Having a retirement plan cannot be overemphasized, especially now that advancements in modern medicine help people live longer, active lives. So, it is never too early to think about where your income will be coming from once you have retired from your job to avoid financial difficulties later in life.
And, what better way to build your nest egg than setting up and building your individual retirement account, otherwise known as an IRA?
An IRA is a form of personal savings account that allows you to contribute a certain amount of money regularly from your income towards your retirement. What sets IRAs apart is they come with tax advantages. That is, your money grows without being taxed, and since you paid taxes on your income upfront, you don’t have to pay again when you withdraw your money at 59 ½ years.
IRAs come in different shapes and forms. But the most common ones include traditional, Roth, and self-directed IRAs. Usually, you can set up your IRA through a bank, insurance provider, custodian (for self-directed IRAs), or other financial entity.
That said, IRAs are generally simple to set up. The primary requirement is that you have earned income.
What Is Considered Earned Income for IRA Contributions?
As already stated, you need to have earned income to make IRA contributions. That means you might not qualify for an IRA even if you can afford the contribution limits. But not every coin you get is earned income. So, what is considered earned income for IRA contributions?
If you earn a fixed amount of compensation for performing your duties as an employee under an employer, that money is considered earned income and qualifies for IRA contribution.
Not everyone earns a fixed paycheck at the end of the month for work done. Sometimes, the compensation earned varies depending on the hours worked. This compensation, known as wages, is also classified as earned income.
Commission or Bonus
If you also earn a commission for sales made, that too can be added to your contributions. The same case goes for monetary incentives your employer awards you for meeting company goals. Both of these are earned income from work done.
For some jobs, more so in the service industry, tips, also known as gratuity, are quite common. The good news is that if you have earned extra payment from customers for satisfactory service, you can include it in your earned monthly income.
If you are self-employed, that is, you run your own business, then whatever you earn as profit is considered income and can go towards your IRA contributions.
So, basically, your earned income can be one or a combination of these sources. However, the IRS may consider other forms of compensation when determining what you can and cannot contribute to your IRA. So, you can inquire as per your case.
What is Not Considered Earned Income in IRA
So, you know what generally falls under earned income. Now, what types of income are you not allowed to direct toward your IRA contributions?
- Any money earned from renting out property
- Interest earned
- Money earned from your pension
- Dividends and capital gains from your investments
- Annuity income
- Deferred benefits
- Certain types of passive income, such as workers’ comp, unemployment benefits, and social security benefits
How Much of Your Earned Income Can You Contribute to Your IRA?
So, say your compensation is considered earned income for IRA contributions based on the provided criteria. How much of that money can you contribute to your IRA? And how often should you do it?
There is no rule about the minimum amount you can contribute to your IRA. However, providers may set a minimum starting balance. In reality, the amount you should be contributing should be based on your goals after you retire, including your expected spending and, of course, your maximum limit.
Yes, there is a ceiling on how much you can contribute to your IRA annually. For most people, that is $6,500. If you are over 50, you can go as high as $7,500. If you can afford this amount while still taking care of your bills and needs, and don’t have expensive debt, then definitely go for the maximum amount. If not, contribute an amount you are comfortable with. That doesn’t have to be the same every year, though.
Remember, you cannot contribute more than your total earned income. So, if, for instance, you earned $5,000 in a given year, you can only contribute as much, even though the ceiling is $6,500.
To maximize benefits for your IRA, start as early as now so that you have ample time to build your portfolio. More importantly, make it often and consistent. Spreading out your contributions over the year rather than making one lump sum payment allows you to take advantage of dollar-cost averaging. The markets are constantly changing, and you want the best average prices for your investments to achieve the greatest growth. Smaller, more frequent contributions spread out your risk.
What if You Don’t Have Earned Income?
Now, if you don’t work and therefore don’t earn an income, you technically cannot contribute to your IRA. You can hold an account but cannot put money into it. But there is an exception. If you are married and your spouse works and earns compensation, they may be able to make contributions to your IRA. But this is only possible if you file tax returns jointly.
Contribute as Much as You Can as Often as You Can to Your IRA for a Secure Retirement
As humans, we work hard in our younger years not only to live comfortable lives now but also to secure ourselves for our older years when we can no longer work. That is why you should start thinking about retirement saving and investment as soon as you start earning some income.
Thankfully, you can set up an IRA, which allows you to invest in different assets tax-free by making small contributions over several years. Once you turn 59 ½, you can begin making withdrawals to meet your day-to-day needs.