Income Too High for a Roth IRA? Try These Alternatives

High earners may have a variety of options for saving for retirement—but income limits mean that direct contributions to Roth IRAs may not be among them. This is unfortunate because Roth IRAs offer tax-free earnings growth and withdrawals in retirement,¹ making them a potentially valuable part of a broader investing and tax-planning strategy. Having both Traditional and Roth accounts can help with tax diversification in retirement.

Here are some strategies to consider.

Are you getting the most from your 401(k)s?

Maxing out contributions to a traditional 401(k) is a good place to start. Such accounts have no income phase out limits, so you can generally contribute the lesser of your income or $19,500 (plus an additional $6,500 if you are 50 or older).  Pre-tax contributions to these accounts reduce your taxable income and earnings will grow on a tax deferred basis—though distributions in retirement are subject to be taxed at ordinary income rates in the future.

If your employer also offers access to a Roth 401(k), then you could consider using one to set aside some post-tax retirement savings. Like their traditional 401(k) counterparts, Roth 401(k)s—unlike Roth IRAs—don’t have income phase out limits. So even if you don’t qualify for a Roth IRA because your income is above IRS income limits you can make after taxes contributions to a Roth 401(k). Your earnings will grow tax-free, and you pay no taxes when you take withdrawals after 5 years and over the age of 59½.

It should be noted that the annual contribution limit applies across all of your 401(k) accounts, not on each account individually. In 2021, contributions are capped at $19,500 between a Traditional and Roth 401(k) and at $26,000 for those 50 and older.

Consider a Roth conversion

Converting some or all of the funds in a Traditional IRA into a Roth IRA is another option. This would mean taking funds from traditional IRAs, paying ordinary income tax on those funds, and rolling them into a Roth IRA. This can make sense particularly if you expect to be in a higher tax bracket in the future and have a long-time horizon.

Some advisors also see a so-called backdoor Roth IRA as another way to secure the tax features provided by Roth accounts. It’s a unique strategy but it could work for you. The backdoor Roth involves opening a Traditional IRA, making non-deductible contributions to it, and rolling over those funds to a Roth IRA at a later date. When those funds are rolled over, you’ll have to pay taxes on any appreciation that occurred prior to the conversion, in addition, the pro-rata rule may also apply. However, once in the Roth IRA, the savings are eligible to grow and be distributed tax free.

See The Backdoor Roth—Is It Right for You? for more details.

What about non-deductible IRAs?

Does it ever make sense to contribute to a Traditional IRA even if you can’t deduct the contributions? At the very least, you could still enjoy the potential for tax-deferred growth in the account.

“Think carefully before considering this option,” Rob Williams, vice president of financial planning at the Schwab Center for Financial Research, says. “You wouldn’t be getting any upfront tax break, and future withdrawal of growth on your original contribution would be taxed at your ordinary income tax rate.”

It’s possible that the future tax rates you’d pay would be higher than what you would owe if you’d invested in a tax-efficient way in a regular taxable brokerage account. “With today’s low long-term capital gains and qualified dividend rates, non-deductible contributions to a traditional IRA may make less sense,” says Rob.

As of 2021, long-term capital gains are taxed at a federal rate of either:

• 0% for single filers with taxable income up to $40,400 or joint filers with taxable income up to $80,800.
• 15% for single filers with taxable income between $40,401-$445,850 or joint filers with taxable income between $80,801-$501,600.
• 20% for single filers with taxable income above $445,850 or joint filers with taxable income above $501,600.

In addition, single filer with adjusted gross income (AGI) over $200,000 or joint filers with AGI over $250,000 may have to pay the Medicare surtax of 3.8%.

Tax-efficient investing in a taxable account

There are many tax-efficient ways to invest in taxable accounts. If you don’t trade often, individual stocks, as well as most exchange-traded funds (ETFs) and index mutual funds, can result in a lower tax bill.

You may owe only the long-term capital gains tax rate on earnings if you sell an investment held longer than a year at a gain, which is generally lower than the tax rates on ordinary income. There may be some distributions along the way, but qualified dividends from stocks are generally taxed at the long-term capital gain tax rate, and ETFs and index funds can be managed tax-efficiently.

Having some money in taxable accounts can provide opportunities to reduce your tax bill by strategically harvesting losses. That’s not something you can do in your 401(k) or any IRA. Investing in tax-advantaged municipal bonds or muni bond funds, depending on your tax bracket, can help too.

Saving in a taxable account can also be helpful for estate planning goals. If you hold long-term investments in a traditional brokerage account, you can donate low-cost-basis securities to charity for a full fair market value deduction and no capital gains tax. You can also leave your appreciated shares to heirs who would receive a step-up in cost basis.

Finally, as noted above, having money in taxable accounts as well as tax-advantaged accounts can give you greater flexibility and access to savings for needs prior to age 59½—the minimum age from which you can withdraw from traditional IRAs and retirement accounts without a 10% early withdrawal penalty.² It can also provide flexibility in managing your tax bracket as you plan for post-retirement cash flows. “This sort of tax diversification can be helpful, no matter your future tax rate,” says Rob.

¹You must be 59 ½ and held the Roth IRA for 5 years before tax-free withdrawals on earnings are permitted.

²Subject to certain exceptions, for hardship or other situations specified by the IRS.