In "Taking advantage of tax advantaged accounts" part 1 and part 2, we saw that retirement accounts make a huge difference in growing your investments due to their tax advantages. However, many of these accounts such as the traditional IRA and Roth IRA contain several restrictions as far as who can partake in these advantages. This post goes into how to get around these restrictions to maximize your retirement contributions (100% legal).
First, a little background: for a traditional IRA, a single filer can only take a full deduction if you're modified adjusted gross income is $63,000 or less. Between $63,000 and $73,000, you can only take a partial deduction, and after $73,000 you can't take any deduction. A non-deductible traditional IRA is actually at a tax disadvantage compared to a regular taxable account because it can no longer claim the lower capital gains tax.
You can contribute to the Roth IRA up to $120,000 AGI. Between $120,000 and $135,000, your contribution limit starts phasing out. After $135,000, you can no longer contribute to a Roth IRA.
In any given year, the total contributions to all of your traditional and Roth IRA accounts cannot exceed $5,500. This puts yet another limit on how much you can take advantage of these accounts even if you meet the income thresholds.
The first technique is fairly well-known and is called the "Backdoor Roth IRA" or more officially as a "Roth IRA conversion". This uses a loophole where any traditional IRA can be converted to a Roth IRA, as long as you pay the requisite taxes. Remember, a traditional IRA may be deductible (i.e. tax deferred) whereas a Roth IRA is taxed immediately, thus when you do the conversion you must make sure you pay the taxes that a Roth IRA requires. However, you should only be using this technique if you're income is above $120,000 anyways (otherwise you should just contribute to a Roth IRA directly). This means your traditional IRA contribution was non-deductible and you already paid taxes on that amount, which means that you don't need to pay any additional taxes on the conversion. The conversion process is relatively simple with most brokerages (see your brokerage documentation for details).
Two things to keep in mind about the process
- If you have taxable balances in any of your IRA accounts, you are subject to the associated pro-rata rules and must pay taxes on the conversion, even if you are converting an after-tax contribution.
- You should do the conversion immediately after your traditional IRA contribution, otherwise you will have to pay taxes on the capital gains.
- You are still subject to the $5,500 IRA contribution limit.
The process is more involved since you should do the conversion after every after-tax 401k contribution, which typically occurs every pay check. However, a few minutes of work every paycheck is a small price to pay for the associated tax-advantage. The total contribution limit for your 401k accounts is a whopping $55,000, which means (assuming a 50% employer match) you can put an additional $55,000 - $18,500 - $9,250 = $27,250 into a tax sheltered account every year. If you forget and do the conversion late and the account grows in the meantime, you'll just have to pay a small tax on the growth.
The mega-backdoor withdrawal does not count towards your IRA contributions, so you can (and should) take advantage of both the backdoor and mega-backdoor techniques. The combination of the two brings your tax-advantaged limits from ~$20,000 to ~$60,000 per year.