(MONEY Magazine) – Q I can't contribute the max to my 401(k) because I am a "highly compensated employee" under IRS rules. Why does the IRS have such a rule? It seems unfair. --James Bilger, Crystal Lake, Ill.
Answer Yes, it's unfair, but you do have other ways to save. And there is a good intention behind the contribution limits: They prevent 401(k) plans from being run mainly for the benefit of top executives. Employers, therefore, must maintain a balance between the contributions of lower-paid employees and those of higher-paid workers (in 2005, anyone earning $95,000 or more). If too few lower-paid workers invest in the 401(k), top executives must contribute less. Still, you do have saving options, points out Debra Morrison, a financial planner with Regent Atlantic in Chatham, N.J. Your first move should be to find out if your company offers a different savings program, such as a deferred-compensation plan, for higher-paid workers.
If you lack such an option, you may meet the income limits for contributing to a Roth IRA: Modified adjusted gross income cannot exceed $160,000 for married couples filing jointly. Finally, you can always save in a taxable account. You can minimize taxes by choosing tax-efficient investments such as tax-managed mutual funds or index funds.
Q I'm 70½ and must take required IRA distributions. Can I take the distributions, pay the taxes and convert the money to a Roth IRA to build up my tax-free savings? --Earl Covey, Beverton, Ore.
Answer Yes and no. Your idea is a good one, but it runs up against two knotty sets of tax laws governing Roth IRAs, according to accountant Ed Slott, an IRA expert in Rockville Centre, N.Y.
The first set of rules deals with Roth IRA conversions--that's when you withdraw money from a traditional IRA, pay taxes on the amount and move it to a Roth. You can convert any amount to a Roth as long as your modified adjusted gross income is under $100,000 (whether you're single or married and filing jointly). Unfortunately, the tax rules do not allow you to treat a required distribution from an IRA as a conversion.
Still, you may be able to invest some money in a Roth as a regular contribution--after paying taxes, of course. That brings us to the second set of rules for contributions. This year you can put only $4,500 into a Roth ($4,000 for those under 50), you must have earned income equal to the contribution, and your income cannot exceed $160,000 for married couples filing jointly. If you can make it over those hurdles, then stashing your IRA distributions in a Roth can be a great way to let your money grow tax-free.