Beyond 401Ks: Tax-Advantaged Investing With IRAs

This post is the first of a five-part series on tax-advantaged investing. Learn more in the Overemployed Discord channels #money-matters and #investing-circle.

Like it or not, taxes can have a huge impact on the Overemployed. One of the quickest ways to reduce taxes is to shield your income in tax-advantaged accounts, such as multiple 401Ks, individual (solo) 401Ks, and IRAs — this is the first step.

As noted in maximizing multiple 401Ks, one of the biggest perks of having multiple jobs is having multiple 401K matching. These are basically free money from employers. And if you’ve got a side-hustle or business income, then you can contribute up to 25% of net profit into a solo 401K up to $61,000 in 2022. Finally, if you have some money leftover — and chances are you do with a double income — you can put the money into an IRA. But there is a catch…

Once you start making over $214,000 in 2022 (and 99.9% of Overemployed Families do), you’ll hit the IRA income limits on contributions and deductions. In this article, I’ll break down the options available to the Overemployed Family. Spoiler alert: as it stands, the Build Back Better Act will eliminate the backdoor and mega backdoor Roth.

Bottom line: investing in tax-advantaged accounts allows for tax-free compounding, resulting in greater asset growth over time. If you’ve got the means, you should consider tax-advantaged investing as a way to tax-hedge your portfolio.

Why You Should Maximize Tax-Advantaged Investment Accounts With A Double Income

The better question is why not! Once you’re debt-free with an emergency fund, the next best action is to put your pre-tax income into tax-advantaged accounts. As a former investment banker, I can unequivocally say the tax shield is your friend. Use it!

1. Tax-advantaged investing has three attributes: tax-free contributions, tax-free compounding, and tax-free withdrawals. In most cases, you’ll pay taxes only once, upfront at time of contributions or during withdrawals. Keep in mind the penalty-free withdrawal age is 59 1/2. The only exception is the HSA, which hits all three of the tax-advantaged attributes when withdrawn for qualified medical expenses.
   
2. Each pre-tax dollar contributed saves you somewhere between 35-37% in federal taxes, in addition to state taxes if applicable. This assumes pre-tax contributions come from income over $215,950 for single and $431,900 for married filing jointly, where the 35% marginal tax bracket starts. For example, a $20,500 pre-tax 401K contribution will save a 35% tax bracket earner $7,175 in federal taxes alone. Similarly, a $6,000 pre-tax IRA contribution will save the 37% top bracket earner in $2,220 in federal taxes. Wow! Now imagine the tax savings on a $61,000 pre-tax contribution to your solo 401K as a self-employed contractor…

Tax-advantaged accounts are basically government-subsidized incomes starting at age 59 1/2. But who said you have to stop working at 59 1/2? The longer you work (W-2 or 1099 self-employed), the more money you get to invest inside tax-advantaged accounts.

Short Version: The Overemployed Options With IRA Income Limits

This short version assumes you’re already familiar with the differences between traditional and Roth IRAs. If not, read the long version.

Bottom line: IRAs are like an extended 401K at the individual level. They’ve income rules limiting contributions (Roth) and tax deductibility (traditional). For the Overemployed Family making over $214,000 in 2022, your options are:

Option #1: Make an after-tax contribution to a traditional IRA and then immediately convert to a Roth IRA. The reasons to do this are so earnings will forever be tax-free and Roth income limits on contribution are bypassed. This is the best option for 2021 but will likely not be around in 2022 and beyond.

Option #2: Start a side hustle or J2 contract to generate self-employed 1099/business income. Then, open a solo 401K and contribute as your own employer up to the limit of $61,000 in 2022. The unique thing about being self-employed is you’re considered both as an employee and an employer for tax purposes. The only stipulation is your contribution is limited to 25% of net profit (oversimplifying but close enough). So if you generate enough of a net profit, then you can easily bet the IRA contribution limit of $6,000. Moreover, the solo 401K does not have income limits on contributions and all contributions are tax-deductible. There’s also a Roth version. It’s like the US government is incentivizing us all to be contractors and entrepreneurs and to stuff our solo 401Ks!

Option #3: Make an after-tax 401K contributions, if offered by your employer’s retirement plan. This is the next best option to get a significant sum ($61,000 contribution limit) inside a tax-advantaged account. During withdrawals, after-tax contributions will be tax-free while earnings will be taxed as ordinary income. Also, keep in mind that future tax laws will likely close the loopholes on after-tax conversion to a Roth IRA. You’ll be stuck with rolling this “after-tax” 401K into a traditional IRA when you leave your employer. But tax-free compounding is still a nice perk. You just won’t get tax-free earnings at the time of withdrawals. Make sure to keep good records of your after-tax contributions. You don’t want to end up paying taxes twice!

Option #4: Similar to the after-tax 401K option but at a smaller annual rate of contribution. Here you make an after-tax contribution up to $6,000 to a traditional IRA and keep it there — the least desirable option. Keep in mind future tax laws will likely prohibit converting after-tax contributions to a Roth IRA. However, if you don’t have business income or employers with after-tax 401K contributions, then this is likely the default option for many families making over $214,000 in W-2 income. Look, it’s still good to have tax-free compounding, just know the earnings will get taxed as ordinary income during withdrawals. Make sure to keep good records of your after-tax contributions.

Long Version: Differences Between Traditional And Roth IRA

The key difference between traditional and Roth is “when have you paid your taxes?” Roth has more flexibility due to its post-tax treatment. Now let’s dive in.

Key Facts: Traditional IRA

Traditional IRAs are tax-deferred, meaning your contributions can be deducted from taxable income for an instant tax break. However, the tax deductions are dependent on your tax filing status (e.g. single, married filing jointly, etc.), income level, and if you and/or your spouse have an employer-provided retirement plan. These complicated rules are precisely why I recommend the solo 401K for high-income earners. It’s like having your own IRA but following the 401K rules.

• Contribution limits. There are no income limits to open and contribute to a traditional IRA. Annual contribution limit is $6,000 in 2022 (and $7,000 if you’re 50 or older). Your IRA contribution limit is separate from any contributions you’re making to a 401K or other non-IRA tax-advantaged accounts. Generally, you (or your spouse) must have earned income to contribute to an IRA. You cannot contribute more than what you’ve earned. You can, however, contribute to a non-working spouse’s traditional IRA when your tax filing status is married fiiling jointly. Again, lots of rules and exceptions.
  
• Contributions may be tax-deductible. For the Overemployed high earners, you’ll likely not get a tax break but instead will have to make after-tax contributions. For 2021, you can still convert this after-tax contribution into a Roth IRA immediately to pocket the forever tax-free earnings. This tactic is commonly known as the backdoor Roth since the Roth IRA has an income limit on contribution (what?!?) but the traditional IRA does not. I don’t make the rules, I just follow them. And the rules might be changing soon.
  
• Withdrawal rules. You can withdraw contributions and earnings penalty-free starting at age 59 1/2. Both will be taxed as ordinary income. Early withdrawals before 59 1/2 may be taxed as ordinary income with an additional 10% penalty. The penalty can be waived for exceptions like buying a home for the first-time or paying for qualified educational expenses but I don’t recommend taking these actions. Lastly, if you’re a money horder like me, then IRS will required you to start takin required minimum distributions (another word for withdrawals) starting at age 72 (I’ll make the safe assumption that 99.999% of Overemployed is born after July 1, 1949). Note this rule also applies to any 401Ks.
  
• Rollover. You can also roll your 401Ks and other retirement accounts into to your traditional IRA (and then convert to a Roth IRA if you so wish). Any after-tax portion will need good record keeping, which an IRA custodian like Vanguard, Fidelity, etc. should be able to track diligently for your annual tax filing and tracking your after-tax basis on IRS Form 8606.
  
• You invest the money in your account. You can invest in stocks, bonds and other assets. How much your account grows per year and whether you lose money depends on how you invest.

Key Facts: Roth IRA

Roth IRAs are basically the “pay now, save later” cousin to the “tax break now, worry later” traditional IRA. The general rule of thumb is to do a Roth when you’re in a low-ish tax bracket. More importantly, the Roth has post-tax withdrawal flexibility that the traditional IRA lacks.

• Contribution limits. For families making over $214,000 in 2022, you can forget about the Roth since that’s likely going away with the new tax laws. Like traditional, you (or your spouse) generally must have earned income to contribute to an IRA. You cannot contribute more than what you’ve earned.
  
• Contributions are NOT tax-deductible Enough said. Pay upfront, and you’re done with taxes forever.
  
• Withdrawal rules. Contributions can be withdrawn anytime penalty and tax-free after a five year waiting period. Earnings can be withdrawal penalty and tax-free after age 59 1/2. Exceptions are given for buying a home for the first-time (up to $10,000) or paying for qualified educational expenses. There’s no required minimum distributions after age 72. Hands down, the Roth IRA is the best place to do forever tax-free investing.
  
• Rollover. You can also roll your 401Ks and other retirement accounts into to your Roth IRA but beware of tax implications. Future tax laws might put a stop to after-tax contributions from rolling over into a Roth IRA.
  
• You invest the money in your account. You can invest in stocks, bonds and other assets. How much your account grows per year and whether you lose money depends on how you invest. Just remember, you’ve already paid taxes on these monies, so try not to lose it all.

Key Differences Between Traditional and Roth IRA

• Roth allows for early access to contributions penalty and tax-free before age 59 1/2. This early access also applies to 401Ks/traditional IRAs converted to a Roth IRA, a strategy known as Roth conversion ladder. More on this in Part Two.
  
• Roth does not require minimum distributions (RMDs) starting at age 72 (for those born after July 1, 1949). In fact, Roth IRAs do not require withdrawals until after the death of the owner. Yay to more tax-free compounding?
  
• Inherited Roth can be withdrawal at the very last day of the 10-year period per the SECURE Act of 2019. This is where the Roth outshines traditional IRA due to taxes. With Roth you don’t have to withdraw regularly to “stretch” your taxes over a 10-year period.
  
• Traditional IRA is available to everyone at all income levels to make contributions. Roth has income limits on contributions. Forget about the Roth IRA if your family make over $214,000 in 2022 with the backdoor loophole closing.
  
• Roth IRA income limit can be circumvented while the backdoor loophole remains open. All it involves is filling out IRS Form 8606 during tax filing, and converting post-tax traditional contributions to Roth. This is a loophole used by joint filers with income over $214,000 or single filers over $144,000. Note: tax law changes may be closing this loophole soon.

Closing Thoughts

My recommendation is to pick one, traditional or Roth, and stick with it. I was once a lowly paid entry worker, so I started a Roth and have stuck with it ever since. Later, as my income grew, I started learning about the Roth backdoor and solo 401Ks If you’ve got a Roth, try to avoid rolling over your 401Ks into a traditional IRA due to the IRS pro-rata rules when doing a conversion from a traditional to Roth IRA. But that was the pre-Overemployed era…

For the Overemployed and the coming tax law changes, I’ll admit the IRA has lost a bit of its luster. Better to hedge with a W-2 J1, a self-employed J2, and growing a side hustle into a high six-figure business. That way, your can control your destiny with multiple employer-sponsored 401Ks and padding your solo 401Ks. You’ll not only get a tax break upfront but also tax-free compounding at scale.

More Tax Rants

US taxes is one of the lowest amongst developed countries. Meanwhile, US tech workers earn one of the highest salaries in the world. Stay grateful, keep earning, put your money into tax-advantaged accounts.

For doting parents, there are creative ways to funnel 1099 or business income to their kids’ IRAs. You can hire and expense them as a personal bookkeeper or administrative assistant. Yes, clean the dishes kids, and we’ll fund your IRA.

US tax laws favor business owners when it comes to solo 401Ks and IRAs. And yes, contractors on 1099-MISC income are small business owners operating Family Inc.

Afterword

Read the caveats. When in doubt, consult a fee-based financial planner, and think for yourself.

Caveat #1: We assume married filing jointly for the Overemployed family. Tax-advantaged accounts are inflexible due to the hefty early withdrawal penalty (10% for IRAs). It’s important to craft a financial strategy with both flexibility and tax efficiency in mind. My recommendation is to find work you enjoy and stay leisurely Overemployed (10-15 hours per week) beyond 59 1/2.

Caveat #2: If you’re currently saving for a home or emergency fund, then you should pursue tax-advantaged investing in parallel. As with everything, there are tradeoffs.

Caveat #3: Future tax law changes are coming. I’ll make an update to this post once the Build Back Better Act passes, likely with revisions. For now, use the information provided with care.

Over the next few weeks, this series will cover:

• Roth IRA conversion ladder and the mega backdoor Roth (while it’s still available)
• HSA (health savings account)
• 529 education savings plan
• Real estate (yes it has many tax advantages too)