Is social security considered earned income for ira contributions

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Individual Retirement Accounts (IRAs) are one of the most popular tools for building retirement savings: More than a third of U.S. households ha ve an IRA. But each year, the IRS adjusts the rules for IRA eligibility based on inflation. In 202 2, those adjustments will make a big difference in who can contribute to a Roth IRA, and who can deduct their contributions to a traditional IRA from their taxable income.

For traditional and Roth IRA s, you can contribute $6,000 for 2022, which is unchanged from 2021. Retirement savers age 50 and older can chip in an extra $1,000 a year as a catch-up contribution, so $7,000 in all, also unchanged from 2021. A person who starts contributing at age 50 can sock away $105,000 in an IRA by age 65 , excluding any investment returns on the principal; a couple could save $210,000.

Traditional IRAs

A traditional IRA allows you to deduct your contribution from your income, which can reduce your taxes and make it easier on your budget to save. For example, suppose you’re in the 24 percent federal income tax bracket. In order to save $7,000 for retirement in a fully taxable account, you would have to earn about $9,211 before taxes. With a traditional IRA, however, you can deduct that $7,000 contribution, meaning that to get $7,000 to invest, you only have to earn $7,000. (You can only contribute earned income to an IRA; investment income and Social Security benefits don’t count .)

If you (or your spouse) don’t have a retirement plan of any kind, you can take the full deduction for an IRA. If you do have a retirement plan available from your employer — even if you don’t take advantage of it — your ability to deduct a traditional IRA contribution is limited by your modified adjusted gross income (MAGI), which is your adjusted gross income on your 1040 or 1040-SR tax form, minus certain deductions, such as student loan interest.

You can’t avoid paying taxes on your traditional IRA contributions , as well as any investment gains, forever. When you start taking withdrawals after age 59 1/2, your withdrawals are taxed at your regular tax rate. For example, if you are in the 24 percent tax bracket and you take out $7,000, you’ll get $5,320 after federal income taxes. In addition, you must take required minimum distributions (RMDs) from your IRA after age 72, based on IRS life expectancy tables.

If you take a withdrawal from your traditional IRA before age 59 1/2, you’ll have to pay an additional 10 percent penalty on the entire amount you withdraw. If you are 58 years old and take $7,000 from your IRA, for example, you’ll owe a $700 tax penalty in addition to any federal and state income taxes on the entire amount you withdraw.

Roth IRAs

Contributions to a Roth IRA aren’t deductible, but you pay no taxes when you withdraw your contributions at any age. And if you make a qualified withdrawal after you hit age 59 1/2, you pay no taxes on your earnings, either. (You must also have started your Roth IRA account at least five years before taking withdrawals from your earnings.) There are no RMDs for Roth IRAs.

There’s one catch: Your ability to make contributions to a Roth IRA are limited by your federal income tax filing status and your MAGI.

The table below shows the income limits for 2022 for making Roth contributions. As with traditional IRA contribution limits, the Roth income limits are adjusted for inflation each year.

John Waggoner covers all things financial for AARP, from budgeting and taxes to retirement planning and Social Security. Previously he was a reporter for Kiplinger's Personal Finance and  USA Today and has written books on investing and the 2008 financial crisis. Waggoner's  USA Today investing column ran in dozens of newspapers for 25 years.

By Natasha Pratts, CIP

In today’s rapidly changing workforce, people are finding alternative ways to earn income. Many businesses arose from the new wave of freelance work and side hustles propelled by the coronavirus pandemic. And members of Generation Z (those born from 1997-2012, also called “iGen”) are much more likely to choose less traditional work structures. Educating these clients on available savings vehicles—and on what makes them eligible to contribute—has become critically important. While many have discovered new avenues to earn income with increased flexibility, these opportunities often lack retirement education and employee benefits. So part-time and self-employed workers are increasingly on their own when it comes to retirement savings.

Why contribute to an IRA?

Most people invest in an IRA to save for retirement. But there are other reasons, as well. Many people will continue to earn income well after traditional “retirement age.” They may use an IRA to build wealth to leave to family, friends, or charity. And some individuals will use their IRAs to help purchase their first home, to reduce their taxable income, or as extra income in case they become disabled.

What’s age got to do with IRA contributions?

Nothing anymore. With the passage of the SECURE Act in 2020, there are no longer age limits to contribute to a Traditional or Roth IRA. Previously, individuals age 70½ and older could not contribute to a Traditional IRA. Today, to be eligible to make a Traditional IRA contribution, an IRA owner (or spouse) needs only to have eligible compensation. Roth IRA contributions may be limited by the modified adjusted gross income (MAGI) of the individual or couple.

What is “Eligible Compensation”?

In most cases, eligible compensation is income a person earns from working. The most obvious eligible compensation is W-2 income, or wages, salaries, tips, professional fees, bonuses, commissions, or any fee-for-service amounts.  Other eligible compensation includes

• self-employment compensation,

• nontaxable combat pay, 

• certain non-tuition fellowship and stipend payments, and

• taxable alimony paid under a divorce or separation agreement.

What is NOT “Eligible compensation”?

Passive income—including most retirement income—is not considered eligible compensation. The following are not considered eligible compensation.

• Social Security payments, pensions, or annuity payments.

• Disability payments, workers compensation, child support, and unemployment compensation.

• Need-based program such as food stamps, cash assistance, rental assistance, or housing assistance.

• Deferred compensation (payments postponed from prior years), and profits from rental income, interest income, and dividends.

• Foreign earned income and housing costs.

• Income from certain partnerships.

Other contribution limit considerations

Your clients should understand that they must earn enough eligible compensation for the tax year to support their IRA contributions. For example, a part-time pizza delivery person earning $2,000 could make a maximum contribution of $2,000, even though the 2022 annual IRA contribution limit is $6,000 (with a $1,000 catch-up contribution for those 50 years and older).

It is also important to note that a six percent penalty tax applies for each tax year that an ineligible contribution remains in the IRA. Such contributions must be removed as an excess contribution or redesignated for a future year. While it is ultimately the responsibility of the IRA owner to know whether they qualify to make an IRA contribution, directing them to the proper resources beforehand may save them time and money in the long run. 

Further information on eligible compensation and IRA contribution eligibility for your clients can be found in IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs), or direct them to seek advice from a competent tax professional.

What is considered earned income for IRA contributions?

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Is Social Security considered earned income for Roth IRA?

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