Mail Pouch

Let's play "Guess What's In My Pouch", a game popular with kids in each hemisphere

Let’s play “Guess What’s In My Pouch”, a game popular with kids in each hemisphere

We’d call it a mailbag, but it features only one question. Here it is, barely edited:

Believe it or not, this is a real question (unlike what you find twice a week in The Simple Dollar’s mailbags), and one I haven’t been able to find an answer to thus far.

The situation: my wife and I are pushing right up against it.  In 2012, we were below it. In 2013….I have no idea where we’ll end up, but it’ll be right near the limit.

So here’s my question: if I don’t know if I’ll be above or below the income limit, can I/do I contribute to the Roth IRA? Why isn’t this clearer, by, for example, setting your ability to contribute THIS year to LAST year’s MAGI? (Duh — stupid government making things far too complex.) What happens if I contribute the max to our Roth IRAs this year but we end up OVER the limit? Do we have to pull our money out of the Roth IRAs?


Chad, Chicago

Even though Chad’s a lawyer, we’re answering his question during one of our non-billable hours. MAGI is Modified Adjusted Gross Income, which to our horror we discovered that we’ve never defined on this site. By the way, if you think the term is redundant because “modified” and “adjusted” are synonyms or close enough, then you’ve never worked for the IRS. MAGI refers to the amount of income that serves as the baseline from which you’re allowed to make IRA contributions that you’re allowed to deduct from your taxes. MAGI derives from Adjusted Gross Income, which itself is a prolix way of saying “taxable income.” AGI is income (from taxable sources) minus the amounts that IRS agents have deigned to let you deduct. You want your AGI to be as low as possible, relative to your true income. MAGI adds some items back in, including any income you made in another country, student loans you took out, and for Chad’s purposes, contributions to his IRA.

Assuming Chad is under 50, he could contribute up to $5000 to his IRA for 2012, and $5500 for 2013. The income limit he’s referring to is $178,000 for him and his wife for 2013. Up to that point, he can contribute the maximum of $5000. Beyond $188,000 (not a typo), he can’t contribute anything. Between $178,000 and $188,000 is where it gets tricky.

Here goes, and we’ll try our best to turn the IRS’s impenetrable jargon into English. However much Chad & wife’s MAGI is over $178,000 (up to $188,000), he divides it by $15,000, and then subtracts that from 1, which gives a number between ⅓ and 1. Then, take that number and multiply it by the maximum contribution limit – again, $5500 for 2013. That’s the amount that Chad is permitted to contribute, reduced because of his inability to make a particular amount of money that doesn’t fall within the prescribed limits.

So what do to if Chad’s 2013 income, a work in progress, exceeds the limit? The way around it is to open another IRA, a traditional one, with the same company that manages his Roth IRA. At the end of the year, should he have contributed “too much” money to the Roth IRA, Chad can move the excess to the traditional one. No fuss, no muss. Of course, this is assuming that (sigh) neither he nor his wife qualifies for a 401(k) (or a 403[b], or something similar) at work.

(God, no wonder most personal finance bloggers write about how to build emergency funds and sell their DVDs on eBay. It’s way easier than this.)

Upon further review, sure enough Chad and his wife both qualify for 401(k)s. If they didn’t have 401(k)s, they still qualify for them, and that’s as bad as being there. So Chad plans to wait until December, at which point he’ll put a trivial amount – $100 or so – into both his and his wife’s Roth IRAs. By then he’ll obviously have a better idea of what his 2013 modified adjusted gross income will be. He’ll have until the following Tax Day to make contributions to his Roth IRA, contributions that will be considered as being made in or for 2013. He’ll be able to max out his Roth IRAs as much as possible, regardless of what his and his wife’s MAGI are.

There’s one more way around this. Chad and wife can still contribute to their 401(k)s of course, without worrying about the Roth IRAs. Beyond that, if they want to shelter even more of their money, they can read Chapter X of The Greatest Personal Finance Book Ever Written and create an S corporation or a limited liability company. Doing so is more than just shuffling paper – the business would have to be generate some form of income. But that doesn’t mean Chad would have to operate a hot dog cart on nights and weekends: said income can derive from investments. Then, he can shelter that income in a separate IRA, or a defined benefit plan. This is more complex than Chinese differential calculus, but the more money you make, the more you want to keep it from the taxman (and the harder Congress makes it for you to do so.)

Remember, the biggest difference between an IRA and a 401(k) is that the limits for the former are set by the IRS, those for the latter by your employer. We here at CYC prefer IRAs only because we hate having regular jobs.

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