MintLife columnist, Matthew Amster-Burton, is answering a reader question this week about a tax-advantaged way to save for retirement when Roth/Traditional IRAs and 401(k)s are not an option.
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Reader Question: This past year my family had a modified adjusted gross income (MAGI) above $180,000. This means contributing to Roth/Traditional IRAs are no longer an option, and my employer doesn’t offer a 401(k). This leaves us with what appears to be no tax-advantaged way to save for retirement. What should we do? -Drew
Matthew Amster Burton: Nice problem to have. It would be easy to use the lack of a 401(k) as an excuse not to save for retirement, or to save too little. Drew is too smart for that.
I asked Drew a little more about his situation. He and his wife both receive W-2s, so they can’t contribute to a self-employment plan like a SEP-IRA or individual 401(k). They have no kids, which means they’re not contributing to 529 college savings plans. And they have no debt other than a very modest, low-interest mortgage. (See? Smart guy.)
Drew does have some money in IRAs and Roth IRAs from previous jobs. And he’d like a 50/50 portfolio: half stocks, half bonds.
Here’s what I recommend:
Keep it traditional
The only IRA you hear about these days is the Roth IRA. The traditional IRA sounds so stuffy. Well, guess what? Drew can’t contribute to a Roth IRA, but anybody who doesn’t have a retirement plan at work can contribute to a deductible traditional IRA, even with a high income. That means Drew and his wife can each contribute $5,000 to an IRA, and it’s tax-deductible.
That takes care of the first $10,000. With an income above $180,000, that’s not enough. Let’s find more ways to save.
Most Americans can do all of their retirement savings in tax-advantaged retirement accounts—IRAs and 401(k)s. If you’re stuck without a 401(k), with a high income (I realize this is a creative use of the word “stuck”), or both, you’ll need to use a taxable account.
A taxable account is just a regular brokerage account where you can hold any kind of investment and pay taxes as they come due. If you have a savings account, you’re familiar with the concept: you contribute after-tax money and pay taxes every year on the interest.
When you’re talking about stock and bond investments, however, it quickly gets a lot more complicated. Some investments are “tax-efficient” and some aren’t. To oversimplify a bit, stocks are tax-efficient (because they’re taxed at the lower capital gains and dividend rate and taxes are deferred until you sell) and bonds are not (they’re taxed much like a savings account).
Bonds are like wild animals that need to be put in the safe enclosure of an IRA or 401(k). That means Drew should put all of his bonds into his existing IRAs, where he won’t have to pay tax on their income until retirement. His taxable account should hold 100% stocks. This seems weird, but it’s all one portfolio that happens to be arbitrarily split into separate accounts because of tax law.
Let’s put some made-up numbers on this. Let’s say Drew has one existing IRA with $100,000 in it, and he’s going to contribute $30,000 this year to a taxable account. At the end of the year, his portfolio might look like this:
$65,000 in a bond fund (such as a total bond market index fund)
$35,000 in a US stock fund
$19,500 International stock fund
$10,500 US stock fund
There, that’s 50% stocks, 50% bonds, with 30% of the stocks international—consistent with typical advisor recommendations for holding international stocks. (International stocks are especially tax-efficient and belong in the taxable account.)
If Drew gets to the point where he can’t fit all of his bonds in the IRA, he should consider municipal bonds and US savings bonds. But not yet. (Although, savings bonds would be a great choice for non-retirement savings.)
Watch out for turnover
When a stock fund in your taxable account trades stocks, you’re on the hook for the capital gains taxes—even if you did nothing but buy the fund and hold it. So those funds should be as low-turnover as possible, which means index funds or ETFs.
Total market index funds buy the entire stock market and hold it forever, which means you pay no capital gains tax until you sell the fund. (Not coincidentally, index funds tend to outperform the vast majority of actively managed funds, after taxes and expenses.)
Stock funds do pay dividends, and you pay tax on those every year. The good news is, no matter what tax bracket you’re in, those dividends are taxed at just 15%.
Look for losses
When you hold stock funds in a taxable account, you can gain additional tax savings by tax-loss harvesting. When the market drops and some of your stocks are worth less than you originally paid, you can sell them and buy a similar (but not identical) fund, and this loss can be used to offset capital gains on other holdings—or even reduce your regular income taxes.
It’s a legal way to defer more taxes—perhaps all the way until retirement, when Drew is likely to be in a lower tax bracket.
Take it up with the boss
No clever portfolio will be half as lucrative for Drew as talking his employer into offering a 401(k) plan. Especially if you’re in a high tax bracket, the tax savings offered by a 401(k) are huge.
That’s all I’ve got, Drew. Congratulations on avoiding a personal recession, and best of luck.