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What Counts as Compensation (Earnings) for IRA Contributions?

I’ve received a few questions recently about what types of income count as “compensation” for IRA contribution purposes.

The definition of compensation is important because your IRA contributions for a given tax year are limited to the amount of your “compensation that is includible in your gross income” for the year. (If you are married, you and your spouse’s combined IRA contributions are limited to your combined such compensation.)

There are two key points here:

  1. The income in question must be something that is included in your gross income (e.g., foreign earned income that is excluded would not count), and
  2. It has to be income that counts as compensation.

So what counts as compensation?

Treasury Regulation 1.219-1(c) provides the following definition:

For purposes of this section, the term compensation means wages, salaries, professional fees, or other amounts derived from or received for personal service actually rendered (including, but not limited to, commissions paid salesmen, compensation for services on the basis of a percentage of profits, commissions on insurance premiums, tips, and bonuses) and includes earned income, as defined in section 401 (c) (2), but does not include amounts derived from or received as earnings or profits from property (including, but not limited to, interest and dividends) or amounts not includible in gross income.

In plain language, that means that the following count as compensation:

  • Wages/salary,
  • Commissions,
  • Net earnings from self-employment,
  • Scholarship or fellowship income if the income is reported in Box 1 of Form W-2 (i.e., reported as wages),
  • Taxable alimony and separate maintenance (i.e., for divorces that became finalized prior to 2019), and
  • Nontaxable combat pay.

And compensation does not include:

  • Interest or dividend income,
  • Other earnings or profits derived from property (e.g., rental income),
  • Social Security benefits,
  • Pension or annuity income,
  • Deferred compensation,
  • Income from a partnership for which you don’t provide services that are a material income-producing factor, and
  • Any income (other than combat pay) that isn’t included in your gross income.

For tax years 2020 and beyond, the SECURE Act made an additional change relating to fellowship/stipend income. Specifically, compensation will also include “any amount which is included in the individual’s gross income and paid to the individual to aid the individual in the pursuit of graduate or postdoctoral study.”

Compensation Reduced by Pre-Tax 401(k) Contributions

One noteworthy point here is that, when it comes to wages, it’s the amount that shows up in Box 1 of your Form W-2 that matters. And this amount in question is reduced by any pre-tax (“traditional”) 401(k) contributions that you make at work. Point being, if your earnings are low enough, pre-tax 401(k) contributions at work could reduce the amount you’re allowed to contribute to an IRA for the year. Roth 401(k) contributions do not, however, reduce the amount in Box 1. So Roth 401(k) contributions would not reduce the amount you can contribute to an IRA.

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