What to Do When You Earn Too Much to Contribute to an IRA
Individual retirement accounts (IRAs) are a special type of account that you can use to save for retirement. They offer unique tax advantages but put restrictions on when and how you are permitted to make withdrawals.
The government designed IRAs as a way to help people save for retirement.
However, the government did not want to offer high-income people unlimited ways to avoid taxes.
To prevent that from happening, there are limits placed on how much people can contribute to IRAs.
One of these limits is based on how much money you make. This isn’t a bad problem to have, because it means you’re making a lot of money.
Still, even high-earners need to save for retirement.
If you make too much to contribute to an IRA, we’ll discuss the retirement savings options that remain available to you.
IRAs are subject to contribution limits. Each year, you’re only allowed to contribute a specific amount to your IRAs.
For 2020 and 2021, you may contribute up to $6,000 to your IRAs in total. If you have both a Traditional IRA and a Roth IRA, they share that $6,000 limit. You don’t get to make double the contribution if you have both types of IRA.
If you are 50 years old or older, you may make an additional catch-up contribution of $1,000. That gives you a total contribution maximum of $7,000 per year.
These limits sound like they are based on the calendar year, but you actually get a bit over 15 months to make each year’s contribution.
You can contribute for a year from January 1st of that year, through the tax-filing deadline for that year, which is usually April 15th.
If you’re making contributions in the first few months of the year, it’s in your interest to try to fill the previous year’s limit before starting on the current year’s contributions. If you fail to max out your IRA before Tax Day, the unused contribution space is lost forever.
On top of the $6,000 contribution limit, there are limits based on your income.
For Roth IRAs, you may be forced to contribute less than the $6,000 if you make too much money.
For traditional IRAs, you may make the full $6,000 contribution but will only receive the tax benefits on a portion of your contribution rather than the full amount.
Traditional IRA Vs. Roth IRA
|Traditional IRA||Roth IRA|
|Contributions may be tax-deductible.||Contributions are not tax-deductible.|
|Pay taxes upon withdrawal.||Earnings can be withdrawn tax-free and without penalties if the funds were in the Roth IRA for 5 years and you've reached age 59 1/2.|
|You must be under age 70 1/2 to contribute.||You can contribute at any age.|
|Required minimum distributions (RMDs) are required starting at age 70 1/2.||No RMDs required.|
Traditional IRAs are usually what people think about when they hear someone say the word IRA.
These accounts provide upfront tax benefits, making it a bit less painful to save for retirement.
When you contribute money to a traditional IRA, you can deduct that amount from your income when you file your taxes.
That means that every dollar you contribute to a traditional IRA costs you less than a dollar in take-home pay.
Consider this example:
After accounting for all other deductions, your taxable income for 2020 is $50,000. You’re planning to file as a single person.
With a taxable income of $50,000, your tax bill will come to $6,939.16. If you decide to make a $5,000 contribution to your traditional IRA before you file your taxes, you can instead report a taxable income of $45,000.
This will reduce your tax bill to $5,839. You will have saved $5,000 towards your retirement, but received a $1,100 discount on your taxes, so saving the $5,000 only cost you $3,900.
Unfortunately, you don’t get to keep the money tax-free forever. When you turn 59½, you are allowed to start withdrawing money from your IRA without penalties.
When you do withdraw the money, you have to pay tax on it as though it were regular income.
Usually, you come out ahead in this scenario, because you are in a higher tax bracket when you are employed than when you are retired. This results in you paying less tax overall.
Make sure to remember that making an IRA contribution is a commitment.
You’re not permitted to withdraw money from your IRA until you turn 59½. If you do make an early withdrawal, you have to pay a 10% penalty on your withdrawal, plus income taxes.
Though you can always contribute the maximum of $6,000 to a traditional IRA, you might not receive the full tax benefit.
If you make too much money, you may receive just some or none of the tax benefits.
The income used for this calculation is your Modified Adjusted Gross Income, which is your income minus certain deductions.
2020 Traditional IRA Deduction Limits (based on income)
|Filing status||Modified adjusted gross income||Deduction limit|
|Single individuals||$65,000 or less||The full amount contributed|
|$65,000 - $75,000||Partial deduction|
|More than $75,000||No deduction|
|Married filing jointly||$104,000 or less||The full amount contributed|
|$104,000 - $124,000||Partial deduction|
|More than $124,000||No deduction|
|Married filing separately||Not eligible||The full amount contributed|
|Less than $10,000||Partial deduction|
|More than $10,000||No deduction|
If you plan to contribute to a traditional IRA, only contribute up to the amount you are allowed to deduct.
Otherwise, you’ll pay income tax on your contributions twice.
Also avoid filing your taxes as married, filing separately.
Roth IRAs offer the reverse of the benefits that traditional IRAs do.
When you contribute money to a Roth IRA, you must include it in your taxable income when you file your taxes.
In exchange, you get to withdraw your contributions, and all of the earnings, tax-free, when you retire.
This is great if you are earning less than you expect to be when you retire, but this situation is uncommon. Roth IRAs are best suited for people who are low-earners, or working a side job while studying since they will be in a very low tax bracket.
One other benefit of Roth IRAs is their flexibility. Because you’ve already paid the income taxes, you can withdraw your contributions from a Roth IRA without penalty, whenever you’d like.
This isn’t a great idea since it will eat into your retirement nest egg, but it can be helpful in a financial emergency.
Roth IRAs limit how much you contribute based on your income. If you are over the income limit, you cannot make a full contribution.
If you accidentally contribute too much, you’ll pay penalties until you remove the money from your Roth IRA.
2020 Roth IRA Contribution Limits (based on income)
|Filing status||Modified adjusted gross income||Contribution limit|
|Single individuals||$124,000 or less||$6,000 ($7,000 if age 50 or over)|
|$124,001 - $139,000||Partial contribution|
|More than $139,000||No deduction|
|Married filing jointly||$196,000 or less||$6,000 ($7,000 if age 50 or over)|
|$196,001 - $206,000||Partial contribution|
|More than $206,000||No deduction|
|Married filing separately||Not eligible||$6,000 ($7,000 if age 50 or over)|
|Less than $10,000||Partial contribution|
|More than $10,000||No deduction|
Your Other Options
If you make too much to contribute to a traditional or Roth IRA, consider one of these alternatives.
Max Out Your 401(k)
If your employer offers a 401(k) plan, take advantage of it. There are no income limits placed on 401(k) contributions, so you can contribute as much as you can afford to, up to the standard 401(k) contribution limits.
For 2020, you may contribute up to $19,500 to your 401(k). If you are 50 or older, you can make an additional $6,500 in catch-up contributions.
As a bonus, many employers offer 401(k) matching as a benefit. Your employer will make some contributions on your behalf whenever you make a contribution yourself.
Even better, your employer’s contribution won’t count towards the $19,500 limit, letting you put even more towards your retirement each year.
Health Savings Accounts
Health Savings Accounts (HSAs), may not seem like a retirement account, but the rule surrounding them make them a viable option.
HSAs are designed to help people save for healthcare expenses, such as visits to the doctor and medication.
Like a traditional IRA, you can deduct the money you contribute to an HSA from your taxable income, reducing your tax bill. When you need to pay a medical expense, you can take the money out of your HSA, also tax-free. It’s like combining a traditional and Roth IRA in one.
The only eligibility requirement for an HSA is that you have a high-deductible health plan. If you have such a plan, you can make contributions to an HSA regardless of your income and other factors.
One little-known rule of HSAs is that you can start taking money out for non-medical expenses when you turn 65. You pay income tax on these distributions, making the account function just like a traditional IRA.
You can contribute up to $3,550 to an HSA each year as a single person and $7,100 each year if you have a family insurance plan.
Most HSA providers will let you invest the money once you reach a certain balance, which means you can grow the account’s balance over time. If you don’t need to use the money for medical expenses, then that can be a significant boost to your retirement nest egg.
Taxable Brokerage Accounts
If you’ve maxed out your employer’s 401(k) and your HSA, or don’t have access to either, you can still invest using a taxable brokerage account.
You’ll have to pay the taxes on the money you use to invest, but you will have unrestricted access to the funds.
If you ever wind up needing to tap your investment account in an emergency, you won’t have to pay penalties like you would for making a withdrawal from a retirement account.
Earning too much money to make IRA contributions is a good problem to have, but trying to reduce your tax bill is still a good idea.
Taking advantage of 401(k)s, HSAs, and taxable accounts will let you continue saving for retirement, even without an IRA.