3665 / What is “compensation” for purposes of IRA eligibility rules and deduction limits?

Editor’s Note: The SECURE Act modified the definition of compensation so that certain stipends provided to graduate students can be counted as compensation for IRA contribution purposes after December 31, 2019. Similarly, qualified foster care payments (excluded from income) can be treated as compensation for plan years effective after December 31, 2015 (retroactively) for defined contribution plans and after 2019 for IRAs.¹

For purposes of the eligibility rules and deduction limits applicable to traditional and Roth IRAs, “compensation” means wages, salary, professional fees, or other amounts derived from, or received for, personal services actually rendered. “Compensation” also typically included alimony paid under a divorce or separation agreement that is includable in the income of the recipient under IRC Section 71.² Because of the changes to the tax treatment of alimony payments following enactment of the 2017 tax reform legislation, non-taxable alimony payments are no longer “compensation” for these purposes.

In the case of a self-employed individual, “compensation” includes earned income from personal services, but in computing the maximum IRA or SEP contribution, such income must be reduced by (1) any qualified retirement plan contributions made by such individual on his or her own behalf and (2) the 50 percent of self-employment taxes deductible by the individual.

Earned income not subject to self-employment tax because of an individual’s religious beliefs is “compensation.”³

An individual whose income for the tax year consists solely of interest, dividend, and pension income has no “compensation” and cannot deduct any portion of a traditional IRA contribution.⁴ In addition, such a person may not make a Roth IRA contribution.⁵

Compensation does not include earnings and profits from property, such as rental income, interest, and dividend income, or any amount received as pension or annuity income, or as deferred compensation (see IRS Tax Topics No. 451).

Further, “compensation” does not include any Social Security or railroad retirement benefits required to be included in gross income.⁶ Payments made to employees terminated because of a restructuring of the company are deferred compensation and may not be used as a basis for IRA contributions.⁷ Amounts received from an employer as deferred incentive awards, whether in the form of cash, stock options, or stock appreciation rights, also are not “compensation.”⁸ However, incentive pay awarded in one year for services performed in that year but paid in the following year is considered “compensation” in that second year.⁹

The IRS has ruled that disability income payments, whether made under public or private plans, do not constitute “compensation.”¹⁰ Also, unemployment benefits do not constitute “compensation” because they are paid due to an inability to earn wages and not for personal services actually rendered.¹¹

Additionally, the IRS has issued a compensation “safe harbor.” The amount properly shown in the box for “wages, tips, other compensation,” less any amount properly shown in the box for “nonqualified plans,” on Form W-2 is considered or purposes of calculating an individual’s IRA contribution.¹²

Amounts paid by one spouse to another spouse to manage their jointly-owned investment property may not be treated by the spouse, on a joint return, as compensation for purposes of an IRA contribution.¹³ Similarly, wages paid to one spouse by another spouse and deposited in their joint account are not considered compensation because deposit in a joint account does not constitute actual payment of wages.¹⁴

Payment in hogs rather than cash by a husband to his wife for her services in running their farm, however, was considered to be compensation for purposes of making an IRA contribution.¹⁵

A self-employed individual who shows a net loss for the tax year cannot take any IRA deduction.¹⁶ A salaried employee who also is self-employed should disregard net losses from self-employment when computing his or her maximum deduction.¹⁷