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.

Additional Resources

Four Reasons to Consider a Roth IRA vs Traditional IRA

What You Need to Know About Your 401(k)

Can Retirement Trusts Help Protect Your Beneficiaries?

The SECURE Act May Bring Big Changes to Retirement