Beyond 401(k)s: Step 2 in maximizing retirement saving
A reader and her husband are maxing our their retirement plans at work. Here's what else they can do.
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (Money) -- READER QUESTION: My wife and I both work and we invest the max, $15,000 a year, in our 401(k)s. Our employer matches the first 6 percent. We used to also invest in a Roth IRA before our income grew above the limit. What other tax advantaged investment options are open to us? - Juan L., Indianapolis, Indiana

First, I suggest you re-check whether you qualify for a Roth IRA since some people get the requirements for Roths and traditional deductible IRAs confused.

Basically, you can make at least a partial contribution to a Roth if your modified adjusted gross income is less than $110,000, if you're single, or less than $160,000, if you're married and filing jointly. (See details on what exactly constitutes modified adjusted gross income and for other things you should know before doing a Roth.)

If you're right and you can't contribute to a Roth, you and your wife might want to consider investing in a nondeductible IRA. Why? Well, in May Congress passed a law that starting in 2010 eliminates the restriction barring anyone who makes more than $100,000 from converting a traditional IRA to a Roth.

The law provides a back-door way to start putting away money today that can eventually go into a Roth. What you and your wife can do is starting this year invest annually in a nondeductible IRA, which anyone with earned income can do.

Come 2010, you can then convert whatever money you've accumulated in your nondeductible IRA to a Roth. And you can continue to contribute to a nondeductible IRA and convert it year after year, in effect skirting the income limitations for doing a Roth.

One caveat: when you convert an IRA to a Roth, regardless of whether it's a nondeductible IRA or not, you must calculate the tax due for the conversion based on all the money you have in all IRA accounts you own.

In other words, you can't just move your nondeductible contributions to the Roth and escape paying any tax. So, for example, if you've got $50,000 in total IRA assets and $10,000 of that came from nondeductible IRA contributions, then 20 percent of the amount you convert would not be taxed ($10,000 divided by $50,000), while 80 percent would ($40,000 divided by $50,000).

Other options

Tax-efficient mutual funds But you also have another options for tax-advantaged investing: tax-efficient mutual funds. These are funds that throw off very little in the way of taxable dividends and other distributions and instead deliver most of their return in unrealized gains.

The advantage to this approach is that you don't have to pay taxes on unrealized gains until you sell shares of the fund. This means your gains can compound for years without the drag of taxes. And assuming you hold your shares more than a year, you'll be taxed at the rate for long-term capital gains when you sell. I like to think of these funds as a DIY tax shelter.

There are several ways to invest in such funds. One is to focus specifically on what are known as tax-managed funds. These are funds that are run specifically to minimize taxable distributions. For example, if the fund has a paper loss in some stocks, the manager might sell those shares to reap the loss, which can then be applied against gains in other stocks the manager has sold. The idea is to minimize realized gains, which by law have to be passed on to fund shareholders.

Index funds are also generally pretty tax efficient. The reason is that, rather than constantly trading to beat the market, the manager of an index fund buys and holds the stocks in a market benchmark or index. Because of the lower turnover, index funds usually generate fewer taxable gains than regular mutual funds. See more on how tax managed and index funds work.

ETFs Finally, there's another breed of investment you might want to consider that can also be quite tax-efficient: ETFs, or exchange traded funds. ETFs are essentially index funds that trade on an exchange. The fact that they follow an index contributes to their tax efficiency, but they also have a unique way of selling and redeeming shares that can make them even more tax efficient than regular index funds.

You'll pay a brokerage commission each time you buy and sell an ETF, so they're not good for dollar-cost-averaging or investing small sums of money. Learn more about ETFs by clicking here and here.

Watch out for...

Let me end by cautioning out about two options you might hear about that I think you should avoid.

Variable annuities The first is a variable annuity. You don't get a tax deduction for the amount you invest in a variable annuity. But you do get to put your money into mutual fund-like subaccounts that throw off gains that go untaxed as long as they remain in the annuity.

So what's the hitch?

One is high fees, often more than 2 percent a year.

Another drawback is that when you do pull out your gains they're taxed at ordinary income rates that can go as high as 35 percent. That's the case even if the gains themselves are the result of long-term capital gains that outside an annuity are taxed at a rate no higher than 15 percent. (See more on annuities, including a type of annuity I think can be useful after you've retired.)

Variable universal life The second investment I think you should steer clear of is a type of life insurance policy that's often sold as an investment called variable universal life. These policies are a bit like variable annuities in that you don't get a tax deduction and you do invest in mutual-fund like subaccounts.

The big lure with variable universal policies, though, is that by borrowing from the policy you can get totally tax-free returns.

As with variable annuities, high fees are a hitch, but variable universal life also carries a risk that the money you borrowed could become taxable late in life. For more on these policies and why I think you should stay away from them, click here.

So keep up the good work maxing out those 401(k)s and if you don't qualify for a Roth, consider doing an end run to one with a nondeductible IRA. And don't forget tax-managed funds and index funds.

If you manage to do all these things, you'll not only build yourself a nice nest egg, you'll also be practicing what I like to call "tax diversification," which can help you squeeze the most after-tax income from your savings in retirement.

That won't guarantee a better retirement, of course, but it will sure tilt the odds in your favor.


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