What’s earned income for Roth IRA?

A Roth IRA is an IRA that taxpayers use to stash away savings for their retirement years. Although there are no immediate tax breaks, the contributions and earnings grow tax-free over the years through compounding. Once you retire, you can take a distribution from the Roth IRA without paying any taxes or penalties as long as you meet the withdrawal requirements. However, if you have a Roth IRA, the IRS requires that you can only contribute earned income to the account.

Earned income for a Roth IRA is the income you earn when someone else pays you, or the income you earn from your business or farm. The earned income is traditionally from work performed, and it may include wages, salaries, bonuses, commissions earned, tips, and self-employment income. Other incomes that may qualify as earned income include taxable alimony, stipend payments, and disability benefits. However, some incomes that don't meet the earned income include rental income, capital gains, IRA distributions, social security, interest income, and dividend income. Hence, these incomes cannot be used to contribute to a Roth IRA. 

Roth IRA Eligibility

The main eligibility requirement for Roth IRA contributions is having earned income. One way to have earned income is when you work for someone else who pays you an income. This form of income may include wages, salary, bonuses, tips, etc. The second way to have earned income is by having business income or farm earnings. Therefore, self-employment income and proceeds from the sale of farm products qualify as earned income, and you can contribute these monies to a Roth IRA.

However, there are certain incomes that don’t meet the earned income criteria. For example, incomes such as interest income and dividend earnings from stocks do not qualify as earned income. Capital gains from the sale of investments and rental income are also excluded. Other incomes that do not count as earned income include IRA distributions, pension payments, profit sharing, social security, unemployment compensation, disability insurance, or life insurance payouts.

Roth IRA Income Limits

The IRS rules allow anyone with an earned income to open and contribute to a Roth IRA, regardless of their income levels. However, the rules are different for Roth IRA contributions, and you may be ineligible to contribute if your income exceeds the IRS limits. The IRS sets income limits based on your modified adjusted gross income (MAGI). For 2021, the IRS limits Roth IRA contributions to $6,000 per year, or $7,000 if you are above age 50.

Married couples filing jointly are ineligible to make Roth IRA contributions if their annual income exceeds $208,000 in 2021. If you are married filing separately, you are ineligible to contribute if your income exceeds $218,000 in 2021. If you are single and the head of the household, you are ineligible if your annual income exceeds $140,000 in 2021.

If your income exceeds the IRS limits, you can get around the limits by using a backdoor Roth IRA. This strategy allows you to rollover a traditional IRA to Roth IRA even if you exceed the limits.

Tax Advantages of a Roth IRA

Unlike a traditional IRA, Roth contributions do not get a tax deduction. A Roth IRA is funded with after-tax dollars, and the contributions you make to the account cannot be deducted from your taxable income.

However, you may qualify for the saver’s credit, which is available to people with low to moderate incomes. The amount of tax credit you get depends on your adjusted gross income and filing status.

If you are eligible for the saver's credit, you could get 10%, 20%, or 50% tax credit on your Roth IRA contributions up to $2000, or $4000 if married filing jointly. The income thresholds vary annually.

Excess Roth Contributions: What to Do With Excess Contributions

If you are eligible to contribute to a Roth IRA, and you contribute more than the allowed limit, the IRS considers the extra amount as an excess contribution. The excess contribution will need to be corrected before the tax due date, failure to which the IRS will impose a 6% penalty for each year the excess contribution remains in the account.

You can correct the excess contribution by withdrawing the excess amount and any earnings generated from this amount before the April 15 deadline. You can also apply the excess contribution to the following year’s contribution, but you will be required to pay the 6% penalty for the current year. If you have already filed your tax return, you can remove the excess contribution, and file an amended tax return before the October deadline.