Should You Open an IRA While on Unemployment?

It’s possible, but understand the rules and consider other financial goals

A couple discusses their IRA.

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Unemployment numbers have fallen since spiking to nearly 15% in April 2020. The unemployment rate was 6.2% in February 2021, but even with the decline, millions of people in the U.S. continue to worry about their immediate financial needs.

While the current situation may feel urgent, retirement is still going to come in the future. Depending on your situation, you may be wondering if it’s a good idea to contribute to an individual retirement account (IRA), or whether it’s even an option. Here’s what you need to know about opening an IRA, especially if you’re one of the many people in the U.S. on unemployment.

Key Takeaways

  • To open an IRA, you—or your spouse if you file a joint tax return—must have received taxable compensation during the year.
  • Your eligibility is based on income for the full year, not just right now. So, prior earned income during the year before you became unemployed may make you eligible.
  • If your financial situation allows for it, make sure you know the rules and best practices to accomplish your retirement goal without sacrificing your present financial health. 

Who Can Open an IRA? 

IRAs can provide significant tax benefits to people who are saving for retirement. But not just anyone can open one. According to the Internal Revenue Service (IRS), you must meet two requirements:

  • You’ll be under age 70½ at the end of the year in which you open the account
  • You, or your spouse if you file a joint tax return, received taxable compensation during the year.

In general, “compensation” is money you earn from working. It can include salaries, wages, commissions, self-employment income, taxable alimony and separate maintenance, and nontaxable combat pay. The IRS does not include unemployment income as earned income on its website.

If you’ve earned any of these forms of income the year you’re unemployed (no matter how much), you can open an IRA. Also, if you’re unemployed but your spouse is still working, both of you can open an account.

If you’re on unemployment benefits now but were working and earning income earlier in the year, you can still open an IRA. 

However, if you’re unmarried without any earned income this year or married and neither of you has received eligible compensation the entire year, you aren’t eligible to set up an IRA.

Can I Contribute to an IRA While on Unemployment?

If you already have an IRA or you’re thinking of opening one, the same rules apply—you, or your spouse, if applicable, must have earned income to make contributions.

So, if you’re on unemployment benefits but your spouse is still working, you may be able to contribute up to the maximum of $6,000 each (or $7,000 if you’re age 50 or older) for 2021.

And remember, your eligibility is based on income for the full year, not just right now. So, prior earned income during the year before you became unemployed may make you eligible. You may be limited to how much you can contribute based on your income, though. For example, if you only earned $3,500 in eligible income for the year, you’d likely be limited to $3,500 in contributions for the year.

For those impacted by COVID-19, withdrawals up to an aggregate limit of $100,000 from all qualifying retirement accounts, including IRAs, were not subject to the 10% tax penalty through Dec. 30, 2020. The penalty is back for 2021.

Why Would I Want to Open an IRA?

If you’re eligible, there are a few reasons to consider opening an IRA while you're unemployed:

  • Continue saving for your future: Even if your current situation isn’t ideal, an IRA can make it possible to keep up with your retirement savings plan so you don’t fall too far off track.
  • Enjoy the benefits of compound interest: The sooner you start saving for retirement, the more you’ll benefit from compound interest. If you wait until you’re working again, you may need to save more going forward to make up for lost time.
  • Roll over your 401(k): If your previous employer offered a 401(k) plan, rolling it over into an IRA will allow you to continue to make contributions to your retirement savings and give you more control over how you invest your money.

There are two types of IRAs to consider opening: traditional and Roth. A traditional IRA may allow you to deduct some or all of your contributions on your taxes for the current year, but the earnings in the account will grow tax-deferred. You can’t deduct Roth IRA contributions on your taxes, but your earnings will grow tax-free. However, you may have to pay taxes on withdrawals within the first five years of your first Roth IRA contribution.

Strategies for Saving for Retirement While on Unemployment

It’s possible to set money aside for retirement while you’re unemployed and there are some clear benefits to doing so. But it’s crucial to consider whether retirement savings should be a priority while you’re unemployed.

In some cases, it may not even be possible to save for retirement, especially if you don’t have a spouse’s eligible income you can use to make contributions or your money situation is so tight that you need to focus on immediate living expenses.

If you do have some money in your budget that you could put toward your retirement, consider whether you could put that money to better use with other financial goals.

For example, if your emergency savings balance is low, it may make more sense to bolster that fund in case you need it in the future.

“If you've already built up your emergency fund and you have excess money that you really don't need within the next five years then taking advantage of tax-deferred growth may be smart," certified financial planner Riley Poppy told The Balance via email. "An IRA truly is intended as a long-term vehicle. However, definitely evaluate your living expenses in the future. Over-investing living expenses can be dangerous for those unemployed.”

If you have high-interest credit card debt, the amount of money you’d save by paying off your cards could outpace the benefits you’d get from saving for retirement.

“(Being) overloaded by credit card or bad debt with interest rates (of) 18% to 24% would hurt people more than what they can gain from any investment in any IRA,” Eric Kam, a financial educator, told The Balance via email.

If you’re in a good place to save for retirement through an IRA, here are some more tips to help you make your efforts more effective.

Make Sure You’re Using the Right Account

There are two main types of IRAs you’ll encounter: traditional and Roth. The distinction is important, according to Colin Day, a financial advisor with St. Louis-based Correct Capital Wealth Management, because of how taxes work.

The IRS taxes your Roth contributions now instead of later in life when you make withdrawals like with a traditional IRA. If your income is low this year because of a job loss, it has a Roth-specific tax advantage.

“If you’re in a lower tax bracket in 2020, funding a Roth IRA could make long-term financial sense because it’s probable that you’ll be in a higher tax bracket in retirement,” Day told The Balance via email. “Because you won’t pay taxes on a Roth IRA you get the benefit of funding the account in a low tax bracket and pay no taxes later.”

Budget Your Savings

Following a budget will not only help you understand where your money is going but also show you where you can cut back in certain areas and reallocate those funds for financial goals like retirement.

Set Up Automatic Transfers

Consider setting up an automatic monthly transfer to your IRA and treating it like any other expense or bill to ensure it happens. Otherwise, you may be prone to spending whatever money you have leftover if you’re relying on manual contributions to your IRA.

The Bottom Line

Contributing to an IRA while you’re unemployed may not be possible. But if your household’s financial situation allows for it, make sure you know the rules and best practices to accomplish your retirement goal without sacrificing your present financial health.