In order to make an IRA or Roth IRA contribution, you must have “compensation.” What exactly is the definition of compensation for IRA purposes?
By far the most common form of compensation is wages. Wages, salaries, tips, professional fees, bonuses and any other amounts you receive for providing personal services are considered compensation. Generally, if you have a W-2 that “properly” shows income in box 1 then you have compensation and can make an IRA contribution or a Roth IRA contribution if you meet the income limits (in this case for 2016).
Commissions that are a percentage of price or profit are considered compensation.
You can also use your self-employment income for making IRA contributions. Your compensation is the net earnings from your trade or business minus deductible contributions made to your retirement account and the deductible part of your self-employment taxes, if any. Interestingly, a self-employment loss is not deducted from any salaries or wages (see above) to determine your total compensation for IRA contribution purposes.
Alimony and separate maintenance you receive, as long as they are taxable to you, are considered compensation. The payments must be a result of a decree of divorce or separate maintenance.
Compensation is generally earnings that are taxable to you. The one exception is non-taxable combat pay.
What is not compensation?
Earnings and profits from property – including rents
Pension or annuity income
Deferred compensation – compensation deferred from a previous year
Partnership income when you do not provide income producing services
Amounts excluded from your income – except for combat pay as noted above
Generally, if you do not have compensation, you cannot make IRA or Roth IRA contributions. The exception to this rule is for spousal contributions, which can be made based on a spouse’s compensation. When contributions are made in error if you have no compensation, the result is an excess contribution, which is subject to a 6% penalty per year for every year that it remains in the IRA or Roth IRA account.
Excess contributions can be corrected without penalty up to October 15 of the year after the year for which the contribution was made. You must tell the IRA custodian that the distribution is a return of an excess contribution and a net income calculation must be done. The amount of the excess, plus/minus the net income amount is what is actually distributed.
If you miss the October 15 deadline, the excess contribution is corrected by removing the amount of the excess contribution. There is no net income calculation that needs to be done.
The penalty is reported to IRS on Form 5329, which is filed with your income tax return. You must also file the form for the year you correct the excess contribution even though you won’t owe a penalty for that year. To report excess contributions after the tax return has already been file, you file the Form 5329 as a standalone return.
Don’t ignore the excess contributions or filing Form 5329. It is considered a standalone return and if it is not filed, the statute of limitations does not start to run.
By Beverly DeVeny, Chief IRA Analyst