Tuesday, February 24, 2015

How to save over $60,000/year in a Roth IRA

Recent changes in tax laws have made it possible for some people in the US to potentially defer over $60,000/year in a Roth IRA. This is perfectly legal, but requires some research upfront in order to see if you qualify, and whether it makes sense to do it. I believe that this article will be relevant for only a portion of you, because this opportunity might not be available for everyone. This new opportunity includes maxing out a Roth 401 (k) for $24,000, maxing out after tax contributions for the remaining $35,000 (assuming no employer match), as well as maxing out a Roth IRA with $6,500. The article will try to explain how some people can save $60,000/year in a Roth IRA per year, and assumes they are over the age of 50, earn more than $60,000/year, and are able and willing to defer that much in a retirement account. Nothing in this article should be considered tax planning advise for you however - please remember to always speak with a Certified Public Accountant before making any tax planning decisions.

As someone in the accumulation phase of my dividend investing journey, I end up paying a lot in taxes. In previous posts, I have discussed the strategies I am implementing in order to shorten my time to financial independence. Qualified dividend income is very tax efficient. It is quite possible to earn $90,000 as a married couple filing jointly, and pay no taxes if you have no other form of income. However, in order to get to that point, you would have to pay steep taxes in the accumulation phase. A married couple whose taxable income exceeds $73,800 in 2014 would have to pay 15% on dividend income received. By paying expensive taxes on dividends today, you are essentially shortchanging your full potential. If you can somehow avoid paying taxes on dividend income and capital gains in the accumulation phase, you can potentially shave a few years of working. I don’t know about you, but it makes sense for me to avoid filing TPS reports for 2 – 3 extra years, if I have the option to not file them. Of course, if you enjoy coming in on Saturdays and Sundays, then chances are you won’t like this article.

Many investors I talk to have used Roth IRA’s to soak up as much in quality dividend paying stocks as possible. The Roth IRA allows them to withdraw contributions at any time, lets money compound tax-free forever, doesn’t have required minimum distribution requirements for the original contributors and its earnings are not taxable if withdrawn after the age of 59 ½ years. The main problem with the Roth IRA is that contributions are limited to $5,500/year for every person under the age of 50 who has employment income. If you are over the age of 50, you can defer $6,500/year. This is not a lot to make a serious dent for you however, especially if you are one of the big savers who dreams of early retirement on your own terms. To add insult to injury, workers who make too much money are not allowed to put money in a Roth IRA. Luckily, there is a backdoor solution, where you can make a non-deductible contribution to a regular IRA, and then rollover the money into a Roth IRA. This involves more paperwork, but achieves the result.

There is another way to contribute up to $18,000/year in a Roth 401 (k) account as an employee. The problem is that not every employer allows it, some 401 (k) plans have terrible investment options, and not many 401 (k) plans offer a brokerage window to select your own stocks. The nice thing however is that even higher earning employees can contribute to the Roth 401 (k). If you are older than 50, you can take advantage of the catch-up contributions which are $6000 extra.

Some 401 (k) plans allow employees to make after-tax contributions to their 401 (k) plan. This is different than after-tax Roth 401 (k) contributions. The contributions I am talking about today are called after-tax contributions. Some 401 (k) plans allow their participants to contribute money after-tax. Up until now, it didn’t make sense to put after-tax contributions to a 401 (k). However recent changes made it potentially profitable.

One thing you might want to know is that the amount you can defer in your 401 (k) is limited to $53,000/year for those under 50 and $59,000/year for those over 50. This includes not only your employee contribution of $18,000/$24,000/year, but also the employer match. Anything left over could be put in a 401 (k) amount as an after-tax amount. If you make $80,000/year, and your employer matched 4% of your pay, that is a neat $3,200. Employer matching contributions are always pre-tax however. Either way, an employee under the age of 50, who earns $80,000/year, gets a 4% match and maxes out their 401 (k) with $18,000, can potentially get $21,200 deferred in their 401 (k). They can then contribute up to $31,800 in an after-tax 401(k). This is calculated as the difference from the limit of $53K, minus the $18K in annual contribution, minus the $3,200 matched by the employer. For someone over the age of 50, they can contribute $37,800 more, due to the $6000 catch-up contribution.

The other hurdle that you want to check is whether the 401 (k) plan allows you to either transfer those after-tax contributions to a Roth IRA account, or if it allows you to do a Roth conversion within the 401 (k) account. If your plan allows you to make after-tax contributions, but does not allow you to convert those immediately into a Roth IRA or Roth 401 (k), then the information in this article might not be worth it for you. This is because if your after-tax contributions are left in a regular 401 (k), any gains are treated like ordinary income upon distribution. Since you don’t want to pay ordinary taxes on investment income, it made no sense to use after-tax contributions before. However, under current legislation, when you quit your job, you can transfer the after-tax contributions to a 401 (k) into a Roth IRA. The gains from those money will be transferred to a regular IRA.

If you want to avoid this, you have to convert the after-tax money to a Roth IRA/Roth 401 (k) right away. That way, all gains from those contributions are Rothified and you will never have to pay income taxes on them under current tax laws.

However, if you are about to retire from your job within 2 - 3 years, it might still make sense to do the after-tax contributions in a 401 (k), since you are less likely to have earned significant returns over that short period of time (unless you are Warren Buffett, in which case thank you for reading my humble site). But everyone's situation is different, which is why the goal of my article is to tell you there is an opportunity to potentially put $60,000/year in a Roth IRA, and for you to start your research, in order to determine if this move is right for your financial situation.

So to summarize, it is possible for someone over the age of 50 to potentially contribute over $60,000/year in a Roth account. To do this, they need to max out their Roth 401 (k) account with $18,000/year. Then they need to max out their after-tax 401 (k) account with the difference between $59,000 contribution limit, minus the $18,000 Roth 401 (k) contribution, and the employer match. Those after-tax funds would then have to be immediately Rothified either by converting them to a Roth inside the 401 (k) account or by taking an in-service distribution from the 401 (k) account on the after-tax dollars into a Roth IRA. In addition, you can also contribute to the regular Roth IRA up to $6,500/year.

Unfortunately, not all company 401 (k) plans offer the option to make after-tax contributions, and from those that do, not all allow employees to transfer those contributions into a Roth IRA or a Roth 401 (k) while they are still employed by the company. However, contacting your HR department with a request to make the option for an In-Plan Roth Conversion available, might do the trick for you. If they allow it, great. If not, there might be other companies available that offer this for highly sought out employees like you.

The other thing to consider with this tax break is the fact that it could be subject to changes. So if you are able to, it might make sense to research this as soon as possible. Otherwise, it might not be even relevant if you read the article some time in 2016.

Full Disclosure: Initially I though I was unable to perform this feature, since my HR department doesn't allow for In-Roth Conversions on after-tax accounts. After talking to several people however, I realized they DO allow it.

As always, please discuss your tax situation with a CPA, before making any moves.

Relevant Articles:

Dividends Provide a Tax-Efficient Form of Income
My Retirement Strategy for Tax-Free Income
Health Savings Account (HSA) for Dividend Investors
Roth IRA’s for Dividend Investors

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