Is it a good idea to invest using a Roth IRA on the exemption borderline?

February 12, 2012 11:14 PM

I have a lot of questions about Roth IRAs and being on the exemption borderline.

Please bear with me. I've been trying to read Ask Mefi topics on this but the US saving/tax system is still very new to me and I'm having trouble making heads and tails of it.

Since this is our first year married filing jointly and my wife didn't change her witholding so we had a rather large tax return. We're thinking of putting $10K into a Roth IRA investing in mutual funds. I want to try a diverse portfolio of Vanguard funds using stable bonds (25%), indexish funds (50-60%) and maybe a bit of growth (15-25%). Her MAGI is just below the exemption and she might be bonused in April to above the exemption limit for the next tax year. We're also expecting me to find employment this year which will definitely put us over the top.

Will this mean we will effectively have $10K stuck on its own if we go over this limit? This seems to be inefficient given that there are some fixed fees on mutual accounts. Would we have to start a second account that is taxable?

How do people who exceed IRA income limits usually invest money? Do they just use a regular taxable accounts? Where do dividends come into it? Do they just get rolled over into the mutual fund or are they given to us as a payout which we then have to take into account for tax purposes and what rate should this be taxed at since there seem to be multiple different rates.

Extra question: It appears if we invest in Californian municipal bonds as residents of California any dividends aren't taxed. How does this work in a Roth IRA where earnings aren't taxed? Does that mean municipal bonds are best put in a taxable account? Are they even a good idea as their returns seem to be quite good but can California default on its bonds despite being unable to declare bankruptcy?

posted by Talez to Work & Money (15 answers total)

Best answer: we had a rather large tax return

You had a large refund. Your "tax return" was the form that you submitted to the IRS.

Will this mean we will effectively have $10K stuck on its own if we go over this limit?

Yes, until such time as you're under the limits again. Making that much money is a nice problem to have, though.

This seems to be inefficient given that there are some fixed fees on mutual accounts.

Yes, but Vanguard's fixed fees are pretty low. I wouldn't particularly worry about it.

Would we have to start a second account that is taxable?

You don't have to do anything. You might find it useful to open a taxable account, though.

How do people who exceed IRA income limits usually invest money? Do they just use a regular taxable accounts?

Typically people have some mixture of 401ks, IRAs (Roth and/or conventional), and taxable accounts. (If you're lucky you have might have some sort of pension plan, if you're a government worker you might have something different than a 401k, etc.)

It's certainly nice to be able to invest entirely in non-taxable accounts, but if you can't, then you can't.

Where do dividends come into it? Do they just get rolled over into the mutual fund or are they given to us as a payout which we then have to take into account for tax purposes and what rate should this be taxed at since there seem to be multiple different rates.

Dividends in taxable accounts are taxed the same way, regardless of what you do with the money. You can choose to take the dividends as cash, or reinvest in the same fund -- the IRS doesn't care.

You may be thinking of the different tax rates for interest or dividends vs. capital gains. That's a separate issue.

Does that mean municipal bonds are best put in a taxable account?

Correct.
posted by xil at 11:38 PM on February 12, 2012 [1 favorite]

Have you maxed out your contributions to a Roth IRA for 2011? If not, you can still make 2011 contributions to your account until April 17, 2012.
posted by TheCavorter at 4:51 AM on February 13, 2012 [1 favorite]

Best answer: If it's a somewhat borderline case, can your wife increase her 401(k) contribution to keep income below the limit?

Putting the money in a traditional IRA would also be an option--if you do become employed, for example, and your income puts the two of you beyond the point of no return when it comes to meeting the Roth IRA income limits.

But yes, once you've put everything you can/wish to put into tax-advantaged retirement accounts, then people put things into regular investment accounts. And yes, dividends in those accounts are taxable--you'll get a 1099-DIV from your brokerage broken down by ordinary dividends (taxed as regular income) and qualified dividends (taxed as long-term capital gains).

I'm about as DIY as they come when it comes to this sort of thing, but you guys are young, newly married, and apparently high income, so I think yours is a case where it's really worth your while to sit down with a good financial planner who can educate you about your options and help set you up with the right mix of investment choices.
posted by SomeTrickPony at 5:20 AM on February 13, 2012

Best answer: If you expect that your marginal tax rate in retirement will be lower than it is now, consider whether a Traditional IRA would make more sense (deduct at current marginal rate, pay tax at future marginal rate).

Do they just get rolled over into the mutual fund or are they given to us as a payout

I have a taxable account at Vanguard, and both are options.

which we then have to take into account for tax purposes and what rate should this be taxed at since there seem to be multiple different rates.

I receive a 1099-DIV every year, listing the amounts of dividends, qualified dividends, capital gains, foreign tax, etc.

How [do Californian municipal bonds] work in a Roth IRA where earnings aren't taxed?

They're tax-free twice over (no credit). If you want to own these, fill your tax-advantaged accounts with everything else first.
posted by questionable accounting at 5:22 AM on February 13, 2012

capital gains

I meant capital gains distributions (distributed to you by the fund even if you haven't made a sale). Your own capital gains (from selling appreciated investments) are handled separately.
posted by questionable accounting at 5:24 AM on February 13, 2012

Response by poster:

Dividends in taxable accounts are taxed the same way, regardless of what you do with the money. You can choose to take the dividends as cash, or reinvest in the same fund -- the IRS doesn't care.

So either way we have to pay tax on the dividends? Or if it's in a Roth IRA and we choose to reinvest them back into the same fund will we not have to pay taxes on them?

If it's a somewhat borderline case, can your wife increase her 401(k) contribution to keep income below the limit?

We're already contributing the max amount for company matching which ends up being equivalent to about 15% of the gross being dumped into a 401(k). I'm just looking for a place to grow savings at the moment but I don't want to have to sacrifice a lot of now income.

Have you maxed out your contributions to a Roth IRA for 2011? If not, you can still make 2011 contributions to your account until April 17, 2012.

We haven't which is why I'm looking at it at the moment.

Putting the money in a traditional IRA would also be an option--if you do become employed, for example, and your income puts the two of you beyond the point of no return when it comes to meeting the Roth IRA income limits.

We'd be over the tax deductibility limit though? Wouldn't this effectively be putting it into a taxable account which we then can't touch for at least five years?

Thanks to everyone that's helped so far.
posted by Talez at 7:10 AM on February 13, 2012

If it's a one off, why not just invest in a single fund? You can balance it with your holdings in the rest of your portfolio. This will minimize fees on your relatively small investment.
posted by crazycanuck at 7:23 AM on February 13, 2012

Too busy/lazy to real Special Snowflakes, but you might find How A High-Earning Couple Got Roth IRAs And You Can Too useful.

Or not
posted by IndigoJones at 8:35 AM on February 13, 2012

Response by poster:

Too busy/lazy to real Special Snowflakes, but you might find How A High-Earning Couple Got Roth IRAs And You Can Too useful.

I read about this exact proposition and while it all seems above board I still have memories of the Australian Tax Office retroactively denying deductions used in tax effective schemes.
posted by Talez at 9:03 AM on February 13, 2012

So either way we have to pay tax on the dividends? Or if it's in a Roth IRA and we choose to reinvest them back into the same fund will we not have to pay taxes on them?

As I understand it, you do not pay tax on your Roth IRA earnings, ever. That's what makes a Roth IRA special. However, you aren't allowed to withdraw the earnings (capital gains distributions, interest, capital gains from sale of stock, etc...) until retirement, with some exceptions available for massive medical bills or buying a new home.

You can reinvest the dividends or take them as cash and you're all good as long as you don't ever take them out of the Roth IRA.
posted by zachlipton at 9:42 AM on February 13, 2012

So either way we have to pay tax on the dividends? Or if it's in a Roth IRA and we choose to reinvest them back into the same fund will we not have to pay taxes on them?

This is not tax advice, but I've had a Roth IRA with Vanguard since 2003, I reinvest all dividends and capital gains, and I have never once gotten a form from them during tax season saying how much I got in distributions or that I owe anything. This Kiplinger article says the same thing.

Also, since you haven't invested for 2011, can't you put in $20,000? $5,000 for each of you for 2011 and 2012?
posted by jabes at 11:57 AM on February 13, 2012

Response by poster: 2012 we probably won't be under the limit. What would happen if we put in the 5K but the MAGI was above the Roth limit?
posted by Talez at 12:44 PM on February 13, 2012

What would happen if we put in the 5K but the MAGI was above the Roth limit?

IRS Publication 590 (Roth IRAs) states:

What if You Contribute Too Much?

A 6% excise tax applies to any excess contribution to a Roth IRA.

I think it might be time to consult a financial planner with your questions.
posted by jabes at 3:56 PM on February 13, 2012

You keep talking about her MAGI. I believe if you're married and filing jointly, you're looking at your combined income which would need to be $173,000 or less to contribute to a Roth in 2012. If you're concerned that your income is going to go over that you could always put the 10K in a taxed account now, and then move it into a Roth in 2013 after you're sure what your 2012 income will be.
posted by willnot at 8:22 PM on February 13, 2012

Actually, there's a phase out between $173K and $183K, so as long as your income is under $183K, you can contribute some money to the Roth.
posted by willnot at 8:28 PM on February 13, 2012