Understanding IRS Compensation for IRA Deductions
It is important to understand how the IRS defines compensation in order to deduct your IRA contributions.
For example:
You own an S-Corporation and you are the single-member owner and employee. If you take a salary of $30,000.00 as W-2 wage, and then another $60,000.00 as a dividend (at a lower tax bracket), you are limited to 25% of the $30,000.00 to make your IRA contribution. Dividend income does not qualify as a deduction.
What Is Included and Excluded in Compensation
Includes…
- Wages, salaries, etc.
- Commissions
- Self-employment income
- Alimony and separate maintenance
- Nontaxable combat pay
Does Not Include…
- Earnings and profits from property
- Interest and dividend income
- Pension or annuity income
- Deferred compensation
- Income from certain partnerships
- Any amounts you exclude from income
Detailed Exclusions from Compensation
Compensation does not include any of the following items:
- Earnings and profits from property such as rental income, interest income, and dividend income
- Pension or annuity income
- Deferred compensation received (compensation payments postponed from a past year)
- Income from a partnership for which you do not provide services that are a material income-producing factor
- Conservation Reserve Program (CRP) payments reported on Schedule SE (Form 1040), line 1b
- Any amounts (other than combat pay) you exclude from income, such as foreign earned income and housing costs
Frequently Asked Questions
What types of income qualify as compensation for IRA contributions?
Income that qualifies as compensation includes wages, salaries, commissions, self-employment income, alimony, and nontaxable combat pay. These are considered “earned income” and can be used to calculate your allowable IRA contribution.
Can I use dividend income to make IRA contributions?
No, dividend income does not count as compensation for IRA purposes. Even if you receive dividends from an S-Corporation you own, they are excluded from eligible compensation for IRA deductions.
How much can I contribute to an IRA if I’m paid both salary and dividends?
You can contribute up to 100% of your eligible compensation or the annual IRA limit, whichever is less. For example, if your W-2 salary is $30,000 and the rest is dividend income, your contribution limit is based only on the $30,000.
Is rental income considered compensation for an IRA?
No, rental income and other earnings from property do not qualify as compensation. These types of passive income are explicitly excluded by the IRS for the purpose of determining IRA contribution limits.
Do partnership distributions count toward IRA contribution eligibility?
It depends. Income from a partnership is only considered compensation if you provide services that are a material income-producing factor. If you are a passive partner, the income is excluded from IRA-eligible compensation.