Do you like paying taxes? No, of course not. So then having access to an account that will be tax-free1 in retirement sounds awesome —That’s the Roth IRA — But you’re married and your modified adjusted gross income is over $196,000 ($133,000 for singles). The IRS doesn’t allow you to contribute to a Roth IRA. Do you know what to do?
In order to answer that question let’s look at how people save for retirement. Most Americans use a 401(k) or 403(b) plan for retirement savings. If you’re a high income earner, then you are likely making the maximum employee contribution of $18,000 (2017) to your 401(k) or 403(b) plan because you can afford it and because you need to shelter income from taxes this year. As a general rule deferred taxation is better than tax now, especially when you make a lot of money. If your income is all W-2 wages that pre-tax savings may be your only tax saving move.
Our clients who earn really well almost always have more money to save. We see people do the next logical step and accumulate cash in the bank or invest in a brokerage account. But what is the goal of these funds? Sure you need a cash emergency fund and you probably want some additional money if you decide to buy a big ticket item like a home or a boat. Beyond that though it’s likely additional savings is for your retirement.
Here’s where a rather misunderstood part of many retirement plans comes in handy — after-tax contributions. Currently almost half of 401(k) plans in existence allow for additional after-tax contributions. Does yours?
Your initial reaction might be, “why would I ever put after-tax money into my retirement plan when I already maxed out my deductible contribution?”
First, after-tax contributions to your retirement plan have the opportunity grow tax-deferred just like pre-tax contributions. Second, after-tax contributions can be withdrawn anytime because you already paid the tax so you have some flexibility.
The game changer however, comes from IRS Notice 2014-54 which allows you to roll over after-tax savings in your 401(k) or 403(b) directly to a Roth IRA! Voila`, you now have access to the Roth IRA that was previously unavailable because of your income level.
Some important rules to do this correctly exist of course. The generic way to do this is — upon severance from your company — you roll the entire 401(k) balance out of the plan. Pre-tax contributions and gains roll directly into an IRA. After-tax contributions roll directly into a Roth IRA.
IMPORTANT: You must notify your plan administrator of your intentions to have a separate check for pre-tax money and another separate check for after-tax money so that distributions are reported correctly to the IRS.
Sounds good, what’s the potential amount?
As an example, let’s assume you’re married filing jointly with a combined income of $315,000. Your individual wages are $215,000 and your employer matches 3% of income. In 2017 the employer limit for 401(k) and 403(b) plans is $54,000.
$54,000 2017 employer limit
-$18,000 Your employee savings
-$6,450 3% employer match
= $29,550 potential after-tax savings you can make
In this example you could save $29,550 to the after-tax portion of your 401(k) in 2017!
If you love saving money or make a lot more than the example, then you should certainly discuss with your financial planner whether contributing after-tax to your retirement plan makes sense.
Finishing the thought on this example, you would certainly have your spouse make the maximum employee contribution of $18,000 before beginning after-tax savings because the pre-tax savings is valuable in the current year. Let’s also assume a 3% employer match of $3,000 on your spouse’s $100,000 of income.
Your personal savings would be $65,550 ($36,000 pre-tax & $29,550 after-tax) — 20.8% of your working income of $315,000. The employer matching is an additional $9,450 bringing 2017’s savings to $75,000 — 23.8% of your working income. And all of that savings enjoys tax-deferred growth potential until you take it out.
How can I be confident this is for me?
The devil’s in the details and you need to make sure you evaluate this information against your personal finances. If you have investment or other income this will further complicate your tax planning. If you don’t have the time to evaluate your savings strategy fully or just want to talk it through with a CFP® Professional give us a call or schedule a free 15-minute phone appointment through the Contact section on our website.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
1The Roth IRA offers tax deferral on any earnings in the account. Withdrawals from the account may be tax free, as long as they are considered qualified. Limitations and restrictions may apply. Withdrawals prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Future tax laws can change at any time and may impact the benefits of Roth IRAs.