Best Savings/Investment Strategy for Roth-ineligible?

[iamlindoro]

I realize this is like a 0th-world problem (even more pathetic than a 1st world problem), but I am in an income bracket that disqualifies me from using a Roth IRA.  I am maxing out my 401k, but I'm saving nearly 60K a year in taxable investment accounts beyond that by living reasonably frugally.  That said, FI is still a decent ways off for me (about 10 years, at age 43) because I also intend to get my mortgage here in the SF Bay Area paid down before leaving work.  I can't help but feel like there's more I could be doing in the tax-advantaged space.  Maybe there's not, and my current plan would allow me to discontinue 401K contributions entirely in the next few years (in fact, at the current rate there's a good chance I'd never even have to touch the 401k even when I become eligible)... Is there anything I should be investigating or reading if I can't put money in a Roth, but I want to have some sort of tax-advantaged account if at all possible for the 16-17 years after FI but before the 401k distributions become an option?

[TLV]

If you don't have any deductible contributions in traditional IRAs yet, then (this year at least) you can do a "backdoor Roth" - make non-deductible contributions to a traditional IRA, then convert them to a Roth. (You can still do this if you already have deductible contributions in a traditional IRA, but it's more complicated and you'll have to pay taxes on the deductible portion that is converted.)

Also, while you're at it look up "Roth rollover pipeline" and "Rule 72(t)" for ideas on how to get 401k money out early without penalty.

[Another Reader]

Rental real estate will shelter a lot of income.

[chucklesmcgee]

If you don't have any deductible contributions in traditional IRAs yet, then (this year at least) you can do a "backdoor Roth" - make non-deductible contributions to a traditional IRA, then convert them to a Roth. (You can still do this if you already have deductible contributions in a traditional IRA, but it's more complicated and you'll have to pay taxes on the deductible portion that is converted.)

Second this, backdoor Roth IRA contributions are great. It's very easy to do in Vanguard, just a few clicks and I don't think any conversion fee. Not aware of any plans for the rules to change soon, but you never know.

I'm in the same boat as you and spent the weekend researching some nice options for tax-sheltered accounts:

HSA- Pretty fantastic secret. Contributions tax-deductible, earnings when used for healthcare related costs are tax-exempt. No income limit, max contribution $3100. You need to have a "high deductible health plan" HDHP to qualify (which, quite confusingly, has a ceiling for deductibles which is actually a bit lower than some current plans). You either get cash out with a debit card or you reimburse yourself for whatever you have receipts for.

Oh just healthcare costs, what's the big deal? Well, the real secret is that there's no limit to how long you have to wait to reimburse yourself. So you can pay out of pocket for costs, hold on to your receipts for 20 years, then break it open and "reimburse" yourself with delicious untaxed earnings when you decide you want a new car. Assumes you've racked up enough medical expenses, but it's pretty fair to say you'll go through at least several years of maximum contributions out of pocket. Healthcare costs include vision and dental care. There are a lot of details, but take a look.

Also you can invest for a whole year's contributions even if you only have the health plan on December 1st. I actually just decided to go off my parent's plan despite being eligible for almost another year when I realized the tax benefits of the HSA greatly outweighed the $40/month premium cost.

Take a look at 529's too. Not that fantastic, but still ok.

[Undecided]

Rental real estate will shelter a lot of income.

What do you mean? I'm not sure if the phaseouts exactly match, but most taxpayers who aren't eligible for a (direct) Roth, can't take the passive loss deduction, either, which is a real hit to the "shelter" aspect of rental real estate.

[Nords]

Rental real estate will shelter a lot of income.

Interesting perspective.  I see rental real estate as a way to generate a lot of income.

[Another Reader]

I should have said create and shelter a lot of income.   If you can't use all the deductions to shelter current income, then the stored loss should come in handy when you sell at a nice capital gain.

Lots of earned income puts you squarely in the sights of the tax collector.  In general, unearned income is easier to tax manage.

[jrhampt]

I am actually not a huge fan of the backdoor Roth for people who are still making huge incomes.  This is because the tax hit you take when you convert to the Roth is so large at this point.  I think it's better to wait to do the conversion until after you've downshifted and are making a lower income. 

I am in your situation and am Roth ineligible.  I did convert an old (small) IRA to a Roth, but I don't actually think it was worth it in retrospect.  So I continue to max out my 401k and contribute to my taxable account.  I've considered an HRA, but my husband is uncomfortable with the idea and will hold onto his PPO plan until they pry it from him.

[iamlindoro]

Thanks all for the input.  It's given me a lot to think about.

In the interest of making myself seem the tinest bit less silver-spooned, I don't make a single massive income, but my reasonably well-paid regular job, and aggressively-pursued outside consulting (20+ hours a week) put me juuuuust outside of eligibility.  I appreciate having some options to consider.

[jrhampt]

In making me seem less silver spooned as well (heehee), I would not be Roth ineligible if I were single.  It's the married contribution limits that ruin it all.

[JohnGalt]

I am actually not a huge fan of the backdoor Roth for people who are still making huge incomes.  This is because the tax hit you take when you convert to the Roth is so large at this point.  I think it's better to wait to do the conversion until after you've downshifted and are making a lower income. 

I am in your situation and am Roth ineligible.  I did convert an old (small) IRA to a Roth, but I don't actually think it was worth it in retrospect.  So I continue to max out my 401k and contribute to my taxable account.  I've considered an HRA, but my husband is uncomfortable with the idea and will hold onto his PPO plan until they pry it from him.

The idea behind backdoor roth isn't to take money that is already in an IRA from previous years and convert it - it's to take money from the current year, put it in a non-deductible IRA, and convert that IRA into a roth IRA.  There is no additional tax burden and the money can be withdrawn tax/penalty free at any time.  There are no downsides and it lets you get money into an account that can grow tax free that you otherwise could not take advantage of. 

[jrhampt]

The idea behind backdoor roth isn't to take money that is already in an IRA from previous years and convert it - it's to take money from the current year, put it in a non-deductible IRA, and convert that IRA into a roth IRA.  There is no additional tax burden and the money can be withdrawn tax/penalty free at any time.  There are no downsides and it lets you get money into an account that can grow tax free that you otherwise could not take advantage of.

I should clarify - it was in an old 401k, which I converted to an IRA, and then into the Roth.  However, you do have to pay taxes when converting to the Roth since the money in the 401k/IRA was pre-tax contributions.  So, yes, if you are in a higher tax bracket when you do the conversion to a Roth, you will pay higher taxes than if you wait until you are in a lower tax bracket to convert.

[Another Reader]

I'm not sure I understand the taxation rules that apply to back door Roth conversions for new contributions by someone that is Roth ineligible.  Let's say the contributor earns $200k.  He or she makes a non-deductible $5,000 contribution to a traditional IRA.  That means the contributor is taxed at whatever their tax rate on that $5,000, along with the other $195k.  Now the contributor wants to convert that non-deductible IRA into a Roth.  Doesn't the conversion create a second taxable event for that money?  In other words, isn't the money taxed twice?  Is it any different if the contribution and conversion occur in different years?

[JohnGalt]

I'm not sure I understand the taxation rules that apply to back door Roth conversions for new contributions by someone that is Roth ineligible.  Let's say the contributor earns $200k.  He or she makes a non-deductible $5,000 contribution to a traditional IRA.  That means the contributor is taxed at whatever their tax rate on that $5,000, along with the other $195k.  Now the contributor wants to convert that non-deductible IRA into a Roth.  Doesn't the conversion create a second taxable event for that money?  In other words, isn't the money taxed twice?  Is it any different if the contribution and conversion occur in different years?

Converting post-tax IRA money into a roth IRA does not create a taxable event. 

[TLV]

I'm not sure I understand the taxation rules that apply to back door Roth conversions for new contributions by someone that is Roth ineligible.  Let's say the contributor earns $200k.  He or she makes a non-deductible $5,000 contribution to a traditional IRA.  That means the contributor is taxed at whatever their tax rate on that $5,000, along with the other $195k.  Now the contributor wants to convert that non-deductible IRA into a Roth.  Doesn't the conversion create a second taxable event for that money?  In other words, isn't the money taxed twice?  Is it any different if the contribution and conversion occur in different years?

Converting post-tax IRA money into a roth IRA does not create a taxable event.

True, but if you already have any pre-tax IRA money in any accounts, then it must also be converted proportionally. IRS doesn't care if it's a separate account, say at a different broker.

Example:
You put $5,000 into your traditional IRA last year and deducted it.
This year you made a lot more money, so you're not only ineligible to deduct traditional IRA contributions, but can't contribute to a Roth IRA. You contribute $5k to the traditional IRA but don't deduct it. Then you decide to rollover to a Roth IRA after learning about backdoor roths.

If you roll over $5k, it's not the $5k non-deductible you contributed this year. It's $2.5k deductible from last year, and $2.5 non-deductible from this year. So you'd have an additional $2.5k of taxable income this year.

If you roll over all $10k, then you get all of it into the Roth IRA, but you have $5k of additional taxable income to report.

[Another Reader]

What happens if you have a traditional IRA with pre-tax money and a non-deductible IRA with post-tax money?  My understanding is that the IRS treats all IRA's as one big pot of money.  So, if you had $45k in pre-tax money in a traditional IRA and $5,000 in a post-tax non-deductible IRA, you could not just convert the $5,000 post-tax money.  The conversion would be treated as 90 percent taxable money and 10 percent post-tax money.  If that's the case, folks that have traditional IRA's from when their incomes were lower might want to look carefully at how the back door strategy would work for them.  Can anyone that works with this (CPA or?) clarify how conversion works with IRA's comprised of pre- and post-tax money?

[Another Reader]

Thanks, TLV, that's what I thought.

[salmp01]

In the interest of making myself seem the tinest bit less silver-spooned, I don't make a single massive income, but my reasonably well-paid regular job, and aggressively-pursued outside consulting (20+ hours a week) put me juuuuust outside of eligibility.  I appreciate having some options to consider.

After reading the above statement I'm thinking that you may get 1099 income (in addition to income on a w-2).  For 1099 income you have the option to defer income in a SEP IRA.  I believe that for 2012 you can contribute up to 50k (but cannot exceed 25% of your income) to a SEP IRA in addition to maxing  your 401k.