Getting around the '401(k) penalty'

NEW YORK (Money) -- Question: My husband and I are trying very hard to get our finances in order and save for retirement. But just when we thought we'd be able to contribute the maximum $15,000 this year to my husband's 401(k) because he got a nice raise, we found out he is considered a "highly compensated employee."

As a result, he's now only allowed to contribute about $6,300, which is less than he was able to put away before the raise. Why are we being penalized?

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I plan on opening two IRAs and maxing out our contributions to them, but I was already planning on doing that in addition to the 401(k). So my question is what are we supposed to do with the money we would have put in the 401(k), other than pay taxes on it? Any suggestions?

-Jami Mergen, El Paso, Texas

Ironic isn't it? Everyone talks about how Americans need to save more, but when you and your husband are ready, willing and able to boost your 401(k) contributions, government rules won't let you do it.

Wait a minute. Maybe ironic is the wrong here. Perhaps crazy or just plain stupid would be better. In any case, the reason your hubby is being forced to scale back his 401(k) contribution is because his company plan is apparently running afoul of the federal "anti-discrimination" rules that apply to 401(k)s.

Basically, Congress doesn't want a company's top execs and highly paid employees benefiting a lot more from company savings plans than Average Joes. So if the percentage of salaries contributed by highly compensated employees (which for 2006 means anyone making $100,000 or more a year) outstrips the percentage set aside by lower-paid workers, the highly paid workers must scale back their contributions. (Not surprisingly, these anti-discrimination laws can get exceedingly complex and are far more detailed than the brief overview I've given here.)

You can argue about whether these rules make sense or not (I lean toward not), but unless people complain to Congress to change them (hint, hint), companies and workers must abide by these regulations.

But in the meantime, what should you do if you can't contribute all you would like to your 401(k)?

Well, your first response makes perfect sense: sock away whatever you can in an IRA. This way you're still saving money and getting a tax break. In fact, if you're really looking to put away as much as you can and are willing to contribute the max to an IRA ($4,000 for 2006, plus an extra $1,000 if you're 50 or older), I'd suggest you consider doing a Roth IRA instead of a traditional IRA.

Yes, you give up the immediate tax deduction with the Roth, but you eventually get to withdraw your original contribution and all earnings tax-free (provided you meet the Roth's withdrawal requirements.

What's more, because the limits for traditional and Roth IRAs are the same, you're effectively sheltering more money from taxes when you do a Roth, assuming you contribute the max. (For an explanation of why this is the case, read an earlier column I wrote on Why Roths Are A Better Deal Than You Think.)

But what if you have even more money that you'd like to sock away for retirement than you can soak up with IRAs?

Well, if any of your extra savings comes from self-employment income - a side business you run or some freelancing or consulting, say - you're probably eligible to open up retirement savings programs geared toward small businesses and the self-employed. Here, I'm talking about SEP IRAs and a relatively new wrinkle on 401(k)s, the solo 401(k) or Uni-K as it's sometimes known. For details on how these programs work, click here.

If your job is your only source of income, however, you're going to have to get a bit more creative. You won't be able to find investments that will shelter your income and gains from taxes in the same way that a 401(k) or IRA does. But you can find ones that will allow your savings to grow with less drag from taxes. And if you manage your investments well, you can also arrange things so that much of the gains you do eventually have to pay taxes on are taxed at a lower rate.

Tax-managed funds are one such investment. Unlike regular mutual funds, which typically pay out taxable distributions from both short- and long-term capital gains the fund manager has reaped throughout the year, tax-managed funds are managed specifically to avoid throwing off taxable gains.

They do this is a variety of ways, ranging from holding onto investments longer to selling high-cost shares when they're forced to make sales to reaping losses that can then be used to offset realized gains from other investments.

The bottom line is that most of your gain in these funds comes in the form of appreciation in the fund's share price. You don't have to pay tax on that gain until you sell the shares. And when you do, your gains will be taxed at the more favorable tax rate for long-term capitals (a max of 15% vs. as much as 35% for short-term capital gains and ordinary income), as long as you've held the shares longer than a year.

Over time, the combination of postponing taxes (which is virtually the same as tax-deferred compounding in your 401(k)) and paying taxes at a lower rate can significantly boost your long-term rate of return, which translates into a fatter nest egg.

Index funds are another way to reduce the taxman's bite on your investment gains. The managers of regular mutual funds buy and sell stocks fairly often in an attempt to outperform the market benchmarks. To the extent this trading is successful, it generates taxable gains that must be passed on to shareholders.

Index funds, on the other hand, buy and hold the shares of securities in various well-known benchmarks like the Standard & Poor's 500, a broad market index of mostly large stocks, or the Russell 2000, an index of small-company shares.

There is some turnover in these funds, mostly because some stocks drop out of the index and others move in, but not nearly as much as in regular funds. As a result, index funds tend to be tax-efficient-that is, they throw off fewer regular taxable gains. (You can learn more about the benefits of tax-managed funds and index funds by clicking here.)

One final alternative you might consider are ETFs. These are index funds that trade like stocks on an exchange and, like index funds, are generally very tax-efficient (in some cases even more so than index funds). You must pay a brokerage commission each time you buy and sell an ETF, however, and that cost can cut into your return.

So ETFs generally make sense only if you're investing relatively large sums of money as opposed to making small regular investments. (For more on how ETFs work, click here.) Between tax-managed funds, index funds and ETFs, you should be able to find a nice home for that extra money you and your husband would like to invest.

And while you're at it, why not let your representatives inside the beltway know that you don't appreciate being forced to contribute less to your 401(k) plan than you'd like. Can't hurt, might help.

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