When planning for retirement, you need to find ways to maximize the amount of money you put aside for your future. Key to that is finding ways to minimize your tax burden now and down the road.
So if you’re a high earner who isn’t self-employed, beyond contributing as much as the government allows to your employer-sponsored 401(k), what are your options?
You can contribute to a traditional IRA.
Given your high income and access to the 401(k), the IRA contributions you make are likely to be nondeductible, perhaps making you question this advice.
But nondeductible IRA contributions can be a means to save tax-efficient funds for retirement, and, when part of a “backdoor Roth” strategy, can be a very valuable estate planning tool to pass assets to heirs.
If you choose to make a nondeductible IRA contribution for 2017, make the contribution before you file your taxes; the deadline to do so is just over the horizon on April 17, 2018 (or it’s as late as October 15th, 2018 if you filed an extension for your tax return).
The decision to make non-deductible IRA contributions a part of your arsenal of retirement planning options depends on several factors.
The Savings Conundrum for High Earners
Most often, people would prefer to make deductible contributions to lower their tax burden. When those options are closed to you, a few non-deductible investment options still exist. Most of your non-deductible savings will go into a standard taxable account. However, you may want to make non-deductible contributions to a tax-deferred account—an IRA.
The more you earn now, the more you want to put away for retirement—and the more impact taxes will have on that income you’re putting away.
Of course, employer-sponsored 401(k)s and deductible IRAs allow you to contribute pre-tax dollars and defer the tax until you retire and begin making withdrawals. But you may need to save more than just your deductible contributions.
Given your high income, there are limits on how much you can contribute to these programs, and in some cases, you may not be eligible at all.
- 401(k)—In most cases for 2018, the most you can contribute is $24,500 if you are age 50 or older, or $18,500 for those younger.
- Traditional IRA—The contribution limits in 2018 are $6,500 for those 50 and older, and $5,500 otherwise; if your income exceeds certain limits (in 2018, $119,000 for those married, $72,000 for singles), you’ll only be able to make nondeductible contributions.
- Roth IRA—High earners (more than $135,000 for a single tax filer or $199,000 for married couples filing jointly in 2018) can’t make direct contributions to a Roth IRA.
The Advantages of Nondeductible Contributions to an IRA
You can defer paying taxes on the growth of your non-deductible IRA contributions until you begin withdrawing the funds. At that time, the growth will be taxed as ordinary income.
If you expect your tax rates to be lower when you are withdrawing funds than when you make the contributions, this can be a tax efficient method to save additional funds for your retirement. For example: if you just invested after-tax dollars in a standard taxable account, the interest, dividends or capital gains would be taxed in the year they occurred.
However, there’s a caveat for non-deductible IRA contributions: the maximum contribution is $5,500 for anyone younger than 50, and $6,500 for those age 50 and older. The growth on that amount may be significant enough to justify the added complexity of tax filing and general record-keeping associated with combining non-deductible and deductible contributions to an IRA.
Or it may not.
Your age may influence your decision; the younger you are, the longer your investment horizon to build returns that can justify the extra work.
The “Backdoor Roth” Conversion Option
If you choose to make nondeductible contributions to a traditional IRA, you may have the opportunity to convert the account to a Roth IRA down the road. This strategy, known as a “backdoor Roth IRA,” allows you to contribute to a nondeductible IRA and then convert those IRA funds to a Roth IRA at a later date.
Keep in mind that the IRA aggregation rule could limit how effective this strategy may be for you.
According to the rule, the tax consequences of any IRA distribution (including the one you would take to roll a traditional IRA into a backdoor Roth IRA) is calculated based on the total value of all IRA accounts you own. When you have both deductible and nondeductible contributions, the aggregation rule limits your ability to convert just the new nondeductible IRA.
It may be possible to avoid the consequences of the aggregation rule by moving pre-tax funds into a 401(k) that permits funds to be rolled in, and then converting the remaining nondeductible funds into a Roth.
However, doing so means you run the risk that a tax court will view these separate actions as an attempt to make an impermissible Roth contribution, so it’s important to allow an adequate amount of time to lapse between the contribution and subsequent Roth conversion. The amount of time needed isn’t defined anywhere, but many experts feel a year is sufficient. Before taking this action, be sure to discuss the tactic with your CPA.
What to Know Post Roth Conversion
After a Roth conversion:
- Funds grow tax free until withdrawn.
- You aren’t required to take minimum distributions at age 70 1/2.
- In some cases, you can make penalty-free withdrawals.
- You can contribute at any time, including after age 70 ½, if you qualify.
A Roth IRA can be an excellent estate-planning tool; assets continue to grow tax free. A non-spouse beneficiary must begin taking required minimum distributions by December 31st of the year following the year during which the owner died, the withdrawals to the beneficiaries remain tax free.
If you do decide to make nondeductible IRA contributions, note that you will be responsible for filing Form 8606 with your tax return every year in which you make a contribution. Form 8606 helps the IRS (and you) know how much you owe in taxes, so failing to file it or not keeping accurate records of your contributions could lead you to be taxed twice on the contributed funds.
Managing nondeductible IRA contributions requires some time and effort to navigate tax considerations. Ask your advisor to analyze the pros and cons as they apply to the circumstances of your individual retirement plan.
After weighing your options, decide for yourself if the time and resources spent are worth the added yearly contributions and resulting compound interest applied to your retirement nest egg.