Sunday, July 22, 2012

Thoughts on IRAs and 401k's for high income individuals, Part 1

As we know, tax in the U.S. can be pretty hefty for anyone with over 100k annual income. And many limitations also come into play as soon as you are slightly over the magic 100k number.

I did some reading on how IRAs and 401k's function, and came up with some personal opinions that I'd like to share with anyone who cares reading my little blog. :) Since I'm in my early 20s, I will mostly focus on info that's relevant to my own age group.

So the first question for many people would be, which one is the best? The answer is clearly ---- both. 
The reason is that you want to maximize the amount of money you have that has the ability to grow tax-deferred or even tax-free. There are limitations to each though, and some apply specifically to high-income individuals. Now let's discuss the relative pros and cons for each.

IRAs have a much smaller annual contribution cap, 5000 USD for people under 50. You put pre-tax money in, the money grows tax-deferred, and later when you withdraw, you pay tax on both the principal and the earning. But the traditional IRA in its original flavor is actually not available to us, since there is an income cap as well. For 2012, the income cap is 68000, which means that if you earn more than 68k a year, you can make zero tax-deductible IRA contributions. 

Now you're probably like, "waaaat". I know, I was the same when I read that line, but as the saying goes, "when god closes a window for you, he often opens an entire door", or something like that. OK, in this case, it's more like a series of hoops. So notice I said "zero tax-deductible IRA contributions", yes, it implies there is another form of IRA contribution, i.e. non-tax-deductible contributions. But wait a minute, if you have any idea of how the retirement accounts work in the US, you'd probably ask: "doesn't that mean Roth? "

The answer is unfortunately "no". It is not Roth, it basically has all the disadvantages and none of the advantages of Roth. A non-deductible IRA contribution is after-tax money, which means the principal will not be taxed again, but since the account is still an IRA, you'll end up paying tax on the earnings. Then why don't we just contribute to Roth?

The problem is, you can't do that either. There is a cap for Roth IRA contribution, too! For 2012, it is 120k. Admittedly, the complete cutoff is much higher, but you'll still get a phase-out issue starting at 110k. I.e. if you make 115k, you can only contribute 2.5k a year instead of 5k. This goes against our doctrine of maximizing tax-free growth! Now we are stuck with no normal traditional IRA and no Roth IRA. Is there another option other than sticking with the sub-par non-deductible IRA stuff?

Prior to 2010, the answer would have been "no". But since 2010, the IRS has decided to remove the cap on what's called a "Roth conversion". Essentially, you withdraw IRAs, pay tax now, and put them back into Roth IRAs within 60 days. It's the IRS's way of getting paid earlier. (much like killing a goose that lays golden eggs, ok, maybe not to that extent) This enables us to convert our non-deductible IRAs into Roth, essentially completely bypass the limitations on both flavors of IRAs. This method is also known as "backdoor Roth".

What you do is stack up 5k, contribute to an IRA, and immediately do a conversion. Since you already paid tax on the 5k, the conversion is free (unless you somehow made a bunch of money during the conversion processing time, in which case, good for you). Now we get to reap the benefit Roth IRA!

One added benefit of Roth IRA which I particularly value is the ability to withdraw the principal after 5 years. Since I'm still in my early 20s, I have ambitious in my life that will need money, such as starting a company or something. If I put a lot of money in retirement accounts, when I really do need money to kick-start my business, I'll probably find myself unable to retrieve them without paying a 10% penalty tax to the IRS. Not good! But if I don't use the retirement accounts, I'm essentially leaving money on the table! Much of the investment gains will be paid to the IRS due to the high income tax bracket. Not good either! Roth IRA solves this problem for me though. With Roth IRA, I can save 5k, let it grow, and withdraw that 5k after 5 years while leaving the earning to do further growth. 

In my opinion, Roth IRA is the best option for anyone that would like to save up for their retirement but don't want to lock themselves completely into the whole retirement saving thing. It is a shame the limit is only 5k, but I still think the benefit is completely worth jumping through these hoops to get the job done. 

On my next blog post, I'll discuss features and limitations of 401k plans. 

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