Individual retirement accounts offer tax-deferred savings with traditional IRAs and after-tax savings with Roth IRAs. Plus, both allow your contributions to grow tax-free in the account, so the money grows at a faster rate than if you had to take some out for taxes each year. However, you end up owing penalties if you open and contribute to an IRA when you're ineligible.
If you only have unearned income for the year, you can't open an IRA or make contributions, because the IRS sets your contribution limit at the lower of your compensation or the annual contribution. Compensation includes your earned income from working, like your wages or net self-employment income, and taxable alimony, but not your unearned income, no matter how much you have. So, if you have only unearned income, your compensation for the year is $0, which makes your IRA contribution limit $0.
As long as you have compensation for the tax year, the IRS doesn't require you to show that the money that went into the IRA was the same dollars that came from working. For example, if you have $40,000 of compensation and $20,000 of unearned income, you don't have to prove that the money you put in your IRA came from the $40,000 of income.
Spousal IRA Contribution
If you don't have compensation, but your spouse does, you can still contribute to your IRA if you file a joint return. When you file a joint return, any compensation earned by one spouse is shared with the other. For example, if you only have unearned income, but your spouse worked during the year and earned $50,000, you both can use that compensation to qualify for an IRA. But, you can't count the same compensation twice. For example, if your spouse has $10,000 of compensation but contributes $6,500 to an IRA, you can only contribute $3,500 to your IRA.
Contributions Without Compensation
If you make a contribution when you aren't eligible because you have only unearned income, it counts as an excess contribution. The IRS imposes a 6 percent annual penalty, every year that the excess goes uncorrected. To avoid the penalty, you must remove the contribution, plus any gains on the money, before your tax filing deadline. For example, say you put in $5,000 when you don't have any compensation. To avoid a 6 percent penalty, you must withdraw the $5,000 plus any earnings before your tax filing deadline.
Based in the Kansas City area, Mike specializes in personal finance and business topics. He has been writing since 2009 and has been published by "Quicken," "TurboTax," and "The Motley Fool."