Reader Question: What do I do if I can’t benefit from a Traditional or Roth IRA?

I love getting reader questions. And I had a fantastic one over the weekend:

 “If one’s AGI is above the threshold for contribution to Roth IRA and for deduction of a traditional IRA contribution, what is the benefit of an IRA contribution at all?”

This is a great question because it highlights the benefit of Individual Retirement Arrangements (IRAs), also commonly referred to as Individual Retirement Accounts.

These vehicles provide a way for people to supplemental their retirement and obtain a tax savings in the process. You can take advantage of a tax deduction and tax-deferred growth for contributions to a traditional IRA. Or you can receive tax -free growth when investing in a Roth IRA.

Unfortunately, both have income limits that may prevent you, like this reader, from qualifying for either tax benefit. So what then?

The Limits

For 2014, if you participate in a company sponsored retirement plan, your ability to deduct your traditional IRA contribution is phased out if:

  • As a single filer or head of household, you make between $60,000 and $70,000 of modified adjusted gross income (MAGI). If you earn above $70,000, you don’t get to deduct anything.
  • If you’re married and file jointly with your spouse, and you can make between $96,000 and $116,000 of MAGI.  Again, earnings above $116,000 prevents any deduction.
  • Lastly, for a married individual filing a separate return, the phase-out range is $0 to $10,000. (Yet another reason not to file MFS.)

If you happen to be an IRA contributor who is not covered by a workplace retirement plan but are married to someone who is covered, the deduction is phased out if the couple’s income is between $181,000 and $191,000.

For Roth IRA contributors, the MAGI phase-out ranges are as follows:

  • Single Filers and Head of Household: $114,000 to $129,000.
  • Married Filing Jointly – $181,000 to $191,000.
  • Married Filing Separate – $0 to $10,000.

Solution #1 – Non-Deductible IRA

Even if you exceed the income limits on both IRAs, you can still make a non-deductible contribution to a traditional IRA. You have to pay taxes on the money you contribute to the account, but you can avoid taxes on any growth (i.e., earnings) until you withdrawal the money.

This solution still allows you more freedom in your investment choices because you don’t have to worry about the tax consequences of any investment. However, losing the initial tax deduction hurts a bit.

Solution #2 – Back Door Roth IRA

Despite the income limits to the Roth IRA, there’s still a way to invest in a Roth account by sneaking in the “back door.”

In order to do this, you make a non-deductible contribution to a traditional IRA and then covert that money right away into a Roth.  There are no income limits to converting, and you’ve already paid taxes on the non-deductible contribution, so you won’t have to pay taxes again. The best part is that you get the benefit of tax-free growth.

(Side note: If you don’t convert right away, you risk having to pay tax on any growth earned between the initial investment and the time of conversion.)  

I love this solution because:

1)   You are already making a non-deductible contribution, so why not get the benefit of tax-free growth, rather than having to pay taxes on the earnings when you eventually withdraw them, and

2)   It offers tax diversification for high-income earners who are likely maxing out their 401k plans at work. In other words, you will have more flexibility in retirement by being able to determine how much you take from your taxable and non-taxable accounts.

The big caveat here is to only do this if you don’t already have a lot of money in traditional IRAs.  With any conversions, all earnings and previously untaxed contributions in traditional IRAs are taxed on a pro-rata basis. In short, you can’t just pay tax on the amount converted, you have to take into account all previously untaxed contributions and earnings. You definitely want to see a tax advisor if you fall into this category to figure out what kind of tax bill you’ll face when you convert.

Still want something else?

If neither of those solutions appeals to you, you can always invest in a taxable account. I’ll talk about the benefits and pitfalls of that on Friday.