A reader writes in, asking:
“My spouse is retired, and I recently began semi-retirement, working just a few days each month. Because of a pension and paid off house, we won’t be spending from our retirement savings. My question regards contributions to retirement accounts with a small amount of income.
My employer offers a 401k. Let’s say I earn $10,000 in 2016. Can my wife and I each contribute the maximum to a Roth IRA? Essentially what I’m asking is can we each count the $10,000 as income? And does that change if I contribute to the 401k?”
First let’s back up a step for readers unfamiliar with this topic. In addition to the normal IRA contribution limits, there is also a rule which says that your IRA contributions for each year are limited to your compensation for that year (i.e., wages, commissions, self-employment earnings, alimony, and nontaxable combat pay).
There is an exception to this compensation-related limit for married people, but for the moment let’s focus on the simpler situation of an unmarried person.
Contributing to a 401(k) and IRA
Your IRA contribution is limited to your compensation for the year. For people earning wages (as opposed to self-employment income) the relevant amount is the amount reported in box 1 of Form W-2. Of note, that figure has already been reduced by any pre-tax (i.e., “traditional”) 401(k) contributions that you make for the year. In other words, if your earned income is low enough, contributing to a pre-tax 401(k) would reduce the amount of IRA contributions that you can make.
Example: Beth earns $5,000 this year. If she doesn’t contribute anything to a retirement plan at work, she can contribute the entire amount to a Roth IRA.* However, if her employer offers a 401(k) and she decides to make pre-tax contributions to that plan, those contributions would reduce the amount of wages that show up in box 1 on her W-2, thereby reducing the amount she can contribute to her Roth IRA.
Things work differently, however, if it is a Roth 401(k) to which you are contributing at work. Specifically, the amount of wages reported in box 1 on Form W-2 is not reduced by the amount of Roth 401(k) contributions that you make. In other words, you can essentially “double count” your earned income by contributing to a Roth 401(k) and a Roth IRA.
Example: Beth earns $5,000 this year. If she contributes $5,000 to a Roth 401(k), she can still contribute $5,000 to a Roth IRA.
Spousal IRA Contribution Limits
As mentioned above, there is an exception to the rule that your IRA contributions for each year are limited to your compensation for that year. Specifically, in a married couple, for the spouse with the lower amount of compensation for the year, the compensation-related limit is calculated as:
- The compensation of the spouse in question, plus
- The compensation of the other spouse (i.e., the one with higher earnings), minus
- Any IRA contributions the other spouse (the higher-earning one) has made for the year.
Example: Bob and Jane are married, both age 60. Bob is retired. Jane still works part-time, earning $20,000 per year. Jane does not contribute to a retirement plan at work. She does, however, contribute $6,500 to a Roth IRA for the year. Despite having zero compensation for the year, Bob can also contribute $6,500 to a Roth IRA, because Jane’s compensation is sufficiently high for both of them to make contributions.*
A key point here is that spousal IRAs do not allow for “double counting” of income. For example, if Jane in our previous example only earned $5,000 for the year and she contributed $5,000 to a Roth IRA, Bob wouldn’t be able to make any Roth IRA contribution.
*For the sake of simplicity, we are assuming here that the MAGI-related income limits are not an issue.