retirement

Note: The content in this article is outdated. As of January 1, 2020, there is a new definition of taxable compensation. You can read or listen to the details about the new definition in: Fellowship Income Is Now Eligible to Be Contributed to an IRA!

Not all PhD trainees are eligible to contribute to an IRA because IRAs require “taxable compensation” (formerly known as “earned income”).

“Generally, compensation is what you earn from working” (source) and includes wages, salaries, and self-employment income, among other few other types of income. A few types of income that are not earned are rental income, interest and dividend income, and pension income.

At first blush, it would seem that PhD trainee pay would fall under wages or working for someone who pays you. However, that is only true for PhD trainee pay that is compensatory. Non-compensatory pay may not be eligible for IRA contributions. Publication 590 states that “scholarship and fellowship payments are compensation for IRA purposes only if shown in box 1 of Form W-2.” (See this explanation of how to calculate your taxable income for a discussion of compensatory and non-compensatory pay.)

The question of whether or not you can contribute to an IRA will come down to what kind of tax forms you receive in January. If you receive a W-2, you have taxable compensation and can contribute to an IRA from that income. If you receive a 1099-MISC, a 1098-T, a courtesy letter, or no notifications whatsoever, the form indicates that portion of your income is not eligible to contribute to an IRA.

Further reading: Earned Income: The Bane of the Graduate Student’s Roth IRA

Remember that you can contribute to an IRA up to your amount of taxable compensation for the year or $6,000, whichever is lower. If part of your income is compensation, you can contribute to an IRA from that portion – this may be the case if you switch funding sources between school years or between the academic year and the summer or if you have outside self-employment income. Also, if your spouse has taxable compensation, you can contribute to a Kay Bailey Hutchison spousal IRA (up to $12,000 between both IRAs).

You will often hear about traditional vs. Roth IRAs and 401(k)s. In both cases, your contributed money grows tax-free, so the chief difference between the two is when the money is taxed. In the case of a traditional account, you take an income tax break when you contribute the money and are taxed when you take distributions from the account. The Roth is the reverse – you pay income tax on the money when you contribute it, but the distributions are tax-free. The main question to ask is whether you believe your income tax rate is currently higher or lower than it will be when you take the distributions. While this answer cannot be predicted perfectly because tax rates are subject to the political process, many graduate students are sacrificing income in the short-term for long-term income potential, so it is likely that their incomes and tax rates will jump after grad school and increase with time. Therefore, the Roth seems to be the better choice for most graduate students and young people in general. Even the most tax-break-enthusiastic professionals will tell people to contribute to Roth IRAs when they are in the 15% tax bracket or lower.

The other noteworthy differences between the Roth and traditional options are:

• there are income limits for contributions to Roth IRAs for high earners (contributions start being phased out with a modified AGI above $114,000 for single filers and $181,000 for married filing jointly)
• you must start taking required minimum distributions from a traditional IRA by April 1 of the year after the year you turn 70.5, whereas there are no required minimum distributions from a Roth IRA
• you can withdraw Roth IRA contributions at any time without penalty (but not earnings)
• you can withdraw Roth earnings without penalty in certain situations such as for qualified educational expenses or a first-time home purchase

You should also consider tax diversification. If you are likely to have a higher-paying job in the future and plan to contribute to a traditional 401(k) or similar, you can diversify your tax situation by contributing to a Roth IRA now. That way, in retirement, you will have more flexibility with your distributions, paying tax on some of your income but getting some income tax-free.

Further Reading: Roth Vs. Traditional IRA: Which Is Right For You?; Traditional vs. Roth IRA: Some Unconventional Wisdom on Which is Better for Young Investors; Roth IRA Basics, In a Question & Answer Format; Roth IRA vs. Traditional IRA: The Complete Guide for Wise Investors