I'm totally confused! Is adjusted gross income the primary determinant of how much of your earned income is eligible for your Roth IRA or is it not?
Here's a nice article that suggests that adjusted gross income is very important in determining how much of your earned income can be contributed to your Roth IRA:
OK. I just reread the article and I think I finally understand. I now understand that there is more than one ceiling (limitation) on your annual Roth contribution. Here are the ceilings on your Roth IRA contribution limit as I understand them:
Ceiling #1:The first ceiling is the maximum amount of money anyone in your tax filing status is allowed to contribute to their Roth IRA. For example, some people will be limited to $5,500 in 2014. This is probably the most commonplace ceiling that hangs over the most people.
Ceiling #2:The second ceiling is how much you contributed to your other IRA, your Traditional IRA. Whatever you contributed to your Traditional IRA gets taken off the amount you contribute to your Roth IRA. In effect, this ceiling interacts with all the other ceilings by lowering them.
Ceiling #3:The third ceiling is if you have more income than the average person. If that is the case, you may be subject to the MAGI ceiling described in the above article. If this ceiling kicks in because you are earning big bucks, it will effectively nullify ceiling #1 by lowering it.
Ceiling #4:The fourth and final ceiling is the total of all your earned income. If you made only one thousand dollars mowing lawns and another 29 thousand selling a small slice of real estate, your total income is 30 thousand dollars. However, only one thousand of that 30 thousand can be set aside for a contribution to your Roth IRA. Ceiling #4 kicks in when you have very little in the way of earnings that can be called earned income. In effect, because your earnings are less than ceiling #1 for the year, ceiling #4 takes over for ceiling #1.
Thinking of the maximum Roth IRA contribution as a series of interlocking ceilings really helps me to understand. Whatever ceiling is lowest is the one that determines how much you can contribute to your Roth IRA.
It's a little bit like a tall person in a small house. Only the ceiling that the tall person bumps their head on is the one that counts. And so it is with your Roth IRA. Whatever Roth IRA ceiling is the lowest is the one that determines your Roth IRA contribution limit for that year.
Hopefully, I've more or less got the right idea on this one. For much greater expertise (I have none when it comes to taxes and tax law) I refer you to the IRS publication that, so far, seems to be the most authoritative:
I can certainly understand why some people feel our tax code is too complicated and too concept rich. The more concepts you have to absorb to fill out the forms, the harder it is for an individual to do their own taxes.
Update: May 12, 2014
I've been studying publication 590 mentioned above. Oddly enough, the publication that details IRAs does not seem to mention earned income at all. Instead, the term it uses is compensation.
As I understand it, earned income and compensation are almost the same thing, but not quite the same thing. That is to say, for most people, compensation and earned income are the same thing. That's my best guess based on what I've seen on other websites.
However, when you get into the nitty gritty of it, it turns out that for a self-employed person, compensation and earned income are similar, but not the same.
The reason for this is that self-employed people must file Schedule SE. Part of Schedule SE is that you are allowed to take a certain amount of your self-employment tax and subtract it from your personal income. In subtracting part of your self-employment tax from your income (adjusted gross income), you are also lowering your earned income as the IRS defines it.
However, for maximum IRA contribution purposes, as I understand it, while you might subtract part of your self-employment tax from your earned income, you do not subtract it from your compensation.
Again, compensation is the key ingredient you need in any given year to make a Roth IRA contribution for that tax year. That's how I understand it after reading the IRS documentation for Roth IRAs.
Therefore, since compensation is the focus of maximum IRA contributions and not earned income, you should ignore earned income in favor of compensation. That is to say, if earned income and compensation are different for you because you are self-employed, ignore earned income and focus on compensation only.
My best understanding (which may not be perfect) is that you only need worry about the distinction between earned income and compensation if you are self-employed. Otherwise, not.
I cannot guarantee I've got this right. However, on the web I see so much written about earned income and IRA contributions. Yet, publication 590 (Tradational and Roth IRAs) barely mentions earned income at all. What gives? It appears to me that compensation is the real focus of Publication 590, not earned income.
From now on, I will be focused on compensation, not earned income, when calculating my maximum IRA contribution in a year in which I earned very little money. This is because I have business (Schedule C) income.
For those of you who only have W-2 income (wages), you can probably forget the distinction between earned income and compensation. For you, the 2 are probably exactly the same thing. That's why so many websites mention earned income and Roth IRAs in the same breath. For most people, they are likely the same thing.
Update: May 13, 2014
This morning I've further solidified my concept of compensation versus earned income. I did a search on Publication 590 for these 2 terms:
- insurance
- medical
Why search Publication 590 for these 2 terms? Because I wanted to know whether or not medical insurance could potentially count against my Roth IRA contribution.
Specifically, I wanted to know whether Line 29, Self-employed health insurance deduction could possibly count against my compensation and therefore lower the amount I contribute to my Roth IRA. In 2013, Line 29 is the health insurance deduction line for self-employed people.
I searched insurance and medical in 2 separate searches. While I found lots of references to these 2 terms, none of these references suggested that taking a medical insurance deduction could ever count against your Roth IRA contribution for the year.
In short, I need not worry about my medical insurance deduction also counting against my Roth IRA contribution for the same tax year. To the best of my knowledge, medical insurance payments are not subtracted from your compensation. At least, that's how I read Publication 590.
Most of the references to medical insurance in Publication 590 are about using your Roth IRA before age 59-1/2 to pay medical bills if you lose your job. This appears to be a hardship provision. If you lose your job and you have medical bills, you can use your Roth IRA to pay these bills. This seems to be the gist of what I read.
After carefully reading Publication 590, I'm convinced that I'm at liberty to take the medical deduction on line 29 of the 2013 Form 1040 without fear that I will compromise my contribution to my Roth IRA for 2013.
Tax law is complicated, isn't it?
Ed Abbott
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