retirement savings

Dear Liz: I’m hoping to retire in three years so I’m saving as much as possible. I’m maxing out my contributions to a 403(b) retirement plan, a 457(b) deferred compensation plan and a Roth IRA. I also contribute $1,000 each month from my paycheck to an after-tax defined contribution plan offered by my employer. A representative from the plan provider told me I should move the after-tax money into a Roth IRA via monthly rollovers as that will be “more tax efficient.” It means a monthly call, which I am happy to do if that is to my advantage. The rep explained it as “a backdoor Roth loophole” that allows one to contribute to a Roth IRA above and beyond the $7,000 limit. Is this advisable?

Answer: If your goal is to stuff more money into a Roth, then this could be a good way to do it.

Roths offer the option of tax-free money in retirement without minimum distribution requirements. That means you can leave the money alone to continue to grow tax free or use it to better manage your tax bill in retirement.

The ability to contribute directly to a Roth phases out with modified adjusted gross incomes of $140,000 for singles and $208,000 for married people filing jointly. People above those income limits can do a “backdoor Roth” by contributing to a traditional IRA and then converting the money to a Roth, since there’s no income limit on conversions. Taxes are owed on the portion of the conversion that represents pre-tax contributions and earnings, so this is usually a technique best used by people who don’t have big pre-tax IRAs.

The “mega backdoor Roth” puts this strategy on steroids. Instead of being held to the usual $6,000 annual IRA contribution limit (or $7,000 for people 50 and older), people make after-tax contributions of up to $58,000 a year to a workplace plan and then convert that money to a Roth IRA. The only tax owed would be on any gains the after-tax money earned between the time you contributed it and the time you converted it. You can have a big pre-tax IRA and still use this technique without that IRA triggering a lot of taxes.

While some plans require you to have left your job before you can make these rollovers, others — like yours — offer “in service” conversions that allow you to convert as you go, which can help minimize your tax bill. People who have to wait until they leave their job to convert will have to pay taxes on any gains the after-tax money has earned. Converting as you go minimizes the taxable gains and instead gets the money into the Roth so it can start growing tax free for you sooner. A monthly call seems like a small price to pay for this benefit, although sometimes the process can be automated. You might ask your employer if they could make that option available.

The $58,000, by the way, is the limit for all contributions to qualified plans. The money you contribute to your 403(b) and 457(a) is deducted from that limit, as are any matches your employer gives you. It’s typically a good idea to max out those pre-tax options, the way you’re doing, before you make any after-tax contributions.

Dear Liz: My husband and I are both in our early 50s and have been contributing the full amount to each of our 401(k) plans, plus the catch-up amounts since we turned 50. I was laid off in February 2020 and had only contributed $3,000. I had assumed I’d get a new job quickly, but as of now, I still have not. Fortunately, my husband still has a good job and has been able to make his full contribution plus the catch-up. Is there any way we can increase my contribution to retirement savings at this point? Can I fund an IRA if I already contributed to a 401(k)? We don’t want to lose any more ground.

Answer: The fact that you were both contributing the maximum amount — $26,000 each, or $52,000 total — is impressive. That, plus the fact that you’re still able to contribute given your unemployment, indicates your household income could affect your ability to deduct your IRA contributions.

You can still make the contributions, however. Anyone with earned income can contribute as much as $6,000 to an IRA (or $7,000 if you’re 50 or older) even if they’re covered by a workplace plan such as a 401(k). There used to be an age limit for IRA contributions, but that’s been eliminated. You have to earn at least as much as you contribute in the form of wages, salary or self-employment income. If you only earned $4,000 in 2020, for example, that’s the maximum you could contribute to an IRA.

Unemployment insurance doesn’t count as compensation, so you can’t use that — or interest, dividends, pension payments and other such nonwage income — to determine your contributions.

If you were covered by a workplace plan at any point in 2020, the ability to deduct your contribution phases out for modified adjusted gross incomes between $104,000 and $124,000 for married couples filing jointly for 2020. (The phaseout range rises to $105,000 to $125,000 for 2021.)

If you can’t deduct your contribution, consider putting the money instead into a Roth IRA if possible. You don’t get an upfront tax deduction, but withdrawals are tax-free in retirement. The ability to contribute to a Roth IRA starts to phase out with a modified gross income of $196,000 in 2020 (and $198,000 in 2021).

If your income is too high and you don’t already have a large IRA, you could use the “back door Roth” maneuver by contributing to a regular IRA and then converting it to a Roth, since there are no income limits on conversions. (You have to pay taxes on any pretax money that’s converted this way, which is why this might not be an ideal approach for those with big IRAs.)

You also can open up a taxable brokerage account and invest an unlimited amount of money. Again, there’s no upfront deduction, but investments held for at least a year can qualify for favorable capital gains tax rates.

Investing in accounts with different tax treatments is a good idea in general, since it can help you better control your tax bill in retirement.