You’ve heard the advice when it comes to saving for retirement: contribute enough to your employer-sponsored retirement plan to get the company match, and then contribute up to $5,500 per year to a Roth IRA.
But Roth IRAs have income limits — $133,000 for single tax filers, and $196,000 for married filers. And if your income exceeds $118,000 (single) or $186,000 (married), you can only contribute a reduced annual amount.
You might reach this income limit suddenly, too. A raise or bonus at work, or a new job with a salary bump, could push you to the income limit.
And one tricky way to reach the limit overnight? Get married! Your income alone might not have exceeded the income limits, but yours plus your spouse’s could.
The IRS considers you married for the entire year in the year you tie the knot. That means that if you got married on December 31, 2016, as far as the IRS is concerned you were married for all of 2016. So if you made your 2016 Roth contribution before your New Year’s Eve wedding, you over-contributed (more on what to do in that case soon — read on!).
So what are your options when you can’t contribute to a Roth IRA anymore?
Keep the Roth IRA Account Open but Increase Your 401(k) Contributions
You don’t need to do anything with your old Roth IRA account. You can simply leave it where it is and keep it invested.
It’s really important that you increase the amount you’re contributing to your 401(k) at work because this is one of the best ways to reduce your tax bill. You should aim to max out your 401(k) ($18,000 for 2017) since you’re earning above six figures now.
If you are close to the income limit cut off, you would reducing your taxable income and could get your Modified Adjusted Gross Income (MAGI) below the amount needed to qualify for a Roth IRA — and you may actually be able to make a Roth IRA contribution after all!
If you are married, you and your spouse can each contribute up to $18,000 to an employer sponsored retirement plan for 2017, which means reducing your taxable income by $36,000!
Consider Switching to a Roth 401(k)
If your employer allows you to make Roth contributions to a 401(k) plan, you may want to consider switching your pre-tax contributions to Roth. If you think that your income is going to go up and that you could be in a higher tax bracket later on, you may choose to forgo the up front tax deduction in favor of a future tax benefit.
The money in a Roth 401(k) grows tax free and when you withdraw it in retirement you won’t pay taxes on it since it was funded with after-tax dollars, just like a Roth IRA. The nice thing about the Roth 401(k)s is that there aren’t the same income restrictions that there are on Roth IRAs. Regardless of your income level, anyone can contribute to a Roth 401(k) as long as it is offered by your employer.
Side note: any money that your employer matches or contributes via profit sharing to your 401(k) will automatically go into the pre-tax portion of your 401(k).
Begin Contributing to a Non-Deductible Traditional IRA
Your contributions to a traditional IRA won’t likely be tax deductible because of your high income, but you won’t have to pay taxes on the gains each year since they are within a retirement account (however, you don’t get to write off the losses either).
You have to keep track of the money you put into a non-deductible IRA each year by filling out a form on your taxes because it comes into play when you withdraw this money in retirement.
This strategy only makes sense after you are already maxing out your 401(k) (and your spouse’s work retirement plan if applicable).
The Backdoor Roth IRA
There is a way to indirectly contribute to a Roth IRA. Open up and contribute to a traditional IRA, and then convert it to a Roth IRA after holding the funds for one year. You can do this every year your income exceeds the limits for a Roth IRA, but this a much more complicated strategy so I would be sure to have a good CPA (and financial planner) on your team in order to execute it properly.
If you have any other IRA money (including Rollover IRAs and SEP-IRAs) this will be taken into account in a tax calculation that has to do with the IRS Aggregation rule, so you usually want to see if you can move this money into a 401(k) if possible to avoid this rule.
Honestly, I think that this is a much more complex strategy than 99% of people need for retirement planning. If you are seriously considering doing this then I would read this article by Michael Kitces on How to Do a Backdoor Roth IRA (Safely), before implementing. I wouldn’t be surprised if the IRS closes this loophole soon. Don’t try this without a tax professional on your team that has done this before and can walk you through the steps.
What if You Over-Contributed?
You’ll pay a 6% excise tax on those over-contributions each year they remain in your account, so you’ll want to take some sort of action. There are a few things you can do to fix the issue (that may or may not prevent you from paying that 6% tax).
If you realize you over-contributed before filing your taxes, you can withdraw your excess contributions. If you didn’t notice the excess until after you filed your taxes you can take out the excess money and file an amended tax return by October 15.
You can also recharacterize the excess contribution into a Traditional Non-Deductible IRA. You’d need to act fast on this, because you have until April 15 to recharacterize part of your Roth contribution for the previous tax year.
If you’re struggling to make a decision, it could be worth talking to a financial planner, who can help you choose between your options (and reduce the taxes or penalties you’ll need to pay). You can reduce the risk of this happening in the future by waiting until April to make your Roth contribution. That way you’ll have the full tax year to see if your income changes before you contribute.
It’s important to wait until the year has ended if you think you may be close to the annual income limit or in the phase out window, especially if you think a year-end bonus could set you over the limit. Once the calendar year has ended, your tax accountant will be able to tell you whether or not you qualify to make a Roth IRA contribution for that year and you’ll have until April 15 to make a contribution for the prior year.
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