Where should I put my savings if my income is now too high for a Roth IRA?
My husband and I earn over $193K annually. I have contributed to a Roth IRA through my employee deduction system and also deposited money in an online Roth Account. I just realized that I may not be eligible for the Roth IRA because I earn too high of an income. Do I move the money to a Traditional IRA? Do I disburse all the deposits due to excess contributions? What about previous years?
Great question. I work with a lot of high-income families and yes, if your Modified Adjusted Gross Income (MAGI) is that high, you cannot make a normal Roth Contribution, but you can make a non-deductible Traditional IRA Contribution and then convert it to a Roth. This is also called a “Back-Door Roth”. There are several things to be careful of, especially the ProRata rule. You can find out more in our free Back-Door Roth Guide and Toolkit:
If you make too much for a Normal Roth Contribution, then you make too much for a deductible IRA contribution. If you made some in error in previous years, look to fix right away.
Other options for high-earners to save:
- Back-Door 401(k) Roth
- Health Savings Account (HAS)
- If you have a side gig
- SEP IRA
- SIMPLE IRA
It does get complicated. Feel free to reach out if needed, we have an hourly service too.
Mark Struthers CFA, CFP®
This is a complicated issue, and you should seek tax counsel with a CPA or an advisor who is well versed in this area. But for last year's contributions, you can recharacterize the contributions to a Traditional IRA if done before your taxes are due including extensions. You need to contract your custodian ASAP to effect this. Previous years are tricky because there a penalties, 6%/year if memory serves, for each year the excess remains in the account before corrected (removed). And this must be done by year-end for the penalty not to take effect for that year, not when taxes are due for that year. So, each contribution that isn't corrected by that years tax due date, there is a 6% penalty. Therefore, you can correct 2016's excess and recharacterize as a Traditional IRA contribution, but it will not be deductible due to your income level and participation in 401(k)s. Anything before that incurs a penalty each year it remained in the account.
Your Roth 401(k) is fine, there are no income limits, only to the Roth IRAs. Once you both max out your 401(k)s, Roth or otherwise, and then max out Traditional IRAs if that is what you want to do because it is not deductible, then you can put any excess savings into a taxable brokerage account.
But if managed correctly, you will pay a lot less in tax than you might think. You can do this with "tax loss harvesting" every year at year end to minimize taxes. Most advisors don't like to discuss this because it admits they have some losses. This is simply part of investing and needs to be addressed AND taken advantage of. But if you book a loss, even if it is a stock, you still want to hold and remain a good investment, you still should book if material. This is because you can always buy that same stock back after 31 days and use the loss to offset gains.
Therefore, the only reason you wouldn't book the loss is if you think the stock is going to go up at least 15% in 31 days (L-T capital gains rate). And nobody is consistently that good or anywhere near it. This will minimize investment gains each year. So you always want to do year-end tax planning so you "compound" your taxable accounts. This strategy is unnecessary in an IRA.
Best of luck, and if you need any further help, just reach out to me. I am well versed in this area as I have a tax background. Dan Stewart CFA®
The responses in previous answers regarding your actual MAGI deserve looking at. If it still turns out that you cannot do the Roth IRA, then I would assume the additional savings are geared towards retirement, yes? If so, as mentioned previously, you could consider an after tax account with suitable investments for your situation. And while the taxes may be lower, there will still be taxes, especially if you rebalance and make any other changes. Even if you have a tax efficient approach, it's hard to avoid.
If you are looking long-term towards retirement, I would suggest considering a low cost variable annuity. Fidelity and Vanguard both offer these. You would get complete tax deferral until you start taking money out.
So it depends whether you want lower current taxes on the investments, with access to them at any time, or whether you want the benefit of longer term tax deferral.
If your employee deduction system is a Roth 401(k), then your earnings limitation does not apply and you may continue to contribute. If you cannot contribute to a Roth, I suggest an normal investment account with an registered investment advisory (RIA) firm. After-tax investing allows you to pay taxes at the capital gains and dividend rates which are lower today than the ordinary income rates. Also, you will enjoy much more freedom with your money at retirement since you will not be subject to IRA rules of RMD's and ordinary income taxation.
It is important to note that Roth IRA contribution limits are based on Modified Adjusted Gross Income or MAGI. Your gross income is very different from MAGI, so it is possible that you still may be eligible.
If you are not eligible, you will need to contact your investment provider and process either an “excess withdrawal” or a “recharacterization.” An excess withdrawal removes from the Roth IRA what you over contributed. The recharacterization will change it from a Roth contribution to a Traditional IRA contribution. You’ll want to act on this quickly because it is best to do it within the same tax year.
You mentioned that you are contributing partly from an employee deduction system. If those contributions are being made to a Roth 401(k), the income limitations do not apply.
There is also what is known as a “Back Door Roth IRA Contribution” where you make a contribution to a non-deductible IRA and then convert it to a Roth IRA. This can be a tricky process. I wrote about some of the pitfalls in an article called Roth IRA Conversion – The Pro Rata Rule Is Lurking which goes into a little more detail.
Please note that this should not be considered investment advice and is only educational in nature. Be sure to consult your own investment, tax, or legal professional for help with your specific situation.
Best of luck!
David N. Waldrop, CFP®