People make money in a lot of different ways, but only the amount made from working is considered earned income. You must have earned income to make a contribution to an individual retirement account, or IRA, and the amount you earn limits the amount you can contribute.
IRAs are tax-deferred retirement savings plans. Maximum annual IRA contribution amounts are set by legislation and enforced by the IRS. In order to make an IRA contribution, you must have earned income or file a joint tax return with a spouse who has earned income. In addition to having earned income, Roth IRAs limit the amount of contributions based on adjusted gross income, or AGI. People earning more than the maximum annual AGI cannot make Roth contributions. Traditional IRAs don’t have AGI limits.
Earned income is any amount received from working. Wages and salaries are reported on W-2 forms in Box 1. Self-employed individuals record earned income as net earnings on their annual income statement. Earned income is reported on line 7 of IRS income tax forms 1040 and 1040A.
Types of earned income include salary, wages, tips, commissions, bonuses, net earnings from self-employment, taxable alimony and nontaxable combat pay for military personnel. Rental income, deferred compensation, interest and dividends are not considered earned income.
Individuals can contribute their entire annual earned income up to the maximum annual contribution limit to their IRA. Nonworking spouses filing joint returns may contribute the smaller of the maximum annual contribution limit or their spouse’s earned income minus the spouse’s IRA contribution.
Income must be earned during the calendar year in which the IRA contribution is applied. For example, if the contribution is for 2008, the income must have been earned in 2008.
Sometimes business owners report minimal or even no earned income, but self-employed individuals must report net earned income in order to make IRA contributions, even if the business had a net loss for the year.
If the IRA contribution is greater than earned income, the IRA owner is charged a tax penalty for making excess contributions. Excess contributions can be redirected to future years, but the individual must have earned income in those years.