401K maxed out – other investment alternatives?
My wife and I have both maxed out our 401K’s with our employers. Our combined income is over $200,000. What other retirement-type investment options do we have available that would allow additional after-tax funds to compound tax free over time? Can we set up individual Traditional IRAs and/or Roth IRAs and fund them with after-tax funds? I seem to recall reading somewhere that our situation would allow us to each fund a Tradtional IRA with the max allowed ($6,000 – over 50) and then convert that TIRA to a Roth, transferring those funds from the TIRA to the Roth. Is that an option? If so, can we do the same thing year-after-year depositing funds in those same two TIRAs, converting them to Roths, and transferring the funds over? Thanks for your replies in advance. Just trying to maximize our long-term investment returns and minimize our tax liability while doing so. 😉
Permalink Submitted by Alan Spross on Mon, 2011-08-01 23:04
Yes, as long as you have earned income, you can make a non deductible traditional IRA (TIRA) contribution of 6,000 for each spouse who has reached age 50. You can then immediatly convert these contributions to a Roth IRA. The conversion will be tax free as long as you do not have ANY OTHER IRA accounts with a pre tax balance. This includes any SEP, SIMPLE or other TIRA accounts, but not inherited IRA accounts.
As indicated if you have any other TIRAs, then you can still convert the new contributions, but the conversion will be mostly taxable under the pro rate rules.
For example, if you have a rollover IRA valued at 94,000 and you make the 6,000 contribution and then convert 6,000, your conversion will be 94% taxable regardless of which IRA you use to fund the conversion.
If you do not have any other TIRAs, you can use this strategy year after year. In effect you have a two step approach to what amounts to a regular Roth IRA contribution, even though your income is too high to actually make a regular Roth contribution.
Further, if you DO have other TIRAs, you may be able to transfer the pre tax balance into your current 401k plan if the plan accepts IRA rollovers. This leaves only the after tax amount in your TIRA which you can then convert tax free. Both the non deductible TIRA contribution and the conversion are reported on Form 8606. Each of you files your own 8606 as an 8606 only holds one SSN. Even though you file jointly, all the mentioned transactions are calculated and reported individually on your joint return.
Permalink Submitted by John Moneypenny on Sun, 2011-08-07 18:51
Thanks for the quick reply and the great information, Alan!
Yes, my wife and I only have one TIRA each in our online brokerage account, along with our own individual Roth IRAs. I guess we each just keep funneling the $6,000 of after-tax money each year into those same 2 TIRAs and then convert those funds over to our individual Roth IRAs. Is that correct?
One more question…when we eventually begin withdrawing those funds, will they be taxed as earned income or as long-term capital gains? Again, we just want to maximize our return on these funds and minimize the tax hit.
Many thanks again in advance for your feedback and suggestions. 🙂
Permalink Submitted by Alan Spross on Sun, 2011-08-07 20:10
The main benefit of a Roth IRA is that once the Roth is qualified (5 years from year of first contribution and age 59.5) all distributions are tax free including the earnings on your contributions.
You do not get a deduction for contributing to a Roth IRA like you might when contributing to a TIRA, so the benefit comes when you take the money out rather than when you contribute it.
To further clarify, if you make the non deductible contribution and have no other prior balance in that TIRA or any other TIRA, your conversion will be tax free. Otherwise your conversion will be partially or mostly taxable. If you ever leave a job and roll your 401k into an IRA, then your TIRA will have a large pre tax balance to it and it would make your conversions taxable because your non deductible contribution of 6,000 would only be a small % of the total TIRA balance. Form 8606 is used to both report your non deductible contribution and your conversion, and it calculates the taxable portion of your conversion, IF ANY.
Permalink Submitted by John Moneypenny on Thu, 2012-02-09 15:02
Follow-up question, Alan. You wrote…
[quote=”alan-oniras”]To further clarify, if you make the non deductible contribution and have no other prior balance in that TIRA or any other TIRA, your conversion will be tax free. Otherwise your conversion will be partially or mostly taxable.[/quote]
When we contribute the $6,000 to our TIRAs each year, there will have been a “prior balance” for a short period of time in that same TIRA from the previous year’s $6,000 contribution. Are you saying that we must close out our TIRAs every year and open up new ones for the next year’s contribution so that we don’t have a “prior balance” from the year before? Just need clarification so that my little brain can comprehend. Thanks, Alan. 🙂
Permalink Submitted by mk foss on Thu, 2012-02-09 17:43
I think Alan was contemplating that you’d start with no IRAs, contribute $6,000 and immediately convert to Roth tax free. If you had $1,000 in the IRA when you start then contribute $6,000 and convert $6,000; part of the conversion will be taxable because you converted 6/7ths of the IRA – part of the original balance will be taxable. If you only have a very small amount in the IRA, the tax on converting the entire amount is small.
The question is: Do you want to open and then close a new IRA every year to maximize the tax free Roth conversion or do you want to pay a small amount of tax by keeping an IRA open from year to year.
Permalink Submitted by John Moneypenny on Thu, 2012-02-09 17:58
Thanks for the reply, Mary. We started those TIRA accounts originally with no money in them. So the bottom line is that we can keep those same original TIRA accounts in ETrade and use them year-after-year to contribute $6,000 of earned income and then immediately do the conversion to our current Roth IRAs tax free, correct?