For high-income households, figuring out how to save for retirement outside of a traditional 401(k) is tough. You might want to open a Roth IRA-or contribute to a traditional IRA-but what if your income exceeds the eligibility cutoffs?
Fortunately, you still have options to supplement your retirement savings, including taking advantage of a recent IRS rule that can help higher earners contribute to a Roth IRA.
Two ways to save post-tax within a 401(k)
If a Roth makes sense for you and you're lucky enough to have a Roth 401(k) plan through your employer, it's an obvious place to put at least some post-tax retirement savings. For the 2015 tax year, you can contribute up to $18,000 and divide it up however you like between your Roth 401(k) and your traditional 401(k). (The limit is $24,000 for those 50 and older.)
Next, a recent IRS ruling gives traditional 401(k) plans the option to let participants make after-tax contributions to the plan and then roll those contributions into a Roth IRA, tax- and penalty-free, when they leave the company or retire. Check with your plan administrator or examine your plan summary document to see if this is an option.
Consider a backdoor Roth
Another strategy for higher-income earners is dubbed a backdoor Roth IRA.
Here’s how it works: You first contribute to a non-deductible traditional IRA (the limits for 2014 and 2015 are $5,500 and $6,500 if you’re 50 or older). Next, you convert that account to a Roth IRA.
It’s an odd loophole, but one that many affluent investors are using to gain access to a Roth’s potential for tax-free retirement income.
If you don’t have any traditional IRAs or rollover IRAs, the backdoor Roth IRA route is straightforward. You can make the conversion the day after you fund the traditional IRA. Because the conversion is done quickly, there likely won’t be a tax bill. Taxes would be due only on a conversion where your contributions have grown in value; the earnings would be taxed as income at the point of conversion.
If you do have existing traditional IRAs or rollover IRAs, there’s a chance you’ll owe taxes at the time of the conversion—read here for more details.
Skip the non-deductible IRA
You might wonder if you should just save in a non-deductible IRA and enjoy the potential for tax-deferred growth in the account. Rande Spiegelman, vice president of financial planning at the Schwab Center for Financial Research, suggests that you steer clear of this option.
You’re not getting any “upfront” tax break, and any future withdrawal of earnings will be taxed at your ordinary income tax rate. Chances are that will be a higher rate than what you would owe if you invested in a regular taxable account. “With today’s low long-term capital gains and qualified dividend rates, a non-deductible contribution to a traditional IRA rarely makes sense,” says Rande.
Long-term capital gains are taxed at a maximum federal rate of 15% unless you’re in the top tax bracket (taxable income over $413,200 for singles, $464,850 for joint filers), in which case a 20% rate applies. A Medicare surtax of 3.8% on investment income for single filers with adjusted gross income over $200,000 ($250,000 for joint filers) may also apply, but even then the rate is still well below the ordinary level in every case.
Why save in a taxable account?
Individual stocks, as well as most exchange-traded funds (ETFs) and index mutual funds, can be tax-efficient ways to save for retirement, as you will owe only the lower capital gains tax when you sell an investment at a gain. There may be some minimal distributions along the way, but qualified dividends are also taxed at the more favorable long-term capital gains tax rate. Moreover, having some money in taxable accounts can mean that you may also further reduce your tax bill by strategically harvesting losses. And that’s not something you can do in your 401(k) or any IRA.
Saving in a taxable account could also help you achieve your estate planning goals. You would have the added ability to donate low-cost-basis securities to charity for a full fair market value deduction and no capital gains tax, or leave your appreciated shares to heirs who would receive a step-up in cost basis if you’re so inclined.
Finally, having money in taxable accounts as well as tax-advantaged accounts can give you greater flexibility in managing your tax bracket as you plan your post-retirement cash flows—call it “tax diversification.”
Bottom line: Your income shouldn’t be a barrier that prevents you from saving more if you need or want to. It’s important to know your options.