Is sick pay considered compensation for IRA contributions?

March 26, 2021 by Jean Lee Scherkey, EA
Golden IRA egg sitting on money

Is third party sick pay considered Compensation for the purpose of contributing to an IRA?

-Cynthia


Dear Cynthia,

Ahh, retirement, the often elusive state most of us dream and aspire to reach with plenty of money in the bank to fund our flights of fancy. Let's see if we can get you one step closer to your retirement dreams!

For IRA contribution purposes, certain third-party sick pay does qualify as compensation. As long as the third-party sick pay is treated as taxable income to the recipient, it is considered compensation for the purpose of contributing to an IRA. For employees, this means the third-party sick pay is included in Box 1 of their Form W-2. Oh, happy day!
 

But, there are instances where third-party sick pay is not considered compensation for an IRA contribution. If the employee pays the premiums for the sick pay, the compensation is generally not considered taxable. Keep in mind that worker's compensation is generally nontaxable and does not count as earned income for IRA contribution purposes.
 

There are special rules when it comes to sick pay distributed six months after the last calendar month an employee performed services for their employer. Generally, these payments may be subject to federal income tax withholding, but not subject to Social Security, Medicare, and federal unemployment taxes. Income subject to federal tax withholding is usually reported in Box 1 of Form W-2, and as such, may qualify as wages with determining an IRA contribution. Remember, if the employee pays the sick pay premiums, chances are the payments may be considered nontaxable. Because sick pay may be taxable or nontaxable, it is important to request paperwork about the plan.


It is not unusual for an employee to receive both taxable and nontaxable third-party sick pay benefits. The employer should provide documentation to the employee explaining which portion of the payments are includable in taxable income and the amount that is excludable. Here is an example.
 

In 2020, Angel Fisch had a job cleaning the lobster tanks at the local live seafood market. During February, Angel had an accident outside of work and received three weeks of sick pay from a short-term disability policy where she paid the premiums. Later in the year, Angel took two weeks off from work to take care of her sister, who was exposed to COVID-19 and required to quarantine. Angel received paid sick leave for the time she cared for her sister. The sick pay Angel received from the short-term disability policy will not be taxable since she paid the premium. Therefore, Angel cannot include the income she received as compensation for determining her eligible IRA contribution. However, the paid sick leave Angel received during the time she cared for her sister is considered taxable income and compensation for IRA contribution purposes.


For 2020 and 2021, the annual IRA contribution limit is $6,000 for a person under age 50 and $7,000 for those aged 50 and over. If a taxpayer meets certain qualifications, their traditional IRA contributions can be deductible. When considering the 2020 and 2021 Recovery Rebate Credits, those who are at or just over the income limit to receive the Recovery Rebate Credit may be able to make a traditional IRA contribution. The contribution would lower their adjusted gross income (AGI) below the threshold level and qualify them for the Recovery Rebate Credit. Here is an example.
 

Art Sellers, a single taxpayer under age 50, had such a great year selling heirlooms online for the local antique store that his boss gave him an $8,000 bonus in December 2020. Art prepared his 2020 return and discovered the bonus put his adjusted gross income at $80,000. He did not receive any Economic Impact Payment distributions during 2020 because, in 2019, he sold his home at a significant gain, and his income was too high. (The Economic Impact Payments are considered advancements of the Recovery Rebate Credit.) Art was looking forward to using the money from the Recovery Rebate Credit to fix his car. Meeting all of the other requirements, Art opened a traditional IRA account and contributed $6,000, which lowered his adjusted gross income to $74,000, under the income limitation for a taxpayer using the Single filing status to claim the Recovery Rebate Credit. In addition to contributing to his retirement, Art received a 2020 Recovery Rebate Credit of $1,800.


Traditional and Roth IRA accounts are excellent vehicles to sock money away for the future. Generally, to contribute to a Traditional or Roth IRA, a person needs to have earned income. There is an exception to this rule. If a married person who files jointly with their spouse does not have enough earned income or has no earned income to contribute to an IRA but their spouse meets the earned income requirement, then the spouse without income may contribute to their own IRA (this is sometimes referred to as a spousal IRA).

Contributions to an IRA account can be made until the due date of the income tax return for the year in question, usually April 15 of the following year. Recently, the IRS announced that the due date for 2020 individual income tax returns is being extended to May 17, 2021. The IRS confirmed that taxpayers will have until May 17, 2021, to make an IRA contribution for the 2020 tax year. Remember, if you are making an IRA contribution in 2021 that you want to apply to the 2020 tax year, please include written instructions to this effect. Without specific instructions as to which year you want your IRA contribution to be allocated to, investment companies will generally default to applying the contribution to the current year. Struggling with the preparation of your return? TurboTax may be able to help. TurboTax offers assistance with self-preparation and has tax professionals ready to prepare your taxes on your behalf. Have you filed your return and are concerned about the potential of being audited? TaxAudit provides audit defense membership. For one low fee, you can be represented by an experienced tax professional if the IRS or state tax agency come calling.

Wishing you the retirement of your dreams and many happy returns,
Jean

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Jean Lee Scherkey, EA
Learning Content Developer

 

Jean Lee Scherkey began her career at TaxAudit in 2015, and her current title is Learning Content Developer. She became an Enrolled Agent in 2005. For several years, Jean owned a successful tax practice that specialized in individual, California and trust taxation, and assisting those impacted by tax identity theft. With over fifteen years of varied experience in the field of taxation, Jean has worked at different private tax firms as a Staff Practitioner, Tax Analyst, and Researcher. Before coming to TaxAudit, she worked over two years for TurboTax as an “Ask the Tax Expert.” In addition to her work in TaxAudit’s Learning and Development Department, Jean is actively involved in the company’s ENGAGE Volunteer Program, which provides opportunities for employees to help and serve the local community.  


 

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