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High Income? Don't Overlook These Savings Vehicles

High Income? Don't Overlook These Savings Vehicles

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Some high-income investors find themselves with a high-class problem: having more savings than tax-advantaged retirement vehicles to put it in. I'm here today with Christine Benz, she is our director of personal finance here at Morningstar. We're going to talk about a hierarchy of where investors who have this much savings should think about putting extra dollars.

Christine, thanks so much for joining me.

Christine Benz: Jeremy, it's great to be here.

Glaser: So, let's start with the IRA. This is kind of the granddaddy of all tax-deferred retirement accounts. But there's definitely some restrictions there in terms of income and in terms of limits. Can you walk us through those?

Benz: Sure. So, for people who want to make a contribution to a traditional IRA and deduct it on their tax return, if you're a single person and you earn more than $72,000; and if you're part of a married couple filing jointly and you earn more than $119,000; and in both cases if you can also contribute to a retirement plan at work, you are effectively shut out of making a traditional IRA and being able to deduct your contribution.

For Roth IRAs, the income thresholds are a little bit higher. So, for singles, it is $133,000, that's the upper limit on what you can have in modified adjusted gross income and still make some type of a Roth IRA contribution. For married couples filing jointly, it's $196,000 in modified adjustment gross income. That's the cap, that's the cutoff. If your MAGI is above that, you're shut out of making Roth contribution.

Glaser: We've talked a lot in recent years about the so-called backdoor IRA. Can you talk a little bit about what that is and who it makes sense for?

Benz: It makes sense for people who can contribute to a traditional IRA, and anyone can make a traditional IRA contribution. They can't deduct that contribution, but you can make a traditional nondeductible IRA contribution, and there are no income limits on those contributions. And there are no income limits on conversions. So, that's where this backdoor Roth IRA idea was born. The idea is that you fund this traditional nondeductible IRA. You leave the money in the account only a short period of time before you convert it to a Roth. So, that's the basic strategy. It allows high-income folks, specifically high-income folks who are shut out of making a direct Roth IRA contribution because they earn too much, it allows them to get some money into a Roth IRA.

Glaser: That seems like a pretty good deal. What's the catch? What are some of the downsides here?

Benz: The key catch is, if you have additional traditional IRA assets that contain money that has never been taxed--so, a great example is, if you rolled over a 401(k) from a former employer into IRA. So, you have this rollover IRA sitting there. Chances are you made pre-tax contributions to that 401(k), and you enjoyed some tax-deferred compounding on that money. You've got this kitty that has never been taxed at all. Well, when you do this conversion of your little pool of new IRA assets, the IRS is going to look at all your IRAs in aggregate, and it's going to look at the tax status of all of those IRAs, and the taxes that will be due upon the conversion, even though it's just a little IRA kitty, your new backdoor Roth IRA, the taxation will be based on the ratio of money that's never been taxed to money that has already been taxed. So, if you have a big kitty over here consisting of money that has never been taxed before, that will inform the tax treatment of your conversion to your new backdoor Roth IRA. That could make it a more taxing event than perhaps you anticipated. So, this is something to watch out for.

Glaser: Are there any workarounds there, or if you have this kitty of other money, you basically are precluded from using this backdoor Roth IRA procedure?

Benz: There's one, and that is, if you are contributing to a 401(k) through your employer and that plan offers roll-ins from outside assets--so if that plan allows you roll in money from an IRA, then you what you can do, assuming that the 401(k) quality is good and you actually want to roll into it, you can roll the IRA assets into that 401(k) and effectively get them out of the equation from the standpoint of calculating the cost due upon your conversion. So, this is definitely something to consider. It's not something you would want to get involved in if you don't like your 401(k), because that would mean that you're putting even more assets behind it. It's probably not worth it just to get another $5,500, $6,500 a year into the backdoor Roth IRA.

Glaser: Another option for wealthy investors could be a health savings account or an HSA. These are paired with high-deductible healthcare plans. Why do you like these accounts so much?

Benz: Well, for people who are covered by a high-deductible healthcare plan, it makes sense to use the HSA, whether you're using kind of a spend-as-you-go sort of strategy or whether you're using the HSA as a long-term investment vehicle. The reason is that this is the vehicle that offers the only triple tax advantage status in the whole tax code. So, you're putting pretax dollars into your HSA account. If you've got the money growing in some fashion, whether in the traditional savings accounts or whether you have it invested, that money grows tax-free. And then if you use the money for qualified healthcare expenses, those withdrawals are also tax-free. The worst-case scenario from a tax standpoint for an HSA is if you need to pull the money out for nonqualified healthcare expenses, at that point then, the money is treated really a lot like a traditional IRA. So, it is taxed at your ordinary income tax rate.

So, for high-income folks, I think this is kind of a no-brainer, particularly if they are already participating in a high-deductible plan. Think about using that HSA as a supplemental kind of single purpose retirement savings vehicle.

Glaser: A lot of employers offer pretty lousy HSAs though, either high fees or poor investment options. Are you stuck with what your employer has or can you look elsewhere?

Benz: Well, I think, for many people from a practical standpoint, it will make sense to contribute to that HSA, have the money come directly out of their paycheck, so stick with that captive HSA. But you can periodically roll the money into an HSA of your choice. So, that's a great idea if you are stuck with an HSA that has a lot of fees attached to it or maybe where the investment choices aren't that good, use the HSA that your employer provides as kind of a conduit to the better HSA of your own choosing.

Glaser: Aftertax 401(k)s are lesser-known savings vehicles. Can you talk to us about what they are and when you might want to use one?

Benz: Right. A lot of people are familiar with the standard contribution limits for 401(k)s. So, in 2017, it's $18,000 for folks under age 50, $24,000 for people over age 50. What they may not know is that there's another contribution limit that's for total contributions and that includes these after-tax contributions. For 2017, that total contribution limit is $54,000, so a much more generous contribution limit.

The big question is though, who would want to contribute aftertax dollars to a 401(k), and why would you even do that? And the key benefit is that if you are contributing aftertax dollars to the 401(k), when you either leave your employer or you retire, or if your plan allows what are called in-service distributions, you can take that money out and effectively get it directly into a Roth IRA. So, you can take your pretax dollars, roll those into a traditional IRA, your aftertax dollars can go straight into a Roth IRA. Thereupon, they can begin tax-free compounding and will enjoy tax-free withdrawals in retirement.

So, it's a more complicated strategy, one where you probably want to get a little bit of tax advice to see if this is even a viable option for you. Also, make sure that you're looking at these other ideas that we've discussed, the backdoor Roth IRA, the HSA, before thinking about the aftertax 401(k) because from a tax standpoint, the benefits are a little less clear-cut.

Glaser: Finally, you say that wealthy parents who perhaps are planning on paying for college just out of cash flow should still consider a 529 plan.

Benz: They should and the reason is that most 529 plans at this point offer you some sort of a state tax break for contributing to the in-state plan. So, even if you have the money on hand and plan to pay for college next semester, for example, it can still make sense to run it through your home state's 529, pocket the tax break on the money that you've invested, and you can then pay for college straightaway, but it does give you that state tax benefit which, depending on the state you live in, can be quite generous--and in other states, it's not quite as generous. But it's definitely something to look at.

Glaser: Christine, thanks for sharing these strategies today.

Benz: Jeremy, great to be here.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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