Supercharge Your Retirement Savings
- If you are a high-income earner, there are limits to how much you can save in your retirement accounts, but there are strategies you can use to maximize retirement savings.
- A less common strategy, a backdoor Roth IRA conversion, can help you access powerful benefits of tax-free growth and tax-free distribution.
- Another commonly overlooked strategy is to utilize after-tax 401(k) plan contributions to help you reach the full annual funding limit.
Saving for retirement is a top financial goal for everyone; however for high-income earners, this can get complicated.
If you’re working and saving for retirement, hopefully you are taking advantage of your company’s 401(k) and maxing out the full $19,000 limit for 2019 (and $25,000 if you are over 50).
While being able to contribute towards your retirement in your 401(k) is good, if the IRS considers you a high-income earner, then you lose the ability to take a deduction on your individual retirement account (IRA) contribution at certain income levels (for 2019, this amount starts at $64,000 for single filers and $103,000 for married couples filing jointly.)
Get more information about 2019 contribution limits with our 2019 Income Tax Essentials overview.
What About a Roth IRA?
In some cases, it makes sense to forgo the immediate tax deduction of a traditional IRA in favor of the tax-free growth and tax-free distributions of a Roth IRA. Unfortunately, there are IRS limitations on how much you can contribute to a Roth IRA if you hit certain income thresholds. (In 2019, these income threshold levels start at $122,000 for single filers and $193,000 for married people filing jointly.) So, what can you do if you participate in your employer-sponsored retirement plan and are hindered by IRS income limitations? We’ll share two less common alternatives to saving that can offer tax-free growth and tax-free distributions.
Consider a Backdoor Roth Conversion
One strategy involves making a non-deductible contribution (meaning you’ve already paid taxes on this money you have contributed) to a traditional IRA, and then immediately converting this contribution to a Roth IRA. If you process the conversion immediately (before any growth has accumulated), then this is not a taxable event. (Recall that there are income limits to Roth IRA contributions, but not for Roth conversions.)
Ideally, this strategy works best for those with discretionary income who are in their early retirement accumulation phase, and who can’t make direct Roth IRA contributions. As with any IRA contribution, deductible or non-deductible, an individual must have earned income from wages, tips, and other taxable employee pay. And optimally, it helps if you don’t have other traditional or rollover IRAs lingering from previous years that are eligible for deductions (IRS aggregation rules apply when you own multiple IRAs). To ensure that you have a clean transaction with minimal tax implications, be mindful to convert non-deductible contributions in your IRA to a Roth IRA.
While there is no immediate tax benefit, with the Roth conversion you will benefit from tax-free growth and distributions, so you can leave your funds to grow tax-free for as long as you’d like. Unlike traditional IRAs where you will need to start taking required minimum distributions at age 70 1/2, the Roth IRA is not subject to mandatory distributions.
Some Caveats about Roth Conversions
If you have other open IRAs (from previous jobs or rollovers), it may still be possible to take advantage of a Roth conversion. But it can get complicated, and there may be tax implications, so we encourage you to talk to your advisor first.
Also, it is important to note that going forward you can no longer change your mind once you have processed a Roth conversion (previously called a “recharacterization”). With the passage of the new tax laws in early 2018, the IRS has removed this option – but Roth conversions may still make sense given the current low tax rates.
Are you a good candidate for these Roth conversion strategies?
- You may be eligible for a Roth conversion if at some point in the past you made after-tax contributions to your:
- 401(k) – but never converted those dollars to Roth dollars
- IRA – but never converted those dollars to Roth dollars
- If you have tax-deferred growth on your after-tax dollars in an IRA, that tax-deferred growth can be moved to one of your other tax-deferred retirement accounts, like a 401(k), so that it can continue to grow tax-deferred, and you can avoid an immediate taxable event.
- If you have excess discretionary income you are saving in a checking, savings or brokerage account.
Optimize Your 401(k): Unlock After-Tax Plan Contributions
This second strategy can be used by any high-income earners who want to maximize their retirement savings, no matter what stage of life they may be in. If you’re clamoring for additional tax-free growth, you may be able to find possible options in your company 401(k) plan.
Defined contribution plans—401(k), 403(b), and most 457 plans—have total annual funding limits. For 2019, the limit is $56,000, and if you’re age 50 and older the limit is $62,000. You may think that the most you can contribute is the salary deferral limit of $19,000 (or $25,000 if you’re over 50 years old). If you work for a company that offers employer matching or profit sharing, you may receive some additional funds in your account.
But what if that combination of employee and employer dollars doesn’t get you to that annual funding limit of $56,000/$62,000? This is where your after-tax contributions can come into play. This commonly overlooked strategy will depend on whether or not your 401(k) plan provides this option, so check with your plan provider. Most often, you’ll find this offering available with bigger company plans.
If your 401(k) plan does allow you to make an after-tax contribution, you may be able to make additional non-deductible contributions to get to that maximum funding limit. But wait, you’re not done yet. To fully maximize the benefits of this strategy for tax-free growth and distributions, you want to turn those after-tax dollars into Roth dollars.
There are a couple ways you can convert:
- You can utilize the Roth IRA to receive the conversion from the 401(k).
- Recently, more plan administrators have started allowing for “In Plan” conversions of after-tax dollars in 401(k) plans to Roth dollars, all inside the plan itself. Your company’s retirement plan rules will dictate whether or not you can take advantage of this strategy, so check with your plan administrator to learn what options are available.
Talk With Your Advisor About Retirement Strategies Right for You
Generally, the faster you can get after-tax dollars turned into Roth dollars, the quicker you can start compounding tax-free growth, instead of just deferring eventual taxes on the growth. Connect today with your financial advisor and your plan administrator to see if you can implement these strategies for your retirement planning.
Mercer Advisors Inc. is the parent company of Mercer Global Advisors Inc. and is not involved with investment services. Mercer Global Advisors Inc. (“Mercer Advisors”) is registered as an investment advisor with the SEC. The firm only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. All expressions of opinion reflect the judgment of the author as of the date of publication and are subject to change. Some of the research and ratings shown in this presentation come from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate, but is not guaranteed or warranted by Mercer Advisors. Content, research, tools, and stock or option symbols are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. For financial planning advice specific to your circumstances, talk to a qualified professional at Mercer Advisors. Past performance may not be indicative of future results. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy or product made reference to directly or indirectly, will be profitable or equal to past performance levels. All investment strategies have the potential for profit or loss. Changes in investment strategies, contributions or withdrawals may materially alter the performance and results of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Historical performance results for investment indexes and/or categories, generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment-management fee, the incurrence of which would have the effect of decreasing historical performance results. Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. This document may contain forward-looking statements including statements regarding our intent, belief or current expectations with respect to market conditions. Readers are cautioned not to place undue reliance on these forward-looking statements. While due care has been used in the preparation of forecast information, actual results may vary in a materially positive or negative manner. Forecasts and hypothetical examples are subject to uncertainty and contingencies outside Mercer Advisors’ control.
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