If I max out my 401(k), what's next?

By Walter Updegrave, senior editor


(Money Magazine) -- Question: My wife and I have a combined annual income of about $250,000. If we max out our 401(k)s, can we each still contribute the full $5,000 this year to a traditional deductible IRA rather than just investing the money through a normal taxable brokerage account? -- Derek N., Colorado

Answer: The short answer is no, you almost certainly can't do a deductible IRA.

walter_updegrave__2009b.03.jpg
Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005).

But that doesn't mean your only choice is putting your ten grand into your taxable brokerage account. You and your wife do have another tax-advantaged option: You can each get $5,000 into a Roth IRA account.

Here's the deal.

Since you and your wife are both covered by a retirement plan at work (regardless of whether you participate), neither of you can deduct a contribution to an IRA account if your modified adjusted gross income exceeds certain limits. And with earnings of a quarter of a million bucks a year, you are well above the threshold for taking even a partial deduction for an IRA contribution, let alone the Full Monty.

The income ceiling for taking a deduction would be considerably lower for you if only your spouse were covered by a workplace retirement plan (or lower for your wife if only you had coverage). But even if you and your wife were in that position, your combined income would still almost certainly prevent either of you from taking a deduction.

As I noted above, however, you and your wife can still put $5,000 each into Roth IRA accounts this year. At first glance, that might not seem possible. After all, as this IRS notice shows, your income also exceeds the limits for making an annual Roth IRA contribution. But with a little bit of not-too-fancy financial footwork, you can get around that restriction.

How? Contribute to a nondeductible IRA -- which virtually anyone under age 70 1/2 with earned income can do -- and then convert the nondeductible IRA to a Roth IRA. Once your money is in the Roth, it will grow free of taxes. And provided you meet the criteria for qualified distributions, you'll owe no tax when you eventually pull the money out of your Roth.

Of course, you could just leave the money in the nondeductible IRA, in which case your investment gains will still grow free of tax. But, unlike with a Roth IRA, you'll owe tax on any nondeductible IRA investment gains when you withdraw them.

Before you pull this little maneuver, however, there are a few things you ought to know. When you convert an IRA to a Roth IRA, you must pay income tax on the portion of the conversion that has yet to be taxed. Let's say that you and your wife each contribute $5,000 to a nondeductible IRA and that by the time the conversion goes through, the investments in each of your accounts have gained $250.

In that case, you would each be converting $5,250, $250 of which is subject to tax. So assuming you and your wife each converted your entire account balances, the conversion would generate $500 (2 x $250) in taxable income and you and your wife would owe income tax on that amount.

If, on the other hand, your nondeductible IRAs had no investment gains at time of the conversion -- that is, your accounts are each worth $5,000 or less -- there would be no conversion income and you would owe no tax. Your original contributions to the nondeductible IRA aren't taxed in the conversion since they have already been taxed and you got no tax deduction for the contribution.

Things get a little more complicated, though, if you or your wife already have other non-Roth IRAs. If that's the case, you must factor in the balances of those accounts when determining how much of the conversion of your nondeductible IRAs is taxable. Here's an example.

Let's say that, in addition to the $5,250 in the nondeductible IRA you plan to convert, you also have a traditional IRA with a $6,000 balance, which consists of a $5,000 deductible contribution and $1,000 of investment earnings.

If you tote up the balances of your two non-Roth IRAs, you have a total of $11,250, of which $5,000 (or 44%) is after-tax, or already taxed, dollars (your $5,000 nondeductible contribution) and $6,250 (or 56%) is in dollars that haven't been taxed and are therefore taxable ($250 in gains in the nondeductible IRA, $1,000 in gains in the deductible IRA and the $5,000 contribution to the deductible IRA for which you took a tax deduction).

Under the rules for conversions, any amount you convert, regardless of which non-Roth IRA it comes from, is considered by the IRS to have the same ratio of taxable and nontaxable dollars as all your non-Roth IRAs combined. In other words, you can't cherry pick, or convert only after-tax dollars to avoid paying tax on the conversion.

Thus, if you convert the $5,250 in your nondeductible IRA to a Roth IRA in this scenario, you would owe tax on 56% of that amount, or $2,940, since 56% of your total non-Roth IRA balances consist of dollars that have yet to be taxed. (The taxable income, if any, resulting from your wife's conversion would be based on her non-Roth IRA account balances.)

So if you're considering this little end-run around the Roth IRA annual contribution rules, you'll want to see whether the conversion will generate any taxable income. I say that for two reasons. One is that taxable income from the conversion itself could conceivably push you into a higher tax bracket (although that would depend on how much income it generates and how close you are to the next tax bracket). The other is that, if the conversion does trigger a tax bill, you'll need money to pay the tab.

On that score at least, you have some wiggle room. People who convert to a Roth this year can split the taxable income from a 2010 conversion into the 2011 and 2012 tax years, which means (assuming you don't owe estimated taxes) that you don't have to come up with the cash until you pay your taxes when you actually file in 2012 and 2013.

As I've noted before, however, if tax rates go up as they're currently scheduled to do, it's possible you could be better off just recognizing all the income and paying the tab in 2010.

By the way, if you or your wife already have Roth IRAs, then you'll probably want to set up new Roth IRA accounts to take the funds from your nondeductible IRAs. Doing that will make it easier if you later decide you want to do a "recharacterization," a process that allows you to undo a conversion and reconvert later, if you wish. You can always consolidate your Roth IRAs later. For more on how recharacterizations work and why people sometimes do them, click here.

One final note: I assume that you're planning to invest this money for the long-term, otherwise you wouldn't have wanted to invest it in an IRA.

Still, you should be aware that withdrawing money from a Roth IRA within five years of a conversion could trigger a 10% penalty if you're under age 59 ½. For more on the tax treatment of withdrawals after conversions, click here.

If you decide that all these nitpicky rules surrounding conversions are just too much of a hassle, you always still have the option of investing in your brokerage account. You won't get the same type of tax break you would with a deductible IRA or a Roth IRA. But you can at least ease the tax hit on any gains by sticking to tax-efficient options like broad-based index funds, ETFs and tax-managed funds.

As long as you actually put that ten thou away and invest it reasonably, either way you'll still be enhancing your long-term financial security. To top of page

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