Make Too Much to Contribute to a Roth IRA? Here Are Three Ways to Do it Anyways
I love putting money in my Roth IRA! I also really like making more money!
Unfortunately, those two things don’t always mix well in the eyes of the IRS. In fact, The IRS gives us this very simple **paraphrased** equation:
High Income + Roth IRA Contribution = Not allowed
Ok, that’s grossly over-simplified. Here’s really what the IRS really tells us (based on 2017 numbers):
For people who are single (based on 2017 numbers):
If your income is below $118,000 then you can make a full Roth IRA contribution ($5,500 for 2017 plus $1,000 catch up)
If your income is between $118,000 to $133,000 then you can make a partial Roth IRA contribution.
If your income is above $133,000 then you are ineligible to make a Roth IRA contribution
For people who are married and file taxes jointly:
If your income is below $186,000 then you can make a full Roth IRA contribution.
If your income is between $186,000 and $196,000 then you can make a partial Roth IRA contribution.
If your income is above $196,000 then you are ineligible to make a contribution.
So what’s the takeaway? Single people need to hurry up and get married so you can stop limiting your Roth IRA contributions!
Or, if a Roth IRA-based marriage isn’t your thing, then here are some other options:
Option #1 Reduce Your Income.
Is that the craziest thing you’ve ever heard? Good. I’m just making sure that I still have your attention.
What I really mean is reduce your ADJUSTED GROSS income, also known as your AGI.
Your AGI is your income after specific deductions, including 401(k) and IRA contributions. What this means is that if your income is flirting with Roth IRA phaseout limits, then simply saving more to your 401(k) could have the added benefit of making you eligible for Roth IRA contributions.
For example – if you’re single and your annual income is $135,000 then ordinarily you would be ineligible to put any money into your Roth IRA.
However, if you simply maxed out your 401(k) at $18,000 for the year then your AGI (excluding any other potential deductions) would drop to $117,000. Now all the sudden you are eligible for a full contribution to your Roth IRA!
But maybe you make a lot more than the Roth IRA exclusion amounts and no amount of 401(k) deductions are going to save you. If that’s the case then fret not. There are still other options.
Option #2 Contribute to a Roth 401(k)
Not every employer offers a Roth 401(k), but for those that do it can be a great tool.
A Roth 401(k) offers many of the same benefits as a traditional 401(k). The difference is that deferrals to a traditional 401(k) avoid any federal or state taxes, whereas deferrals to a Roth 401(k) do not.
The benefit of contributing to a Roth 401(k) is that there are no income limits to do so.
So unlike Roth IRA contributions that are capped by certain income limits, you can earn as much as you’d like and still contribute to a Roth 401(k).
That still not good enough for you? Here’s an added benefit – IRAs limit you to $5,500 per year plus $1,000 for catch up contributions. With a Roth 401(k) you can contribute up to $18,000 per year plus an addition $6,000 for catch up contributions if you’re over age 50. That can add up to a lot of tax-free money for retirement!
Keep in mind a couple things when you’re considering making contributions to a Roth 401(k).
First, if you’re considering Roth 401(k) contributions because you make too much for a Roth IRA, then chances are good you’re in a high tax bracket. That means you may want to at least consider the traditional 401(k) option based on the tax savings it offers.
Second, even if you do make contributions to your Roth 401(k), your employer will still make any matching contributions into the traditional portion of your 401(k).
Keep that in mind when you go to rollover your 401(k) at a future date. Rolling the entire amount into a Roth IRA could be considered a Roth conversion and could trigger an expensive tax bill!
Option #3 Then There’s the “Backdoor” Roth IRA Option.
The backdoor Roth IRA concept emerged in 2010 when Congress made it possible for all people to convert their IRAs to Roth IRAs regardless of their income. There are many details and nuances to this strategy, but put simply it looks like this –
If you make too much money to contribute to a Roth IRA then you put it in a traditional IRA instead. The income limits that apply to Roth IRAs don’t apply to IRAs. Meaning even if you make $10 million per year you can still put money into your IRA.
You might not be able to deduct this IRA contribution on your taxes, but you can make the contribution nonetheless.
If you’re unable to deduct the IRA contribution, then the IRA contribution that you make is considered “basis”.
You then convert this basis to your Roth IRA, and because it’s already after-tax money you don’t owe any additional taxes on the conversion.
What does that mean? We get to make a new equation! That new equation is:
High Income + Good Planning + Roth IRA Contributions = Allowed!
Before you go any further, there’s a catch.
When you use the backdoor Roth conversion, the IRS aggregates the value of any other IRAs, SEP IRAs, and SIMPLE IRAs that you have.
They do this to help calculate the portion of the conversion that might be subject to taxes. Because if it’s only basis that you’re converting to your Roth IRA then you don’t owe any taxes. But once you start converting pretax portions of your IRA you become subject to taxes.
Say, for example, you have an old IRA from years ago and it’s worth $15,000. Then you set up a new IRA and make a non-deductible $5,000 contribution which you immediately convert to your Roth IRA because you’re a genius and you know the rules of the system.
You would think that the $5,000 would go into your Roth IRA tax-free, while the $15,000 stayed in a pretax IRA, right?
The IRS thinks otherwise.
The IRS aggregates the value of all of your IRAs, which means they would view the conversion like this:
You have a total IRA value of $20,000. It doesn’t matter that they’re in separate accounts. $5,000 of that $20,000 is after-tax basis. So 25% is after-tax basis and 75% is pretax.
You then convert $5,000 of your total IRA to a Roth IRA.
25% of this will be tax-free and 75% will be taxable.
What this means for you is that $1,250 of that conversion will work out exactly like you planned, but the remaining $3,750 will be subject to federal and state taxes.
The best way around this is to transfer all pretax IRA money into your 401(k) plan if you have that option. This is a complex strategy and there are a lot of rules around it.
For detailed instruction on everything you need to know about the taxability of this conversion please see Michael Kitces’s article How to Do a Backdoor Roth IRA (Safely). I urge you to meet with your tax professional or your financial planner before executing this strategy.
If done properly though, it could help you save a tremendous amount in taxes over time!
So is a Roth IRA Right For You?
With the benefit of tax-free growth, the option of accessing Roth IRA contributions prior to age 59.5, and the control that it provides, A Roth IRA is a wonderful investment tool in my opinion.
Thankfully, with strategies like we’ve covered above the Roth IRA may be available for many people that don’t even know it!
Please feel free to comment below or share this article with anyone who may not know the Roth IRA strategies that they’re missing out on.