When I make too much for a Roth... in plain English

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When I make too much for a Roth... in plain English

Postby KMK » Sun Apr 22, 2007 5:16 pm

I am likely going to make too much money this coming year to contribute to my Roth IRA. Unfortunately, I only have a bare minimum in the Roth as it is because of debt repayment efforts. That aside, I saw the thread about this topic, but all the options sound like a foreign language to me. Can someone explain in very simple terms what the options are when I can't contribute to a Roth anymore? And what is the penalty if I do contribute, and then end up making more money than I anticipated? Thanks

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Postby jdroth » Sun Apr 22, 2007 5:28 pm

KMK, this is actually a subject that has become a topic of interest in our household. We never expected to reach that point, but now it's looking as if we need to address the issue in the next couple years. I don't have any answers for you, but want you to know that I'm interested in the answer, too. I'll probably start planning a blog entry on the subject, though it may take a while (as in weeks or months) for it to actually find its way to publication.

My understanding is that if you contribute to a Roth and then aren't eligible at the end of the year, you can get out of it without any sort of penalty. You'd just have to pay taxes on your capital gains. Don't quote me on that, but that's what I believe is true. As for other options: as far as I know, a traditional IRA doesn't have any sort of earnings cap. You're taxed at the back end, but I think you get a tax deduction when you put money in.

Hopefully Dylan will come along and answer the question for both of us. :)

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Go traditional

Postby ronnieboy » Sun Apr 22, 2007 9:12 pm

My wife and I got hit with a partial contribution in our Roth this year. It starts to phase out at 150K to a zero contribution if you hit 160k for married filing jointly. It does go up to 166k this year. Anyhoo, we ended up having to take some monies out of the Roth, pay taxes on the earnings.
This year we are expecting to exceed the 166K so instead of putting anything in a Roth, we are placing after tax monies into a tradtional IRA. We plan on doing this for 2007, 2008, 2009, and in 2010 convert all these years of tradional contributions to a Roth when the income limits are lifted.

I believe that if the lawmakers do not nix the 2010 income limits, then when we convert, we would only owe taxes on the earnings since the contributions were all after tax.

If anyone knows differently, please let me know.

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Postby nickel » Mon Apr 23, 2007 4:31 am

RonnieBoy: That sounds about right. The main risk that you're running is that you're locking away non-deductible contributions in an IRA - What if the conversion loophole goes away? Your money will be tied up with minimal tax advantage. The real downside here is that Traditional IRA disbursals are taxed as income even if the earnings are largely based on capital gains. Arguably, you could invest in a tax efficient fund that creates minimal income along the way and then owe only capital gains when you liquidate. Obviously, if you can get the money into the Roth, then the strategy you've outlined is great. But you might end up restricting access to your money for no real reason if this doesn't pan out.

KMK: Here are some articles that I've written on the topic. I like to think that I write in plain English, so hopefully they'll help:

Two articles on contribution limits (2006 and 2007):
http://www.fivecentnickel.com/2006/11/0 ... out-works/
http://www.fivecentnickel.com/2007/04/0 ... -for-2007/

An article on the income limits for converting traditional IRA funds to a Roth IRA:
http://www.fivecentnickel.com/2006/11/1 ... -roth-ira/

Two articles on fixing things if you contribute when you shouldn't have:
http://www.fivecentnickel.com/2007/01/1 ... -mistakes/
http://www.fivecentnickel.com/2006/11/0 ... -mistakes/

And finally an article defining Modified Adjusted Gross Income (this is what all these limits are based on):
http://www.fivecentnickel.com/2006/11/1 ... ncome-agi/

Hope this helps.

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Postby Dylan » Mon Apr 23, 2007 7:57 am

Some of the options when you cannot make Roth contributions, in my best plain english:

1. If you have a retirement plan at work that allows you you to make contributions directly out of your salary before taxes are calculated, you can make contributions unless you are already contributing the maximum allowed in your plan at work.

2. You can make contributions to a "traditional" IRA. If you or your spouse have access to a retirement plan through work, your traditional IRA contribution may not be tax deductible based on a phase out similar to the Roth, but you can still make non-deductible contributions. In a traditional IRA you only pay taxes when you take the money out (the withdrawal is considered income in the year you take it), but you do not pay taxes at withdrawal on a prorated portion based on money you have already paid tax on (the non-deductible contributions). If either you or your spouse has access to a retirement plan at work and are not eligible to contribute to a Roth IRA, you likely would not be able deduct your traditional IRA contributions. Current laws would allow you to convert a traditional IRA to a Roth IRA after 2009 with out the income limitations.

3. You can also save into an account that has no tax deferral such as a plain old brokerage account. Some people advocate buying non-income producing securities so they don't have to pay annual income tax and then holding them to pay the lower long-term capital gains rates in the future when they finally sell them. This is possible, but in practice it is harder to do than it sounds.

There are a number of other places to save money into but these are the most common for saving for retirement when you can't contribute to the Roth IRA.

On the issue of contributing to the Roth and then learning you've made too much money in the same year, Nickel addresses "Recharacterization" well in the http://www.fivecentnickel.com/2007/01/1 ... -mistakes/ link. The only thing I'll add, in the spirit of plain english, a Recharacterization is done by getting a "Recharacterization" form from the company where you keep your IRA account, filling it out, and returning it to them before the tax filing deadline. If you don't have a traditional IRA, you will need to open one so the recharacterized money can go into it.

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