Carrie Schwab Pomerantz

Dear Carrie: My wife and I are currently living on my military retirement and her interest income. We will both start drawing Social Security this summer/fall. All of it counts for income tax purposes. Is any of it "earned," under the definition, for IRA contributions? --A Reader

Dear Reader: There are so many types of income as defined by the IRS that it's not surprising folks get confused. As you mention, much -- if not all -- of your income is taxable. Unfortunately, though, it's not what the IRS considers earned, and therefore it is not qualified for an IRA contribution.

The IRS definition of earned income is very specific, only including salary, wages, tips, commissions, bonuses, net earnings from self-employment, taxable alimony and nontaxable combat pay for military personnel.

Sources of income such as pensions and annuities, welfare benefits, unemployment compensation, worker's compensation benefits or Social Security benefits are not considered earned income. Therefore, neither your current income from military retirement benefits and interest nor your upcoming Social Security benefits qualify for an IRA contribution.

However, just because you can no longer contribute to an IRA doesn't mean you can't manage your income and your accounts to maximize other tax advantages. Here's what I'd suggest.

UNDERSTAND HOW THE IRS DEFINES INCOME

Your question about earned versus unearned income is just the beginning. As you mention, the IRS also makes a distinction between taxable and nontaxable income. While your current sources of income are generally taxable, things like gifts, bequests and inheritances are considered nontaxable. Likewise, you don't have to pay income tax on any compensatory damages, welfare benefits and cash rebates from a dealer or manufacturer.

Complicating things a bit more, the IRS divides income into three major categories:

-- Ordinary--Earned income plus interest and dividends.

-- Capital--Income from the sale of property, including capital gains from investments.

-- Passive--Income from real estate, limited partnerships or a business where your participation is minimal.

These types of income are taxed differently -- for instance, you pay taxes according to your income tax bracket on ordinary income and short-term capital gains (for property you have held for one year or less), but long-term capital gains (for property you held on more than one year) are taxed at a lower rate. And passive income is distinguished as a separate category, with passive losses only offsetting passive income, not ordinary income.


Carrie Schwab Pomerantz

Carrie Schwab Pomerantz is a Motley Fool contributor.

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