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So You Can't Contribute to An IRA, Now What?

"Thank you for the detailed explanation of both a traditional IRA and a Roth IRA.  My understanding of both investment mechanisms has been increased tremendously.  One question which may generate a very long, detailed answer:  What happens (or more importantly what are the alternatives) if your income level falls outside of the limits set by either the Traditional IRA or the Roth IRA?"

I certainly appreciate your kind words, and I am glad that you are learning something from these posts.  You are spot on that your question would require a very long, detailed answer, but I will do my best to shed some light on some of the options that are out there.

The easiest option is to make contributions on a pretax basis to your employer’s 401(k), 403(b), 457(b), or SIMPLE plans if you have one of these options.  These plans do not have limitations on how much you can earn in order to contribute.  Some plans may offer a Roth option as well and if you read my last post on Roth IRA’s you know how big of a fan I am of Roth accounts.

If you are self-employed, I would encourage you to utilize a Simplified Employee Pension (SEP) IRA.  A SEP IRA enables you to make pretax contributions just as you would with an employer sponsored plan.  I tend to look at a SEP IRA as a 401k (without the hassle of setting up a 401(k)) for self-employed individuals and sole proprietorship business owners.  They are easy to set up and enable you to save for retirement just as you would through an employer.

Another option is to use a variable annuity as these investments also grow tax deferred.  Generally variable annuities are sold just as life insurance policies are sold.  Because of this, they usually charge significantly more in fees than if you made the same investments outside of the insurance company that sells the annuity.  In general, I would usually avoid variable annuities though in some rare circumstances they may prove beneficial.  If you think an annuity may be right for you, then I encourage a low load one such as that offered by Vanguard.

There are other options but this is where things get complicated quickly.  I simply will not be able to provide all the details that you would need in this post.  For the first time in my posts, I will recommend that you consult with a fee only financial planner if you do not thoroughly understand these next two options.  It will be impossible to provide all the details that you will need to perform these options correctly as that would result in at least a chapter in a textbook on investing.  If one of these options interests you, please either do more research or consult with a fee only financial planner.

The first option is to make a nondeductible traditional IRA contribution and convert that to a Roth IRA.  You have to be very careful with this situation, and I strongly recommend talking to a professional to make sure you don’t overlook something and end up owing all sorts of tax and interest penalties.

The second option is to make contributions to a taxable account but choose investments that do not trigger taxable events.  For instance, municipal bonds are a good investment in a taxable account because the dividends that they pay are tax-exempt on the federal level.  Of course, all of the associated risks should be evaluated before making any investment.  There are many other investments where you have the ability to control the annual tax implications.  Mutual funds usually do not provide you with this ability because they pass through all the dividends that are earned as well as your portion of the capital gains that have been recognized.  In general, index funds are more tax efficient than actively managed funds.

It is important for you to choose not only the appropriate asset allocation (percentage of stocks, bonds, etc.) for your total portfolio but in which accounts those investments are held.  For instance, you would want to invest in municipal bonds in a taxable account and not in one of your IRA’s.  Invest in something with a large tax impact in your IRA instead.  I hope this makes sense.

Again, I hate to say consult with a fee only financial planner over and over because that is not the intent of these posts.   It simply isn’t possible to provide you with all the information here for you to make a completely informed decision so I have to add the disclaimer.  This question really gets into the meat and potatoes of investing and financial planning especially when you start earning more than the limits on IRA contributions.  The benefits of having a professional evaluate all of your investment opportunities and provide unbiased advice is critical.  All of your finances should be working together and not have an advisor managing one portion, you another, and maybe your spouse their portion.  There are tremendous opportunities to minimize current taxes and enable your money to work even more for you.

This isn’t to say that you can’t learn this on your own.  It is absolutely possible as I can speak from experience.  I learned all of this for the benefit of our own finances long before deciding that this is what I love and want to do full time.  Keep reading and learning and if you have specific questions please contact me, and I will be happy to help.  Good luck Bill and everyone else.