I Maxed Out My Retirement Funds—What Now?

So. You’ve maxed out your 401(k) and IRA.

Big deal.

No, really. It’s a big deal! Before we move forward, let us take a moment to congratulate you. You’re in amazing financial shape, and you should be proud.

“Maxing” isn’t the same as “finishing,” though. Unfortunately, “finished” isn’t a word we often hear in relation to personal finance. There’s always more you can do.

And this time around, after maxing out your existing accounts, you can actually keep contributing—by opening a non-deductible IRA.

The Fourth Account

We often talk about three main types of retirement accounts: the 401(k), the Roth IRA and the traditional IRA. The one we don’t often mention is the non-deductible IRA, which is simply a traditional IRA where you don’t get tax deductions for your contributions.

There are two specific situations where you would open a non-deductible IRA: If you’ve maxed out your 401(k) and your Roth (the law says if you’re covered by a 401(k) at your place of employment, you can’t have a traditional IRA as well), or if your income exceeds the limits for both traditional and Roth IRAs.

Basically, the non-deductible IRA allows anyone to contribute $5,000 per year. The money isn’t taxed until you take it out, at which point taxes are due on any investment gains–but not on what you contributed, since that was taxed when you contributed originally. It isn’t nearly as good a deal as a Roth, where you’re never taxed on the investment earnings, or a 401(k) with any amount of company matching, so we recommend it only as a backup.

But since there is no income limit to use a non-deductible IRA, it can be the only option available once your income rises above the IRS limits. For a single person, an income over $125,000 in 2012 means you can’t do the Roth IRA or the traditional IRA, but you can still go the non-deductible route. For a married person, an income of $183,000 phases you out of the Roth and traditional. (There are income limits for both types of accounts, but Roth is higher.)

Converting a Non-Deductible IRA to a Roth IRA

If you are earning too much to contribute to your Roth IRA, the non-deductible IRA can be a handy loophole. You can convert a traditional or non-deductible IRA to a Roth each year no matter what your income. Even though your high income disqualifies you from traditional or Roth IRAs, you can still contribute to a non-deductible IRA, then convert it and violà: You have a Roth IRA after all!

The best part is that there are little to no conversion taxes to pay. Usually, when you convert money from a traditional IRA to a Roth IRA, you have to pay taxes on the entire balance, meaning the contributions plus the investment earnings. But if you convert quickly (there is no mandated waiting period), you likely won’t have any investment earnings to be taxed, either. Between the taxes you’ve already paid on the contributions and the minimal investment earnings, you’ll owe very little in conversion tax.

To convert either type of IRA to a Roth, you need to call up your account holder (such as Vanguard) and file paperwork both with them and with the IRS. You’ll need to file form 8606, but let your representative guide you.

Non-Deductible IRA or Investment Account?

Since a non-deductible IRA isn’t the most rewarding of retirement savings vehicles, it seems like opening a taxable brokerage account in its place could be a better move. But actually, if you know you’ll be using those funds for retirement, the non-deductible is better.

This is because the money, although it will be taxed upon withdrawal, will grow tax-deferred while it’s in the account. In contrast, any realized gains from money in a brokerage account are taxed the year they’re made. For example, if you rebalance your portfolio and buy or sell stocks in a brokerage account, you could be subject to a capital gains tax.

So it’s helpful that money in a non-deductible IRA is not taxed until you take it out. It is subject to strict early withdrawal penalties from the IRS, which makes it a lot harder for you to access before retirement, and that can actually be a good thing, because it ensures that the money is there when you need it.

As we said: always more to do.