Brad Tinnon

Brad Tinnon

An Awesome Investment Strategy For High Income Earners Who Don’t Qualify For A Roth IRA

Lots is written these days about investment strategies for high income earners. But today, I will be sharing a strategy that you likely have not heard of. 

If you’re a high income individual or family, then there is a strong likelihood that you don’t qualify for a Roth IRA. This is unfortunate because a Roth IRA can potentially provide tax free benefits to you in the future. In addition, it can serve as a way to protect you from rising tax rates and can play a powerful “tax savings” role.

In this blog post, you’ll discover that high income earners just may be able to contribute to a Roth IRA even though they don’t qualify!

WHAT IS CONSIDERED HIGH INCOME?

First off, let’s tackle what is considered “high income”. According to the IRS, for 2017, if your modified adjusted gross income is more than $133,000 (for a single tax filer) or $196,000 (for a married filing jointly tax filer) then you do not qualify to contribute to a Roth IRA. 

WHY YOU NEED TAX FREE MONEY IN RETIREMENT

As mentioned above, a Roth IRA provides tax free money in retirement, but why is this so important?

Imagine going into retirement and your only investment is a pre-tax account like a 401k or a Traditional IRA that is fully taxable when withdrawals are made. Now imagine that tax brackets have risen dramatically (which is not out of the question considering the amount of debt our country is in). For argument’s sake let’s say that you’re in the 25% tax bracket today but in the future that equivalent tax bracket is now 50%. So, for every dollar that you withdraw, 50% goes to Uncle Sam. If you withdraw $100,000 then you will only net $50,000. Not exactly a very comforting thing.

This is why I am a fan of what I call the 3 Bucket Strategy. With this strategy, you aim to have money in pre-tax accounts (401k’s and Traditional IRAs), tax free accounts (Roth IRAs), and taxable accounts (individual, joint, and trust owned investment accounts). All 3 of these are taxed in different ways and can provide you with substantial flexibility in retirement.

If tax rates are high, then why would you want to withdraw from the fully taxable pre-tax accounts? You would likely be better off withdrawing from the tax free or taxable accounts. Or if tax rates are really low then taking from the pre-tax accounts and paying a small amount of tax is likely the better solution.

By effectively employing the 3 Bucket Strategy, you are actually preserving your wealth and reducing your tax burden!!!

INTRODUCING THE AFTER-TAX 401K

Now that we’ve established the importance of the Roth IRA, how does this benefit a high income earner who doesn’t qualify in the first place?

The key lies in the rules of the 401k plan you have at your employer or business. For 2017, the IRS allows you to contribute up to $18,000 per year ($24,000 per year if age 50 or older). However, did you know that “total” contributions to a 401k could be up to $54,000 per year? These “total” contributions would consist of your own contributions, employer matching contributions, profit sharing contributions, employee forfeitures, and after-tax contributions. It’s this last part, after-tax contributions, that I want to discuss.

If your 401k plan allows after-tax contributions, then as a high income earner, you have a tremendous opportunity. Typically a high income earner will maximize their yearly pre-tax 401k contributions ($18,000 or $24,000), but if after-tax contributions are allowed, then up to an additional $36,000 can be contributed.

Why is this important? It’s important because after-tax money that grows tax deferred in a 401k is extremely beneficial. And when ultimately rolled over to a Roth IRA it will be tax free. The alternative is to invest your after-tax money in a taxable account or even an annuity that would ultimately be taxable. Whereas, after-tax money in a 401k that is rolled over to a Roth IRA will be completely tax free. 

MAJOR CAVEAT

One major caveat here is that only your after-tax contributions can be rolled over to a Roth IRA; not the earnings that were generated from the after-tax contributions. The earnings will be considered pre-tax and ultimately taxable. This is why it is so important to see if your 401k plan allows for “in-service distributions” (essentially rolling over your 401k while your still employed). If allowable, then you can rollover your contributions rather immediately and then any earnings will accumulate in the Roth IRA tax free.

PITFALLS OF TAKING AN IN-SERVICE DISTRIBUTION

There are a few pitfalls that you must navigate when executing this strategy. Be sure to check with your 401k company to see if these apply. Mainly they consist of the following:

1. Your own contributions or company match could be restricted or suspended for a period of time. 

2. There are some advantages to keeping money in the 401k. Click here to read a prior blog post regarding this.

3. Be careful if you have publicly traded stock in your 401k as you may lose the ability to execute a potentially valuable Net Unrealized Appreciation (NUA) strategy.

4. You can’t do an in-service distribution just for the after-tax portion. If you attempt to do this, then the distribution will be treated in a pro-rate fashion with a portion being pre-tax and a portion being after-tax. In order to take out the full after-tax balance you must do an in-service distribution for the entire 401k balance.

TAKEAWAYS FOR HIGH INCOME EARNERS

If you work for an employer whose 401k plan allows for after-tax contributions, then hopefully this blog post has encouraged you to consider making after-tax contributions. Be aware that your contributions could be limited due to discrimination testing that must be done; check with your 401k provider. If your employer doesn’t provide for after-tax contributions then make an appeal to your HR department or better yet the owner.

If you are a small business owner that has a 401k plan, then review the Plan Document to see if after-tax contributions are allowed. If so, you’ll need to contact the Third Party Administrator to determine if your after-tax contributions will be limited (due to discrimination testing). If your 401k plan doesn’t allow for after-tax contributions, then consider amending the plan. If you don’t have a 401k plan, then give some consideration to installing one to minimize your tax burden and maximize your net worth.

CONCLUSION

Of all the investment strategies for high income earners that exist, hopefully you’ve found this one to be eye opening. The Roth IRA may be elusive for many, but with some careful planning you just may be able to back-door your way into this tax free investment.

Please feel free to share comments, questions, or experiences below.

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Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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