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Retirement Perspectives

Tax season may almost be over, but some clients may still wonder what is (and isn’t) compensation for funding purposes.

The rule of thumb is that an individual must have compensation to contribute to a traditional or Roth IRA. But it can't be just any type of income. In addition, there is an often overlooked and misunderstood exception to the compensation requirement–known as a Spousal IRA. Often overlooked by couples caring for children and/or elderly parents, spousal IRAs can be a valuable tool to save for retirement.

What Is (and Isn’t) Compensation?
IRA limits are established annually by the IRS. For both 2017 and 2018, the maximum funding amount is $5,500; $6,500 for those investors age 50-plus by the end of the calendar year. To qualify for an IRA contribution, earned income is defined as a paycheck, including wages, salaries, tips, bonuses, and professional fees. In addition, taxable alimony, combat pay, and spousal income are deemed compensation. For those individuals that are self-employed earned income from your business is referred to as net employment income

According to the IRS, earned income does not include income from property, interest, dividends, capital gains, workmen’s compensation, disability payments, and Social Security payments. For those who work and live outside the United States, earned income that is excluded under the foreign earned income rules is not included as compensation for funding an IRA. If you’re unsure if certain income is eligible to be considered for IRA funding purposes, you are urged to discuss your situation with a tax professional.

 

Compensation for Purposes of an IRA

Source: IRS Publication 590-A “Contributions to Individual Retirement Arrangements (IRAs)

 

Fund Your Spouse’s IRA
As mentioned, generally, the only requirement a taxpayer needs to fund an IRA is earned income. But like most retirement rules, there is an exception. Married couples that want to boost their household retirement savings, while providing a stay-at-home spouse the ability to build a nest egg, can certainly do so. This arrangement is often referred to as a spousal IRA

For married couples, the non-working spouse may be able to make an IRA contribution based on his/her working spouse’s taxable compensation for the year. So spousal IRAs serve well in families in which a spouse has left the workforce to stay at home with the kids or for older households in which one spouse may have retired early.

You may make spousal IRA contributions in some years and regular IRA contributions in others. There is no need to keep regular and spousal contributions in separate IRAs. You do not have to inform the IRA custodian that you are making a spousal contribution instead of a regular contribution, because there is no special reporting required by the IRS. You are not required to contribute to the same type of IRA as your spouse. If you are single and have no compensation, you are not eligible to fund an IRA.

The contribution limit for the lower compensated (or non-compensated) spouse is based on the spousal IRA contribution rules. The contribution limit for each spouse is the lesser of:  the annual IRA contribution limit OR the combined compensation of both spouses, reduced by the actual IRA contribution of the highest compensated spouse.

Here are four steps to follow:

1. Determine the amount of contributions to be made by the spouse who has the most compensation for the year;

2. Combined the eligible compensation of both spouses and then subtract from it the amount of any contributions calculated in #1;

3. Using the adjusted joint eligible compensation calculated in #2 above, calculate the spousal IRA contribution for the other spouse;

4. File a joint tax return in order to qualify for the spousal IRA contribution.

Since IRAs can’t be held jointly, a married couple has the opportunity to contribute the maximum amount to two separate IRAs. As a result, the working spouse can contribute $5,500 to his or her own IRA, and contribute another $5,500 to the IRA in the name of the non-working spouse, for a total of $11,000. For those who are older than 50 by the end of 2018, the limits are increased, to $6,500 per IRA, for a total of $13,000.

TIP! To make a spousal contribution for 2017, you must be legally married on the last day of the year, December 31, 2017.  If you are divorced or legally separated as of that date, you are not eligible even if you may have been married earlier in the year.  In addition you are required to file a joint federal income tax return  whereas those married and filing separately are ineligible to make spousal IRA contributions.

 Key Points about Establishing a Spousal IRA:

  • The IRA will be established, registered, and funded under the name and Social Security number of the non-working spouse.
  • All IRA (including a traditional and Roth) eligibility and deduction rules continue to apply.
  • The non-working spouse is eligible for the back-door Roth strategy.
  • When it comes to spousal contribution eligibility for 2017, the couple must be legally married on or before December 31, 2017. If you are divorced or legally separated as of that date, you are not eligible, even if you may have been married earlier in the year.
  • As for taxes, the couple must be married filing jointly.
  • The non-working spouse must be under age 70½ in the year of the contribution for a traditional IRA, whereas there are no age restrictions on a Roth.
  • There is no need to segregate “regular” and spousal contributions in separate IRAs.
  • The IRA custodian does not need to be notified an account is being established as a spousal IRA.
  • Spousal IRAs do not require any special reporting to the IRS by the taxpayer or the IRA custodian.
  • There is no requirement to contribute to the same type of IRA as the working spouse, assuming all IRA eligibility rules have been satisfied.
  • Two of the rules for spousal IRA contributions are that the spouses must file a joint tax return for the year and they must be legally married on December 31 of the year for which the contribution was made
  • The IRS says that IRA contributions cannot be made on behalf of a deceased person, even though that person had compensation before he died and could have made an IRA contribution. Because an IRA is for the benefit of the IRA owner, a deceased IRA owner cannot possibly benefit from an IRA contribution made for him after he died. However, if you as the surviving spouse, have little or no compensation, and would like to make an IRA contribution for yourself, you can use your deceased spouse’s compensation to do that. Under the spousal IRA rules, you can use the compensation your deceased spouse earned prior to death and make an IRA contribution to your own IRA.
  • Spouses must be legally married and file a joint federal tax return. This includes same-sex couples. 
  • The spouse receiving the contribution must have less compensation, or no compensation, than the spouse making the contribution. 
  • The IRA account must be held in the name of the spouse for whom the contribution is made.
  • Contributions cannot be made for a deceased spouse.

What are the implications for funding an IRA using compensation that doesn’t qualify? The IRS assesses a 6% penalty for making an ineligible contribution. That continues to apply each year the ineligible contribution remains in the IRA.

And if you have any questions on whether or not you have compensation, I urge you to discuss with a tax professional and consult IRS Publication 590-A, “Contributions to IRAs.”

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP-IRA plan for your business, you and any eligible employees establish your own separate SEP-IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

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