High earners may have a variety of options for saving for retirement—but income limits mean direct contributions to Roth IRAs generally aren't among them. This is unfortunate because Roth IRAs offer tax-free earnings growth and withdrawals in retirement, making them a potentially valuable part of a broader investing and tax-planning strategy. Having both traditional and Roth accounts can help with tax diversification in retirement.
That doesn’t mean you don’t have other options for making your retirement savings plan more tax efficient. Your income doesn’t have to be a barrier. Here are some things to consider.
Are you getting the most from your 401(k)s?
Maxing out contributions to a traditional 401(k) is a good place to start. Such accounts have no significant income limits, so that shouldn’t be a constraint. Earnings will grow on a tax-deferred basis, though distributions in retirement will create future tax liability.
If your employer also offers access to a Roth 401(k), then you could consider using one to set aside at least some post-tax retirement savings. The good news here is that like their traditional counterparts, Roth 401(k)s don’t have strict income limits. As with a Roth IRA, you make Roth 401(k) contributions after taxes. Your earnings grow tax-free, and you pay no taxes when you take withdrawals in retirement.
Note that the annual contribution limit applies across all of your 401(k) accounts. For example, in 2018 contributions are capped at a combined $18,500 ($24,500 for those 50 and older), meaning you could consider contributing up to the maximum to between both a 401(k) and a Roth (401)k.
Consider a Roth conversion
Converting some or all of the funds in a traditional IRA into a Roth IRA is another option. This would mean paying tax on the converted funds up front and leaving them to grow tax-free for the future. This can make sense particularly if you expect to be in a higher tax bracket in the future than you are today and have a long time horizon.
Some advisors also see a so-called backdoor Roth IRA as another way to secure the tax perks provided by Roth accounts. It’s a unique—and for some tax advisors, controversial—strategy, but can work.
If you don’t already have a traditional IRA or rollover IRA, the backdoor Roth IRA route involves first opening a non-deductible traditional IRA and then at some point later converting it to a Roth account. How long you should wait is a matter of some debate as doing it too soon could cause complications with the IRS. The conversion would trigger income tax only on the portion of contributions that had grown in value since the initial funding. Once in the Roth IRA, the savings would compound tax-free.
If you already have a traditional IRA or rollover IRA, calculating your taxes can be more complicated. See The Backdoor Roth—Is It Right for You? for more details.
What about non-deductible IRAs?
Does it ever make sense to contribute to an IRA even if you can’t deduct the contributions? At the very least, you could still enjoy the potential for tax-deferred growth in the account.
“Think carefully before considering this option,” Rob Williams, managing director of financial planning at the Schwab Center for Financial Research, says. “You wouldn’t be getting any upfront tax break, and any future withdrawal of earnings would be taxed at your ordinary income tax rate.”
It’s possible that rate would actually be higher than what you would owe if you’d invested in a tax-efficient way in a regular taxable account. “With today’s low long-term capital gains and qualified dividend rates, non-deductible contributions to a traditional IRA may make less sense,” says Rob.
Long-term capital gains are taxed at a maximum federal rate of 15% unless you’re in the top tax bracket (taxable income over $418,400 for singles, $470,700 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 below the ordinary income tax rate .
Tax-efficient investing in a taxable account
There are other tax-efficient ways to invest in taxable accounts. Individual stocks, as well as most exchange-traded funds (ETFs) and index mutual funds, if you don’t trade often, can result in a lower tax bill.
You may owe only the long-term capital gains tax rate on earnings if you sell an investment at a gain, which is generally lower than the income tax rate. There may be some distributions along the way, but qualified dividends from stocks are taxed at the long-term capital gain tax rate, and ETFs and index funds can be managed tax-efficiently.
Having some money in taxable accounts can provide opportunities to reduce your tax bill by strategically harvesting losses. 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. If you hold long-term investments in a traditional brokerage account, you can donate low-cost-basis securities to charity for a full fair market value deduction and no capital gains tax. You can also leave your appreciated shares to heirs who would receive a step-up in cost basis.
Finally, as noted above, 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. “This sort of tax diversification can be helpful, no matter your future tax rate,” says Rob.
What you can do next
- As you’re preparing your taxes, determine whether you’ll be eligible to make a Roth IRA contribution—and if you’re not, consider contributions into a Roth 401(k), if your workplace offers it, Roth conversions, or saving in a taxable account.
- For the current tax year, see if your 401(k) plan will allow you to make post-tax contributions that you can then roll over into a Roth IRA.
- Invest tax efficiently in a brokerage account—put tax-efficient investments (like municipal bonds) in taxable accounts and less efficient investments in retirement accounts.
- Read more about tax-smart approaches to investing.