An aggressive saver who can't save enough

By Walter Updegrave, senior editor


(Money Magazine) -- Question: I'm 27 and have had a Roth IRA since I was 16 years old. I've been maxing out that account since I graduated college, and I now also max out my 401(k). But this year my income will be too high to allow me to contribute to either a Roth IRA or traditional deductible IRA. I still have money I want to save, so I'm wondering whether I should just open a regular taxable account and invest in muni bonds, annuities or something else. Any suggestions? --Donald J.

Answer: Wow, talk about a role model for your fellow Echo Boomers. You are one lean, mean savings machine.

The latest research from Vanguard shows that people between the ages of 25 and 34 who contribute to their plan sock away just 5.5% of salary on average. But you, sir, not only max that baby out, you fund other retirement accounts as well. Kudos.

I can't tell you how much it pains me, though, to see someone so willing, no, so eager, to save being thwarted by those pain-in-the-butt contribution limits that our free-spending legislators who obviously don't know diddlysquat about saving impose.

Fortunately, you can beat the nit picky rule makers at their own game by using a technique I call the "Roth Contribution End Run."

A little background is in order, however, before I tell you how this strategy works.

As you've probably heard -- it's been hard not to hear, as investment firms have been pounding the drum about it big time -- the provision banning people who earn more than $100,000 from converting a traditional IRA (or eligible 401(k)) to a Roth IRA was lifted at the beginning of this year. Which means almost anyone with an IRA can convert.

Generally, I think it's good for people to at least consider this option, although conversions aren't freebies and don't make sense in all cases.

But at the same time that the reins were loosened for conversions, lawmakers left the income limits for regular annual contributions to Roth IRAs untouched.

You've no doubt heard the old expression, "Bar the doors and they'll come in the windows." Well, here's your window to stashing up to $5,000 (people 50 and over can do as much as $6,000) into a Roth IRA even though you exceed the income limits:

Contribute to a nondeductible IRA -- which pretty much anyone under age 70 1/2 with earned income can do -- and then immediately convert that nondeductible IRA to a Roth IRA. Voila! You've got your extra savings where you want it, sitting in a Roth IRA account.

There are some possible complications to this strategy, however.

When you convert a traditional IRA to a Roth IRA, you must pay tax on any part of the conversion that consists of dollars that have yet to be taxed.

What's more, you must take all your non-Roth IRAs into account in determining how much of the conversion is taxable. You don't say anything about owning traditional IRAs, deductible or nondeductible. But even if you don't, there's another reason you might have to pay some tax when you convert that nondeductible IRA to a Roth.

Let's say that you contribute $5,000 to a nondeductible IRA. And let's further assume (just for the sake of this example) that before you can pull off the conversion, the market soars, giving you a $1,000 gain. If you convert the entire $6,000, $1,000 would be taxable, as that amount represents investment earnings, which haven't been taxed. Even if you decided to convert only the amount of your original contribution, or $5,000, you would still owe tax on one-sixth of that amount, or $833, since one-sixth, or $1,000, of your total $6,000 nondeductible IRA balance consists of yet-to-be-taxed dollars.

If you do this end run, you'll probably want to open a separate Roth IRA account for the conversion rather than move the funds from the nondeductible IRA into the Roth account you already have. This will make things easier in the event you want to do a recharacterization, a move that reverses a conversion.

If the market takes a dive and your account balance plummets, you may be able to recharacterize and then re-do the conversion before your account balance rebounds. That would reduce your tax bill for the conversion. You can always combine your Roth accounts after the recharacterization deadline expires.

By the way, withdrawing money from a Roth IRA within five years of the conversion can have tax consequences. So if you think you might need to tap funds from a Roth account after converting, you'll want to check out the withdrawal rules, which you'll find spelled out in detail on Fairmark.com.

You can always withdraw your original annual Roth IRA contribution dollars at any time without tax or penalty. So if you've been contributing to a Roth IRA faithfully since you were 16, you've probably got a substantial pot of such dollars that you can tap. Still, the withdrawal rules in the wake of a conversion are something you should be aware of.

If all this is just too much trouble for you, you always have the option of simply plowing your savings into investments held in taxable accounts. Munis are certainly an option, although I think someone your age might first want to consider tax-efficient investments that offer the prospect of higher long-term gains, such as stock index funds, ETFs or tax-managed funds.

As for variable annuities, well, let's just say I'm not keen on them as a way to accumulate retirement savings. They often carry onerous fees and have some tax disadvantages when you eventually withdraw your money.

Whether you decide to do the end run to a Roth IRA or put that extra savings to work somewhere else, you'll come out fine. That's because you are doing the single most important thing someone in your position must do to get on and stay on the path to a secure retirement: save. To top of page

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