Laura answers a listener's question about who can contribute to an individual retirement account or IRA based on your income.
Laura answers a listener's question about who can contribute to an individual retirement account or IRA based on your income.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Welcome back to Finance Friday, another special edition of Money Girl, where I answer your burning money questions! Today's topic comes from Christina T., who says, "I'm a junior in college and have earned several scholarships and a stipend to pay for school. I've been able to save some of that money and want to open a Roth IRA to jump-start my future.
But I understand you can only have a Roth IRA when you have earned income, and I'm not working. My stipend is taxable income because I received a 1099-MISC form for tax filing. Would that income allow me to open a Roth IRA?
Thank you for your excellent question, Christina! And congratulations on earning money to pay for college. I love that you're already thinking about your future financial well-being and opening a Roth IRA.
This post will review who can contribute to an individual retirement account or IRA based on the types of income you or a spouse receives.
Welcome back, everyone, and thanks for joining me on episode 873! I'm Laura Adams, an award-winning author, female finance spokesperson, money speaker, founder of The Money Stack, a Substack newsletter, and host of the Money Girl podcast with over 43 million downloads.
If you're getting value from the free content we love creating, subscribe and consider submitting a 5-star rating or review on your podcast app of choice! If you have a question about money for the show, leave it on our voicemail at 302-364-0308. You can also send an email and sign up for the free Money Stack newsletter at LauraDAdams.com.
What is a traditional individual retirement account (IRA)?
An IRA is an account where you own investments that get preferential tax treatment. An IRA or any retirement account is a shelter that protects your assets from taxation while they're inside the account.
You might choose a traditional IRA, which allows you to skip paying tax upfront on the money you put in. In other words, your contributions are tax-deductible. However, your future withdrawals of contributions and earnings are subject to ordinary income taxes.
For 2024, you can contribute an amount equal to your (or, if you're married and file a joint tax return, your spouse's) qualified income up to $7,000. However, if you're over 50, you can contribute an additional $1,000 or $8,000. I'll address what qualifies as income in a moment.
Let's say you're 35, earn $50,000 yearly, and file taxes as a single. If you max out your traditional IRA in 2024 by contributing $7,000, you only pay income tax on $43,000, not on $50,000. Every dollar you contribute to a traditional IRA reduces your taxable income and the tax you owe, which is a nice benefit.
So, a traditional IRA allows you to defer paying tax on your contributions and earnings until you make future withdrawals. You can begin taking penalty-free distributions after the official retirement age of 59.5. You must start taking required minimum distributions (RMDs) after age 73 (or 75 beginning in 2033).
If you tap a traditional IRA before 59.5, in most cases, you must pay income tax on the withdrawal, plus an additional 10% early withdrawal penalty. That's why I never recommend tapping a traditional account early--it's expensive!
One rule to know about traditional IRAs is that if you (or a spouse) participate in a retirement plan at work, like a 401(k) or 403(b), you can max out a traditional IRA; however, some or all of your IRA contributions may not be tax-deductible, depending on your income.
ALSO READ: 4 ways to fund a Roth no matter your income
What is a Roth individual retirement account (IRA)?
A Roth IRA is similar to a traditional IRA in many ways, except how it's taxed. You make after-tax, non-deductible contributions and can make tax-free withdrawals in retirement.
Using my previous example, let's say you're 35, earn $50,000 a year, and contribute $7,000 to a Roth IRA. You'd have to pay tax on your total earnings of $50,000.
However, you'd never have to pay tax on the account again–even if your Roth IRA mushrooms with massive investment growth. Skipping taxes on growth and enjoying tax-free income in retirement is a huge deal, which is why I always recommend having a portion of your portfolio in a Roth.
Additionally, there are no RMDs with a Roth IRA, as with a traditional IRA. Your Roth IRA funds can stay in the account and easily get passed to your heirs.
Unlike a traditional IRA, you can only contribute to a Roth IRA when you earn less than an annual threshold, which I'll review in a moment. For 2024, the contribution limit for a Roth IRA is the same as a traditional IRA. It's equal to your (or your spouse's) qualified income up to $7,000 or $8,000 if you're over 50.
Another significant Roth IRA benefit is that it's less punitive for taking early withdrawals before age 59.5. Since you pay tax upfront on Roth contributions, you can take them as penalty-free distributions anytime. However, withdrawals of earnings would be subject to taxes plus a 10% penalty if you're younger than 59.5.
Be aware that Roth IRAs have a rule that you must own the account for five years before qualifying to withdraw your earnings penalty-free, no matter your age. Therefore,
I recommend opening a Roth IRA sooner rather than later, even if you can only make a small contribution.
That ensures you'll never be in a situation where you must pay tax on the earnings portion of a Roth IRA distribution because you still need to satisfy the five-year ownership requirement.
LISTEN: Roth IRA vs Roth 401(k)--10 Differences Investors Should Know
What are the Roth IRA Income Limits?
I mentioned that you can't have a Roth IRA when you earn over an annual threshold. The limit depends on your tax filing status and modified adjusted gross income (MAGI).
For 2024, single taxpayers must have a MAGI below $161,000 to qualify for a Roth IRA. Married taxpayers filing a joint tax return must have a MAGI below $240,000.
If you qualify to contribute to a Roth IRA but become ineligible in the future, you can keep your account indefinitely and enjoy its tax-free growth. However, you can only make new contributions if your income dips below the annual allowable limit.
However, if you earn too much to qualify for a Roth IRA, you can make Roth conversions, which I explain in podcast 768, Too Rich for a Roth IRA? 3 Legal Ways to Have One.
RELATED: When should I do Roth conversions?
What types of income qualify for an IRA contribution?
Now that we have reviewed the differences and benefits of traditional and Roth IRAs let's get to Christina's question about whether her stipend qualifies her to have one. In general, you can make IRA contributions if you or a spouse receive taxable earnings during the year.
Here are five types of income that qualify you to make IRA contributions:
1. Compensation for work.
Your wages, salaries, tips, commissions, and bonuses from employment qualify you to have an IRA. You can verify the amount by looking at the W-2 you receive annually and, specifically, the number shown in box 1 of the form.
2. Self-employment income.
If you're self-employed, the net earnings from your business are taxable earnings that qualify you for an IRA.
3. Alimony income.
For IRA purposes, compensation includes taxable alimony payments you receive under a divorce decree or separation agreement that began on or before December 31, 2018. However, if you got divorced in 2019 or later, you can't use alimony to qualify for an IRA.
4. Nontaxable combat pay.
If you were a member of the U.S. Armed Forces, compensation for an IRA includes any nontaxable combat pay you received. You should see the amount reported in box 12 of your W-2.
5. Education benefits.
Income like a scholarship, fellowship, or stipend is generally taxable compensation if it gets reported in box 1 of your W-2. However, starting in 2020, certain payments not reported to you on Form W-2 are treated as taxable compensation for IRA purposes.
Like Christina, you should receive a 1099 for those amounts, which get included in your gross income for taxes. Let's say Christina received a taxable stipend of $5,000 for 2024, she could contribute up to $5,000 in an IRA. If she received $10,000, she could max out an IRA with a $7,000 contribution.
READ ALSO: Is it better to have a traditional IRA or a Roth IRA?
What types of income don't qualify for an IRA contribution?
For the purposes of contributing to an IRA, you can't include:
RELATED: 7 Pros and Cons of Investing in a 401(k) Retirement Plan
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That's all for now. I'll talk to you soon. Until then, here's to living a richer life!
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