What kinds of income enable you to deduct IRA contributions?

A recent tax case highlights the confusion over what counts as compensation for contributing to an individual retirement account.

In the case (Alex Halo v. Commissioner; T.C. Summ. Op. 2014-92; No. 23774-12S, Sept. 11, 2014), the court ruled that Alex Halo did not have qualifying compensation, or earned income, and denied a $3,000 deduction for his 2010 IRA contribution. Mr. Halo was unemployed for all of 2010, receiving only unemployment compensation, interest income and Social Security benefits.

To qualify for an IRA contribution, an individual must have compensation, which is generally earned income, including wages or self-employment income. The court ruled that unemployment payments and Social Security benefits do not qualify as compensation for making an IRA contribution.

Mr. Halo lost his case, and his IRA deduction was disallowed.

Even though it counts as taxable income and contains the word “compensation,” unemployment compensation is not considered such for IRA contribution eligibility.

But you would have to dig deep to find exactly where it says that — all the way to a little-known IRS proposed regulation issued in 1981 [(Prop. Reg. Section 1.219(a)-1(b)(3)].

SOCIAL SECURITY

Social Security benefits are another area of confusion.

While the benefits are earned and paid for, the Halo case reminds us they do not qualify as compensation for IRA contribution eligibility.

According to tax code section 86(f)(3), Social Security benefits are treated as an “amount received as a pension or annuity,” and such income does not qualify for IRA contribution eligibility.

The court ruled that Mr. Halo was not entitled to a deduction for a contribution to his IRA, because that is what the IRS challenged.

In fact, he was not even eligible to make it. To contribute to either a traditional IRA or a Roth IRA, a person much have compensation, and Mr. Halo didn’t have any.

When a person has no compensation or less compensation than his or her total IRA and Roth IRA contributions during the applicable year, the contribution results in an excess contribution. Such contributions are subject to a 6% excise tax for each year they remain in the account.

In a related case in 2011 [Robert Kobell v. Commissioner (T.C. Memo 2011-66; March 17, 2011), Robert Kobell claimed he was a professional stock trader and that his trading income should count as compensation for making an IRA contribution.

The Tax Court ruled that Mr. Kobell did not qualify as a professional trader. Therefore, the income from his investments was not earned income, and he could not take a deduction for a contribution to his IRA.

In stating that he was clearly not a professional trader, the court pointed out that he met none of the general guidelines. He had three stock transactions all year and no customers.

PRETTY STRAIGHTFORWARD

What kinds of compensation qualify for an IRA contribution.

It is generally straightforward. For most clients, earned income comes from employment — either as a worker at a business or as a self-employed person.

The safe harbor is an amount shown in box 1 of Form W-2.

Sometimes, however, what counts as compensation is not so clear cut.

For instance, many clients (and even many advisers) fail to recognize that alimony and maintenance payments represent earned income.

Such clients can contribute to traditional and Roth IRAs even if they do not work and have no other source of income.

Another thing for advisers to consider is that clients with qualifying compensation (such as wages or alimony) must meet other criteria to be eligible to put money into an IRA.

AGE LIMIT

For example, contributions to a traditional IRA cannot be made beginning the year in which a person turns 701/2.

Though there is no such age restriction with a Roth IRA, contributions are not allowed once earned income exceeds certain limits.

For 2014, those limits are $191,000 for married-filing-jointly taxpayers and $129,000 for single taxpayers.

Ed Slott, a certified public accountant, created the IRA Leadership Program and Ed Slott’s Elite IRA Advisor Group. He can be reached at irahelp.com.