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Maximizing the Contributions to your Retirement Accounts

The approach of the end of the year is a good time to think about maximizing your annual contributions to your retirement account(s), whether these are part of an employer-based plan (401k, 403b, 457) or are individual accounts (IRA, Roth IRA). The logic is powerful: since these contributions are generally pre-tax (except for the Roth IRA and some other situations that I’ll discuss in a moment), you have a chance to have these contributions grow tax-free for many years or even decades. Only when you start taking distributions from these accounts (typically after age 59 1/2) do you have to pay tax. 

But many people are not exploiting these pre-tax retirement savings vehicles to their fullest extent because they are not aware of all the rules, some of them admittedly esoteric. Most are aware of the standard annual maximums for each kind of account. For employer-based plans (e.g., 401k, 403b, and 457), the employee may make a maximum “elective deferral” of $19,000 for 2019. For traditional and Roth IRAs, the annual maximum is $6,000. If you are not reaching the maximum contribution for whatever kind of retirement savings account you have, then you may wish to stop reading here, because generally the first thing you should do (if your budget allows) is increase your contributions until you reach the maximum.

Many people work for employers who also make contributions to their employees’ retirement accounts. If your employer makes “matching” contributions, it would be a shame not to make at least a sizeable enough employee contribution to qualify for the maximum employer match: that’s leaving money on the table!

“Catch up” Provisions

There are a number of ways that you can exceed the standard caps when contributing to employer-based plans and IRAs. Perhaps the best known is the “catch-up” provision for people over 50 years old: when you reach this age you can contribute an additional $6,000 per year to a 401k, 403b, or 457 (for a total of $25,000) and/or an additional $1,000 per year to an IRA (for a total of $7,000). And you are entitled to the full catch-up for the year even if you turn 50 on December 31!

There are also more esoteric catch-up provisions for 403b and 457 plans. If you have a 403b plan, are 50 or older, and have worked at the employer for 15 years or more, you may be entitled to contribute up to an additional $3,000 (for a total of $28,000). And if your employer (typically some kind of governmental agency or non-profit) offers a 457 plan, you may be able, in each of the three years prior to the plan’s official “retirement age,” to make an additional $19,000 contribution (for a total of $38,000 each year) to the extent of any shortfall in previous years between actual contributions and the maximum permissible.

Double Dipping: 457 Plans and the Traditional IRA

Another unusual feature of 457 plans is that you can make the maximum annual contribution to it ($19,000 or $25,000 if you are older than 50) as well as the maximum annual contribution to a 401k or 403b, if your employer offers both. Other types of employer-based plans do not allow this. For instance, if you have access to both a 401k and a 403b (or both a 401k and a 401k Roth), your total annual contribution across both accounts cannot exceed $19,000 ($25,000 with catch-up). Not a lot of employees have access to a 457 and a 401k or 403b account, but if you do, this is a great opportunity.

There are other ways to “double dip” as well. For instance, many people can max out an employer-based retirement plan and also contribute to an IRA. This option is subject to income limitations (Roth IRAs are subject to even more severe income limits). If you are single and are what the IRS calls an “active participant” in an employer-based plan, then your ability to contribute pre-tax money to the IRA (in the form of a “deduction” on your tax return) begins to be phased out when your adjusted gross income reaches $64,000 and is totally phased out when your income reaches $74,000. And if you are married filing jointly, and you are an “active” participant in an employer plan, then your ability to deduct an IRA contribution begins to phase out when your joint adjusted gross income reaches $103,000 and phases out completely when the income reaches $123,000. If you are not an “active participant,” but your spouse is, your ability to make a deductible contribution begins to phase out if your joint modified adjusted gross income is $193,000 and is completely phased out when that income reaches $203,000.

But the term “active participant” does not apply to government employees with a 457 plan (whereas it does apply to 401k, 403b, SEP IRA and other plans), so that a single person with a 457 plan can contribute to an IRA and fully deduct the contribution no matter high the income, and same for a married person filing jointly, unless the spouse is an “active participant” and the couple’s income exceeds $193,0009-203,000 (see above). Jeez, things are starting to get pretty complicated!

Advanced Tricks I: Non-Deductible IRAs with Roth Conversion

But many people don’t realize that even if your income is too high to make a tax-deductible contribution to an IRA (i.e., make a pre-tax contribution), you can still make a non-deductible (i.e., after-tax) contribution up to $6,000 ($7,000 with “catch up”). Why would you want to make an after-tax contribution? Because the account still grows tax-free. If you make the maximum contribution of $6,000 at the beginning of the year for twenty years, and earn a modest 5% per year on your investment, your $120,000 in contributions would be worth more than $208,000 at the end of the period, and the $88,000 of growth would not be taxed until you started taking withdrawals after age 59 1/2.

That is a pretty good scenario for many people, but there’s another option worth considering: if you quickly roll over your non-deductible IRA contribution each year into a Roth IRA, your investment growth ($88,000 in the previous example) can escape taxation also. Now that is starting to sound pretty good! There are some rules you have to abide by—e.g., you generally cannot take withdrawals from the account until you are 59 1/2 and must have the account for five years—but these aren’t a problem for most people. This is sometimes called a “backdoor Roth” strategy, because it is a way for someone to contribute to a Roth who is otherwise prohibited by a high income level.

Advanced Tricks II: The Mega-Backdoor-Roth-Conversion

There is also the so-called “Mega-Backdoor-Roth-Conversion,” the pièce de résistance of completely legal maximization strategies for retirement savings. This is not available to all employees, but if it is available to you, it is worth considering. In a nutshell, this strategy typically piggy-backs on a 401k. You remember that you are allowed to make your own pre-tax contributions to the 401k up to $19,000 per year ($25,000 if you are over 50). But the IRS has another rule that states that the total of all contributions, from both employee (pre-tax and after-tax) and employer, can be no more than $56,000 per year ($62,000 if you are over 50). That gives you an additional $37,000 to work with, and if your employer makes no contributions, you can make up that entire additional $37,000 per year yourself, after-tax, if your plan allows it (not all plans do).

How does this strategy work in practice? You contribute $19,000 in pre-tax contributions ($25,000 if you are over 50), then up to an additional $37,000 in “after-tax” contributions and then, as soon as possible, roll over these after-tax contributions into a Roth IRA or a Roth 401k. Now you may think that after-tax contributions are not as attractive as the pre-tax kind, but remember that after they are rolled over into a Roth, you can withdraw the money and any growth on it (after age 59 1/2 and having the account for 5 years) tax-free! 

Some of these provisions can get pretty complicated, and it may be a good idea to consult a financial professional to see if you qualify for any of these special strategies for maximizing your retirement savings. But they are definitely worth looking into!