Financial Advice for Retirement, Social Security, IRAs and Estate Planning

Understanding the Rules of IRA Contributions

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By Bruce Miller
understanding-rules-ira-contributions

Contributing to an individual retirement account (IRA) is an action that every account holder should be familiar with and comfortable doing.  While, on the surface, contributing may seem like a simple enough part of managing an IRA, it is actually an incredibly important pillar of the retirement finance sector.

As an experienced IRA owner can probably tell you, you simply can’t just allocate money from a specified source and have it added automatically to your IRA account.  There are a plethora of rules in place that define every facet of IRA contributions, from what are acceptable amounts to contribute to the conditions under which a contribution may be made.  Even if you have owned an IRA for many years, some of the biggest, most frustrating problems you may face are likely going to be as a result of having to navigate around these rules.

To help you understand IRA contributing better, I have assembled a series of questions that are reflective of a wide range of life events and circumstances, collected over my many years as an IRA expert.  You may find that one is similar to your own situation. These questions, and others, can all be found in my book “IRA: A Quick Reference Guide for 2016.”

Q. I contribute to my employer’s retirement plan. Can I also contribute to my own IRA?

Yes. The fact that you contribute to an employer’s plan has nothing to do with your ability to contribute to you or your spouse’s IRA. However, it may affect your ability to deduct contributions you might wish to make to your traditional IRA account (TIRA).

Q. My bank advertises that they will set up an IRA and transfer my 401(k) balance to it for free.  Do IRA custodians usually charge for this service?

I have never seen or heard of an IRA custodian charging to set up an IRA or rollover other retirement plan dollars into it, as the custodian is usually delighted to have more money under its “roof” and will hopefully use the money to purchase its own investment products.  I think the “Free” advertisement is mostly there for marketing reasons.

Q. We have a 14-year old daughter and would like to make an IRA contribution for her. Can we legally do this?

Yes, you can, if your daughter has earned income that at least equals the amount of the contribution.  This could come from babysitting, work at a youth camp or anywhere she may work and receive compensation for her services. Indeed, an infant used as a “model” for TV commercials could have a Custodial or Guardian IRA set up for them with any IRA custodian.

Similarly, a minor who works in the family business where they receive reasonable compensation for work done would also be eligible for IRA contributions.

But what if there is no such outside-the-family employment? This is where it gets a bit tricky.  The IRS has not provided much guidance on what constitutes “earned income” for a minor being “paid” by their parents or other family members where the “pay” is not from a bona fide business.

What about an allowance for chores? Or reward-style payments for the child doing a good job on a project?  The IRS has not addressed this.  Some tax pros take a conservative approach and do not consider this compensation income. Others take a more relaxed approach, referring to these payments as a form of compensation for service, and argue that this is a great tool for educating the child and a good way to begin the savings process. Thus, this payment is a broad benefit to society. How conservatively or aggressively you may interpret this is up to you and your conscience.  But be mindful, if the IRS audits the contribution to the minor’s IRA, you will most likely have to show your records proving that payment to the child was for actual work performed.

Q. I’m 68 and retired.  Last year, I did some farm work at harvest time for a neighbor who paid me with part of his harvest.  Part of this harvest produce I kept and some I sold at a roadside farmer’s market. Can I somehow use this to make a contribution to my IRA?

Yes, but you must report the fair value of the farm products you received as income. Unless farming is your primary source of income, you would likely report this as “other” income on your form 1040.

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Q. I’m 68 and retired and my wife is a retired state employee. This last year, she was asked to do some contract work for her old employer.  Since she doesn’t get a W2 for her work, when will we know how much we can contribute to her IRA for the year?

Once you get the 1099MISC from the state employer (usually by the end of January of the following year), you’ll know how much she has received in contract payments for the year. You, or your tax preparer, will then use this for completing her schedule C or schedule C-EZ, where she can deduct any business expenses she had (the IRS requires this step). The net of her self-employment income will be line 31 of the Schedule C or line 3 of Schedule C-EZ (2015).  She, or her tax preparer, must then complete a Schedule SE to calculate her FICA (Social Security and Medicare) tax. Once this is done, she will subtract ½ of the FICA tax from her net income as shown on Schedule C or C-EZ. This value will be the amount she may contribute to either her TIRA or Roth IRA (RIRA), or yours, assuming your other sources of income do not put you over the adjusted gross income (AGI) limit for a RIRA contribution.  For 2015 and 2016, the maximum contribution that can be made, assuming she is at least age 50 or older, is $6,500 each or $13,000 for both of you.

Q. Neither my husband nor I had any employment income last year, but we did have unemployment and investment income. My husband worked full time on our investments to provide us the income we had to have to live.  I think I read that there is a way we can consider this income from his work as income we may contribute to our IRAs for the year?

This is possible, but you must be able to show the IRS three things. First, that you invest only for short-term profit and not long-term investing or income from dividends or interest. Second, that your activity provides most of your support and you conduct the activity regularly and continually. Third, that all gains are ordinary income, not capital gains and are reported on Schedule C.  There are many rules governing this activity that you must be aware of. Look at the IRS Tax Topic 429 or speak to your tax advisor for more information.

Q. I started graduate school last year and received a scholarship and stipend for my graduate work.  My stipend totaled about $8,000 that I’ve been told I must pay income tax on.  Can I contribute any of this to my IRA?

Yes, providing you receive a form W2.  If so, the amount shown in box 1, minus any amount shown in box 11 (which would probably not apply to you), is the amount you may use to contribute to your IRA, up to the maximum contribution limit for that year.

Q. This will be our last year of having earned income before retirement.  I understand that my maximum contribution this year (age 61) to my IRA is $6,500.  If I contribute $13,000 this year, could I carry the extra over to contribute for next year after paying the 6% penalty for excess contribution?

Yes. If next year you did enough part time work or worked enough during the first few weeks of the year to have earned income at least equal to $6,500, then this would be doable.  But if not, you must withdraw the excess contribution in the ensuing years you do not have earned income. If you do not withdraw the excess by October 15 of a given year, there will be a 6% penalty due, which will continue each year the excess remains in the IRA.

Q. My employer offers an “IRA Contribution Option” for our 401(k) plan, where I can designate part of my contribution to an IRA with the employer, but according to the Employee Handbook, I cannot contribute to my own IRA if I do.  I thought you said my contributing to my employer sponsored retirement plan has nothing with my ability to contribute to my own IRA. Can you explain?

There is one condition where this is indeed the case.  Although this doesn’t seem to happen very often (in fact, I’ve never seen it personally), an employer has the option of adding a “Deemed IRA” or sometimes referred to as a “Side Car” IRA to the regular retirement plan.  Under this condition, if the employee contributes to this “Side Car” IRA, it counts as their annual contribution to their own IRA, so in effect, the employee agrees to move their own personal IRA up to the employer.  All rules regarding deductibility and maximum contribution amounts as well as all other IRA rules still apply.  And contributing to this really has nothing to do with the amounts the employee elects to contribute to their regular employer retirement plan, such as a 401(k), 403(b) or 457(b) for government workers. This kind of arrangement can offer either a RIRA or TIRA and would likely be offered by the employer as a convenience to employees.

Also note that this arrangement is not related to an employer offered retirement plan that has an associated Roth IRA, such as a 401(k)-Roth, where the annual salary deferral can be divided by the employee between the 401(k) pretax and the Roth portion as an after tax contribution. A 401(k)-Roth or a 403(b)-Roth or a 457(b)-Roth are all part of the employer’s retirement plan offering and are not related to the offering of a ‘deemed IRA’ if the employer were to offer it.

Q. I think I made a boo-boo.  I’m retired and wife and I have been running 3 rental properties for the past 4 years.  Each year, we have been reporting our taxable gains on Schedule E, per our tax preparer’s recommendation.  Each year I have been making tax deductible contributions to our TIRAs.  Now I read that rental income is NOT earned income one may contribute to their IRA.  Since we have no other form of earned income, did I make a mistake? And what must I now do about it?

Yes, you did make a mistake, as rental or royalty income is not considered compensation income….unless you “Substantially” participated in it as a profit oriented business and filed a schedule C. Now, if you did materially and substantially participate by providing most of the services to the operation of the rentals and you operated it as a business, you may be able to go back and amend past returns, adding schedule C and deleting Schedule E and amending your 1040 to reflect these changes, as well as pay past FICA tax. This may also change the amount you may contribute to your IRA for the year if you don’t have enough net Schedule C or C-EZ income to at least equal the amount of the IRA contributions for you and your spouse for a given year.  This will be a bit involved, so you are well advised to seek the assistance of a tax CPA.  But if you did not ‘materially and substantially participate’ in the operation and management of the rentals, then you will have to amend your past tax returns to remove the IRA deduction and then to actually withdraw past IRA contributions and all associated earnings and perhaps a 6% penalty for past year’s excess contributions.  Again, this is going to be complicated, so you’ll want to seek the services of a CPA or other tax preparer experienced in filing amended tax returns.

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