No company 401k, what are my options?

I just started a new job at a startup that doesn't have a 401k plan yet. I tried to open a Roth IRA but was told there is an income cap, I had no idea! So what do I do? I want to take care of my retirement, but I don't think a general savings account is the best way to go.

- Megan

Hi, Megan! It’s funny that you write in with this question because I just answered a very similar one from another concerned reader yesterday.

Here is the deal with the ROTH income cap. It’s true. You can make enough money that you’re prohibited from making a contribution. Those limits, however, are pretty high. For single individuals and heads of household, the ability to make contributions begins phasing out once you make $120,000 and is completely eliminated once you get to $135,000. For married couples filing jointly that phase-out range is $189,000 - $199,000.

You’re correct to think that a savings account isn’t really an appropriate vehicle to build retirement funds. With the minuscule interest rate you’ll earn, you’ll actually be further behind once you factor in the effects of inflation. I’d suggest keeping your emergency fund in a savings account because it’s easy to access and liquid. That’s what you’re looking for when you absolutely need to get to your money. That’s not the case for retirement savings, however.

So, since I have your attention, let’s take your question one step further. What if you decide to go ahead and open a ROTH account because you’re unsure if you’ll reach the income phase-outs and you want to save towards retirement anyway. You’re a gambler (you work for a start-up, right?) and you’re going to take the chance. But, the end of the year rolls around and you find out that you’ve earned more than you thought would and no longer qualify to make a ROTH contribution. Now what?

Good news, you made a lot of money. More good news, you've got a few options on how to handle your ineligible contributions.

1) Pay a penalty - You could, in theory, leave the ineligible contribution in the account and pay the applicable penalty. That penalty is 6% of the contribution. That doesn't sound so bad, does it? However, you pay that 6% every year the ineligible contribution remains in the account. Yikes. Plus, if you don't catch the mistake until after the tax filing deadline for that year and then withdraw the money trying to correct the issue, there is an additional 10% tax for early withdrawal if you're not 59 1/2 or older.

2) Correct the mistake - If you catch the mistake before you file your taxes for the year, you can withdraw the contribution and any Net Income Attributable (NIA) without penalty. In other words, the original contribution, any appreciation (growth), and any capital gains or dividends that were paid in cash would need to be removed from the account in proportion to your income phase-out limit. If this is the route you take, the NIA will be treated as income for tax purposes.

3) Recharacterize the contributions - You could recharacterize the contributions to a Traditional IRA. Since you’re not covered by an employer-sponsored retirement plan (this is key), you could simply recharacterize your contributions to a Traditional IRA for the tax year in question. No penalties apply.

4) Apply the ROTH contribution to next year - If you choose this route, you'll still have to pay the 6% penalty, but you can leave it in the account. The bad news is, you may still have to pay the 6% again next year if you don't qualify (again).

In your situation, recharacterizing your contribution to a Traditional IRA would make the most sense. You’ll be able to save all year long and, in this particular case, get some immediate tax benefits because of the recharacterization to Traditional IRA. That’s where I’d start if I were you.

And one more bonus thought for you, Megan. If you earn enough money to disqualify yourself from making ROTH contributions, the standard IRA/ROTH contribution limit of $5,500 isn’t going to be enough to get you to a successful retirement. You might want to consider investing money in a non-qualified account (that’s fancy talk for a non-retirement account). You’ll be subject to taxes on capital gains and dividends, but you’ll be putting money to work for you sooner which means it can grow for a longer period of time. Here is a side benefit of this approach. This pool of money will be available whenever you need it. IRA/ROTH/401(k) accounts aren’t intended to be used until you reach age 59 ½. If you dig into those accounts early, you’ll pay a penalty (10%!) in most cases plus income tax, if applicable. That’s not the case with a non-qualified account. You aren’t getting any tax advantages, in this case, so the government doesn’t regulate, or penalize, your access to it. For example, let’s say you’d like to retire at 55. You’re going to need access to some money to get you from 55 to 59 ½. The non-qualified account could fit this need perfectly.

Not having access to a 401(k) and an employer match is a bummer, but that doesn’t mean you shouldn’t be putting money away for retirement anyway. Being creative and focused now will pay off mightily in the long run.

Congratulations on the new job and good luck in the future!