Can non-taxible Medicaid waiver income be used for deductible Traditional IRA contributions?

[bobdrad]

I am retired (age 70). I have no wage income in 2025, but my spouse had over $16000 and we are filing jointly.

However, my spouse's income came from the state for care-giving of our special-needs child. As such, it is largely not federally taxable. On her W-2, it only shows about $1000 in Box 1 (Wages). It shows the full amount of over $16000 in box 12. Box 12a shows "II" ("Medicaid waiver payments excluded from gross income under Notice 2014-7")

As best I can tell, it appears that the full amount of her non-taxable Medicaid waiver payments are eligible for maximum deductible IRA contributions (for both my spouse and myself). Is that accurate?

[Opus 17]

No. Because the income is excluded from tax, it is not counted as compensation for purposes of making IRA contributions.

If you look at publication 590-A under "what is compensation", it includes the following:

Compensation doesn’t include any of the following items.

• Any amounts (other than combat pay) you exclude from income, such as foreign earned income and housing costs.

[bobdrad]

I'm not sure this "Accepted Answer" is correct, in light of section 116 of the SECURE Act.

Here's an analysis:

“Difficulty of care payments” is defined in Code Section 131(c)(1)(A) as “compensation for providing the additional care of a qualified foster individual.” In other words, if you provide care in your home to an individual who has a physical, mental or emotional handicap, including payments received for caring for foster children, the income you receive is excluded from taxable income.

Now, however, under Section 116 of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, home healthcare workers are able to contribute to an IRA or qualified retirement plan because the provision amends Code Sections 415(c) and 408(o) to state that tax-exempt “difficulty of care payments” are treated as compensation for purposes of calculating the contribution limits to DC plans and IRAs.

However in reading the actual Section 116 of the SECURE Act I'm having difficulty in determining whether this only applies to foster children, or whether it's been amended to apply to any individual with a physical, mental, or emotional handicap.

[Opus 17 · Accepted solution]

@bobdrad 

You are partly correct.  Revenue Ruling 2014-7 applies difficulty of care payments under the foster care rule to Medicaid waiver payments as well.

https://www.irs.gov/irb/2014-04_IRB#NOT-2014-7

However, difficulty of care payments can only be used to make non-deductible IRA contributions, not deductible IRA contributions, and not Roth IRA contributions.  This is also noted in publication 590-A. 

https://www.irs.gov/publications/p590a

Difficulty of care payments. For contributions after December 20, 2019, you are able to elect to increase the nondeductible IRA contribution limit by some or all of the amount of difficulty of care payments, which are a type of qualified foster care payment, received. If you receive difficulty of care payments, then those amounts may increase the amount of nondeductible IRA contributions you can make but not above the $7,000 IRA deductible amount ($8,000 if you are age 50 or older). The increase to the nondeductible IRA contribution limit equals the lesser of (i) the amount of difficulty of care payments excluded from gross income, or (ii) the amount by which the deductible limit for IRA contributions exceeds the amount of the taxpayer's compensation included in gross income for the tax year.

Form 8606. To designate contributions as nondeductible, you must file Form 8606.

You don’t have to designate a contribution as nondeductible until you file your tax return. When you file, you can even designate otherwise deductible contributions as nondeductible contributions.

You must file Form 8606 to report nondeductible contributions even if you don’t have to file a tax return for the year.

So yes, you can make non-deductible IRA contributions using the difficulty of care payments to qualify.  If you have not already made the contribution, and you want to make a 2025 contribution, it may be difficult to get the plan to process the deposit by close of business tomorrow.   If they miss the deadline, it won't count that you tried.  And you will have to use form 8606 and track your non-deductible basis, so that future withdrawals would be partly non-taxable using the pro rata rule.  (And I'm curious to see if Turbotax understands this exception.)