easy by matching you to vetted advisors that meet your unique needs. Matched advisors are all registered with FINRA/SEC. Click to compare vetted advisors now.
3. Income from alimony
As per a special IRA rule, any income generated through alimony payments shall be considered as earned income after deduction of taxes. This rule is only applicable to taxable alimony income and forms a part of divorce decree or separation agreement ratified after 2018. So, in a scenario wherein you do not work and are solely dependent on your alimony payments, it can be deemed as earned income as long as it is taxable alimony. With that said, child support payments are not considered as earned income and cannot be used to pay for IRA contributions.
4. Combat pay
If you have served in the United States armed forces and been posted in a combat zone or have been provided with qualifying services outside the combat zone, then you are deemed eligible to receive combat pay. Do note that combat pay is a non-taxable income. In addition, it is the only non-taxable income source deemed eligible for contributions to an IRA.
What are the income sources not considered as eligible for IRA contributions?
Retirement pensions, Social Security payments, interest income, annuity benefits, dividend income, unemployment benefits, nontaxable alimony, and child support are income sources that are deemed ineligible and not considered as earned income for contributions to an IRA account.
To summarize
An IRA is a popular and wise investment option for investors looking to plan for their retirement. But it only works if you are eligible to make contributions to it. So, do ensure that when you open an IRA account that you adhere to all the requirements, and the compensation you receive is eligible to make contributions to your IRA account. Do consult with a professional financial advisor to understand the different kinds of IRAs, its tax benefits, rules pertaining to withdrawal, penalties, annual contribution limits, availability of investment options, and more.
To get in touch with a fiduciary advisor who may help you with creating an effective retirement strategy for your unique financial requirements, use the free advisor match service. Answer a few simple questions about yourself and the match tool will help connect you to 1-3 advisors suited to meet your financial needs.