Retirement Accounts

This post is for knowledge sharing only. It is not intended to be investment or tax advice.

0. Account Overview 

Table 1 Common retirement  accounts in U.S.

I summarizes the common retirement accounts in Table 1: 

  • The second row in Table 1 lists the company-sponsored accounts that are offered through employers.
  • The third row in Table 1 lists the individual retirement accounts (IRA) that is unrelated to employments.
The columns in Table 1 are about different tax advantages as described below. WARNING: because of the tax advantages, there are also limitations and specific rules imposed by IRS for early withdrawal before the retirement age.
  • For accounts listed in the second column, 
    • Contributions are made with before-tax dollars.
    • The money taken out will be taxed as regular income in the year of withdrawal.
  • For accounts listed in the third column, 
    • Contributions are made with after-tax dollars.
    • The money taken out is tax free.
  • For after-tax 401K in the fourth column,
    • Contributions are made with after-tax dollars.
    • When taking money out, only the earnings will be taxed.
Among all the accounts in Table 1, there are two accounts that are of great importance:
  • Pre-tax 401K: One of the very a few tax shelters for W2 workers.
  • Roth IRA: A tax-free investment account. Consider to fund this account before ordinary brokerage accounts for long-term investments.

Remarks on after-tax 401K:

  • A common mistake is to confuse Roth 401K and after-tax 401K. Almost all companies offer both pre-tax 401K and Roth 401K. But not everyone company offers after-tax 401K.
  • See this post for a list of some tech companies that provide after-tax 401K.
  • In practice, the only reason to contribute after-tax 401K is to do mega backdoor as introduced in Section 4.

1. Highlights on Contribution 

401K

IRA imposes two limits on annual 401K contributions that can not be exceeded at the same time: \begin{eqnarray} \text{ Pre-tax 401K } + \text{ Roth 401K } &\leq& M_1\,,\tag{1}\\ \text{ Pre-tax 401K } + \text{ Roth 401K } + \text{ Employer Match } + \text{ After-tax 401K }  &\leq& M_2\,,\tag{2} \end{eqnarray} where the amounts $M_1$ and $M_2$ are adjusted each year by IRS. In 2024 for example, $M_1=\$23,000$ and $M_2=\$69,000$.

In practice,
  1. Contribute first to pre-tax 401K and/or Roth 401K to get the free money from employer match. The contribution amount is bounded by Eq. (1).
    • At least contribute the required amount for the full employ match.
    • For high-income earners, simply max out pre-tax 401K, as discussed in Section 2.
  2. Then contribute to after-tax 401K (if available) for mega backdoor as discussed in Section 4. The maximal amount contributed to after-tax 401K can be calculated by Eq. (2).

IRA

IRS also imposes a limit on annual IRA contributions: \begin{equation} \text{ Traditional IRA } + \text{ Roth IRA } \leq M_3\,,\tag{3}\end{equation} where the amount $M_3$ is adjusted each year by IRS. In 2024 for example, $M_3=\$7,000$.

Unlike 401K, there are additional requirements on the IRA contributions based on the income (or MAGI, strictly speaking). For example,
  • IRS does NOT allow high-income earners to contribute to Roth IRA. See Roth IRA contribution limit for details.
  • High-income earners are free to contribute to traditional IRA, but they not able to deduct the contribution amount from their annual income. See IRA deduction limits for details.
Important:
Instead of contributing directly to Roth IRA, high-income earners have to use Roth backdoor as described in Section 3.

2. Pre-tax 401K or Roth 401K?

Theoretically, whether to choose pre-tax 401K or Roth 401K depends on the comparison between the marginal tax rate in the year of contribution and the expected marginal tax rate in the future year of withdrawal.

In practice, for high-income W2 workers, assuming 37% federal marginal tax rate plus10% CA state marginal tax rate, simply consider to max out pre-tax 401K since the current marginal tax rate already reaches the highest tax bracket. 

While maxing out pre-tax 401K each year, do plan ahead to reduce the marginal income tax rate in future years of withdrawal. For example,
  • Eventually transit family financial status from high income with low net assets to low income but with high net assets. It is worthy learning "buy, borrow and die" for details.
  • Take every opportunity or retire early to create such opportunities to rollover some of the balance from pre-tax 401K to Roth 401K/IRA in the years when the taxable annual income (including the rollover amount) is low.
    • This is important given the existence of Required Minimum Distribution (RMD): Once reaching the age of 72/73, one will be forced by IRS to withdraw all the money out of pre-tax 401K within certain years.
  • Retire outside of California to avoid CA state income tax.

3. Roth Backdoor

The so-called Roth backdoor is a strategy for high-income earners to put money into Roth IRA:
  1. Open an traditional IRA account and a Roth IRA account (better at the same provider) if you don't have one. 
  2. Contribute the amount of annual limit $M_3$ in Eq. (3) to traditional IRA (NOT Roth IRA).
  3. Convert all the amount in traditional IRA to Roth IRA.
See this article for step-by-step instructions of Roth backdoor with Fidelity.

Remarks:
  1. For high-income earners, the contribution to traditional IRA is after-tax dollars. As a result,
    • The contribution cannot be deducted from annual income.
    • The contribution is "nondeductible" when reporting Roth backdoor in tax return using Turbotax.
    • When converting from traditional IRA to Roth IRA, only the earnings will be taxed.
  2. To minimize the tax on the earnings, convert immediately once the contribution made into the tradition IRA is ready to be moved.
    • The legality of backdoor has been confirmed by the Congress in the Tax Cut and Job Act (footnote 268 and 269 on the bottom of the page 289).
  3. Keep the traditional IRA clean, i.e. do NOT contribute any before-tax dollars such as converting pre-tax 401K to traditional IRA when leaving a job. Otherwise, one has to follow the pro-rata rule of Roth conversion.
  4. Note that Roth backdoor is a conversion instead of contribution, keep in mind that there are additional withdrawal rules for Roth conversion as compared to Roth contribution.
Notes on IRA provider:
  • One is free to open many traditional and/or Roth IRA accounts at different providers like Vanguard, Fidelity, Charles Schwab, etc. But all the opened traditional (Roth) IRA accounts should be considered jointly as a single traditional (Roth) account when following IRS regulations.
  • Personally, although I opened my first traditional and Roth IRA accounts at Vanguard, I now find that Fidelity is a better choice:
    • Fidelity also offers many low-cost or even cheaper mutual funds and ETF as compared to Vanguard (for example, FXAIX vs VFIAX and IVV vs VOO).
    • More importantly, when you move the Roth IRA to another place, for example, for relationship mortgage discounts, Fidelity is more likely to support direct electronic transfer of the assets while Vanguard needs to sell your assets and mail a check.

4. Roth Mega Backdoor

If the employer offers after-tax 401K (NOT Roth 401K), one can rollover much more money into Roth IRA besides backdoor using the so-called mega backdoor:
  1. First contribute to after-tax 401K;
  2. Then rollover the money from after-tax 401K to Roth IRA.
Here are my steps on Roth mega backdoor with Fidelity:
  1. Open a Roth IRA account at Fidelity if you don't have one.
  2. Set the contribution percentage to after-tax 401K. When maxing out after-tax 401K, it will take several payrolls to complete all the contributions.
    • I usually complete all the contributions within the first three months of a year.  So plan ahead for the cash flow since there will be no money taken home from paychecks in these months.
    • (Optional) Set the investment in after-tax 401K to be different from the investments in pre-tax 401K or Roth 401K like money market funds.
  3. After each payroll's contribution to after-tax 401K, immediately call Fidelity custom service and ask for a rollover from after-tax 401K to Roth IRA also at Fidelity.
Remarks:
  • For the rollover from after-tax 401K, only earnings get taxed. Reporting mega backdoor in tax return is much easier than backdoor: simply import the 1099-R form issued by the 401K administrator in Turbotax.
  • Some 401K administrators charge a fee for the rollover. In this case, there is a tradeoff between the fee and the possible tax on the earnings:
    • One may consider a one-time rollover after all the contributions are made to save the fee.
    • On the other hand, the longer the money stays in after-tax 401K, the more earnings could be generated.
  • Some 401K administrators including Fidelity provides Roth in-plan conversion. The best advantage of this feature is full automation. However, the in-plane conversion is to Roth 401K instead of Roth IRA. Here are some differences between Roth 401K and Roth IRA:
    • Some Roth 401K is NOT allowed to rollover to Roth IRA during the employment.
    • 401K is protected from creditors while IRA assets qualify for relationship mortgage discounts.
    • Most importantly, there are fewer investment choices in Roth 401K than that in Roth IRA, if without BrokerageLink.

Location: 美国加利福尼亚帕罗奥图

Comments

Post a Comment

Popular posts from this blog

529 Plan

This post is for knowledge sharing only. It is not intended to be investment or tax advice. 529 Plans are tax-advantaged accounts specific for education saving: Contribution are made with after-tax dollars. Growth within the account is tax-free. Withdraw for qualified education expenses is also tax free. Roth IRA First 529 Plans are very similar to Roth IRA . But Roth IRA withdraw under  the 5-year rule  is tax free for any purpose. Therefore, unless for the state tax deduction in some states, it is always better to max out Roth IRA first (through backdoor and mega backdoor  for high income earners) before funding a 529 plan. Note: there is NO California state tax deduction for any 529 plan. 529 or Not? Here are some considerations in reality before funding a 529 plan: What if no qualified education expenses In the worst case that there will be no qualified education expenses, you can still take money out for non-qualified expenses, but you have to pay: federal income tax + 10% federa
Read more

How to offset W2 tax

This post is for knowledge sharing only. It is not intended to be tax or investment advice. 1. Contribute to pre-tax 401K and HSA As well known, pre-tax 401K and health saving account (HSA) are the only a few tax shelters for W2 workers.  2. Tax-loss harvesting If your total capital losses exceed your capital gains in a tax year, you can deduct up to \$3,000 (married filing jointly) from your ordinary income. If your losses are more than $3,000, you can carry over the remaining amount to future years, continuing to offset your income until all the losses are used up. A popular method to generate these deductible losses is  tax-loss harvesting . This involves selling a security at a loss to offset gains or reduce ordinary income, and optionally purchasing a similar, but not "substantially identical", security to avoid missing out on the market. However, be aware of the  wash-sale rule , which disallows claiming a loss if you buy the same or a substantially identical security
Read more