The Roth IRA danger zone (part 1): What to do when you almost make too much to contribute

A Roth IRA is awesome. There are lots of reasons, but the main one is that your money can grow and be withdrawn tax-free. So whatever you have in your account, that’s yours. Got a hundred grand? You’ve got a hundred grand.

(Don’t have a Roth IRA? Here’s my guide to setting one up with Vanguard.)

Not everyone can contribute to a Roth IRA. You need to have earned income, for one. But you also can’t have too much income either. There are limits.

As of 2019, the income limits for contributing to a Roth IRA are as follows:

  • Single: $137,000
  • Married filing jointly: $203,000
  • Married filing separately: $10,000 (not a typo)

The maximum you can contribute is $6,000, $7,000 if you’re over 50.

Your contribution limits start to be gradually reduced as your income approaches these thresholds, according to these charts I made.

It’s that “gradually reduced” area that could cause you a bit of trouble. After all, if you make, say, $300,000 a year, you know you can’t contribute to a Roth IRA. If you make $50,000 a year, you know you can contribute the full amount.

But what if you’re on the threshold? What if your salary is, say $125,000 a year? How do you know how much to contribute?

MAGI vs. income

First, let’s not conflate terms here. Income is not the same as Modified Adjusted Gross Income.

The definition of MAGI is, from Investopedia, calculated by:

…taking [your] adjusted gross income and adding back certain items such as foreign income, foreign-housing deductions, student-loan deductions, IRA-contribution deductions, and deductions for higher-education costs.

You can leave most of the details out of your brain, but just remember that, in general, your MAGI is going to be less than your salary.

So if your salary is $125,000, your MAGI is almost certainly going to be less than that.

This is both good news and bad news. The good news is that you have more income leeway in which you can contribute to a Roth IRA.

The bad news is that you have no idea when/if you’re going to hit that threshold, or, if you’re in that gradually reduced area, what you’re going to be legally allowed to contribute.

Option 1: Wait to contribute

Your MAGI is calculated from a number of factors that won’t be fully known until tax time.

So to be really, truly careful, and to ensure that you don’t make any mistakes, you can wait until you do your taxes, and then contribute to your Roth IRA in one lump sum (if you’re able to).

You usually have until April 15th to contribute toward the previous year, so that should give you plenty of time to calculate what you can contribute.

This option is exact, with no ambiguity or guesswork here. That’s a plus.

On the other hand, you have to wait until the end of the year to make any contributions, meaning that you miss out of all the potential gains.

Vanguard, in a research paper, states that it is better to make lump sum investments sooner rather than later, regardless of market conditions.

There isn’t a huge difference, but every little bit counts when we’re working toward being millionaires.

Option 2: Contribute now and adjust later if necessary

If you think you might be on the threshold of the contribution limit, you could contribute during the year in advance.

In short, you could hope.

Hope isn’t a strategy of course, but you never know what might happen during the year. You might get laid off, or your MAGI might be even less than you thought. If you find that you could have contributed more and you didn’t, that’s compounding interest time that you won’t get back.

And if you find that you contributed too much? Well, that’ll be in the next post. But the short version is that you have some recourse to fix things if you contribute too much.

Contribute if you can

I don’t know why there are income limits here.

Presumably, these limits were put in place so that super high-earners can’t game the system and make out disproportionately to the rest of the population. However, I don’t know how plausible that is, since that pretty much describes how our entire financial system is set up. Why we’d suddenly get all righteous here is a bit of a mystery to me.

But whether you choose to contribute early and hope/adjust, contribute later when you know for certain, or something in between, a Roth IRA is a powerful tool in your retirement arsenal.

Sure, the contribution limits aren’t nearly as high as the 401(k)’s limits (which are about three times that), anyone can open an IRA, unlike with a 401(k) that needs to be provided by your workplace.

If you have the option, you want to take advantage of it. If you haven’t signed up, make a plan to sign up soon. It’s pretty easy.

How would you handle your Roth IRA if you were near these income levels? Have you experienced this?

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