Why the interest in 401k limits? Well, we found out that my wife now gets a company match to her 403b retirement plan. Score! I then wanted to explore how to maximize both our $16,500 401k limits and the company match.

Example: Maxing Out But Missing Out Too

You make $120,000 per year and get a full 3% company match during each pay period. Let’s just say you get paid $10,000 gross monthly. However, you are a really motivated saver and can defer 20% of your income each month into the 401k.

For the first 8 months of the year, you put away $2,000 (20% of $10,000) and the company matches $300 (3% of $10,000). That’s brings you to $16,000 in salary deferrals. On the 9th month you can only contribute $500, which the company also matches $300 again. On the remaining 3 months of the year, you can’t contribute at all, so there is nothing to match! Even though you contributed significantly more than 3% of your salary, you’ll miss out on $300 x 3 = $900 of free money.

Solutions and Potential Problems
The solution is usually given to space out your salary deferrals evenly throughout the remainder of the year. For the above example, you would divide $16,500 by 12 = $1375 each month. If you can only set percentages, you’d set aside 13.75% each month ($1,375 / $10,000).

The problem with this is that for those people who earn hourly wages, overtime, or bonuses, it can be hard to synchronize. Get paid too much, and you’ll lose match again. Get paid too little, and you might max out your match, but not fully reach the $16,500 limit. Also, if you quit or are laid off before the end of the year, you might not be able to reach the limits either.

My tweaked solution. I would vary the percentage so that you always contribute at least 3% each pay period the entire year, but otherwise front-load contributions early on. Again with the example, you could set aside the $2,000 per month for 6 months, and then put in $750 per month for 6 months. Percentage-wise, this is 20% for first half the year, and then 7.5% for the last half. This way, you are balancing getting your annual limit maxed out as closely as possible, along with getting all the available match.

True-Up Contributions

But before going too far, you should ask your benefits administrator whether they offer what is called “true-up” contributions. What this does is compare your year-to-date (YTD) contributions to your YTD salary. If you contributed at least 3% of your YTD salary, but did not receive a 3% company match, then they will send in an additional contribution to “true-up” the numbers.

Some companies perform this true-up calculation after every pay period, while others wait until the end of each year. If they true-up every pay period, then it would seem to be a good idea to contribute as much as you can as early as you can – you’ll get the full year’s match early this way.

Our company does one true-up after the end of the year, and the credit doesn’t show up until March. However, I was also told that if you aren’t employed in March, you won’t get this credit. So again, the front-load with minimum method might be the best idea to get your match as it comes available.

As I write this, I realize that I really overthink some of this stuff. What can I say, I’m excited about our new match, and I just can’t help myself!

So you listened to the financial experts and dutifully contributed $5,000 to your Roth IRA in early 2008. Unfortunately, stuff hit the fan and now you’re left with a lot less. Wouldn’t it be nice to be able to find some silver lining and shield another ~$1,000 plus earnings from taxes forever?

Well, here’s a slightly controversial idea that I ran across in this Boglehead Forum thread that might help you do just that. I think the easiest way to explain it is to continue with an imaginary scenario. Note that this leaves some variables in exchange for simplicity.

Example Scenario
Sometime in early 2008 you contributed $5,000 to your Roth IRA for the 2008 tax year. At the time, your IRA was worth $20,000 in total after the contribution. Now, in January 2009, the entire IRA is now worth $15,000.

You first “undo” your 2008 $5,000 contribution by following the same steps as someone who ended up being ineligible for a Roth IRA due to too much income*. Because your entire IRA account dropped by 25%, your $5,000 contribution is considered to have dropped by the same amount. You end up receiving a check for $3,750. You have received a return of your contribution, and have now technically contributed nothing to your 2008 Roth IRA.

Soon afterward, you simply open up a new IRA either at a new broker, or at your current broker if they are on the ball and have your 2008 total contributions as zero. (Otherwise they might throw a fit…) You can now throw in another $1,250 and contribute $5,000 again to your Roth IRA for the 2008 tax year before April 15th, 2009. Even if you just reinvest the $3,750 the same way as you did before, by using this strategy you have allowed another $1,250 to grow shielded from taxes, forever.

Is This Legal?
This is somewhat similar to the Traditional-to-Roth IRA reconversion method to save taxes. I read some skeptical posts in the BH thread as to the legitimacy of this action, but none were really backed by any evidence. I don’t see why both methods aren’t equally legal.

As another example, you might have made two separate $5,000 contributions by accident, and need to undo one of them. If everything is accounted for correctly by your IRA custodian, the IRS shouldn’t blink an eye. Here is another educated discussion in support of this idea. Other tax pros please add your thoughts in the comments below.

We ended up not being eligible for a Roth IRA this year, but if I was a candidate I think I would take advantage of this idea. In the long run, even stuffing another $1,000 in a Roth could save a lot of money in taxes.

* More information on correcting excess contributions in this Investopedia article. It must be done by the owner’s tax-filing deadline, which usually April 15, 2009 unless you file for an extension. Note that this is not the same as taking a distribution.

In my last post on 2009 marginal tax rates, reader Alexandria (aka MonkeyMama) made a very good point that planning our retirements around future tax brackets is very difficult as they change all the time. But isn’t that what we are forced to do every time we contribute to a IRA and/or 401k? We can either pay tax now (Roth), or pay tax later (Traditional). In any case, I figured I should look into this more.

I previously explored this area in my post about historical marginal tax rates vs. median income. There, I concluded that at my current high income level, my personal tax rates would probably go up in the future. Now why might I change my mind?

Total Federal Tax Rate vs. Income Group
More recently, the NY Times published the following graph that plots the total federal tax rate vs. income starting from the 1960s. Total federal tax rate includes income taxes and also things like payroll taxes and capital-gains taxes.

As you can see, tax rates as a whole have been dropping recently and are relatively low compared to the past. I would also note that the total tax rate at the median income group (middle 20% line) has varied very little over the last few decades, hovering around 18-20%.

Federal Income Taxes For Median Family
Next, here is a 2006 chart from the Center on Budget & Policy Priorities, which is based on Treasury Dept. data. The Center estimates that the median-income family of four will pay only 5.6 percent of its income in federal income taxes in 2006, the lowest since 1955.

As you can see, the range for this median family has stayed between 6 and 12%.

My short take. Tax rates right now are historically low. Given this and all our future governmental obligations, they will most likely go higher. However, future tax hikes will probably be more heavily placed on high income earners as opposed to those earning at the median or below. The tax rate paid by the “middle class” tends to stay in a relatively low and narrow range.

Everyone’s situation is different. Right now, we are earning in the top 5% or so. But in retirement, I think we can easily fit into this median group, especially if the mortgage is paid off. So even though the future is unknown, my bet is that our tax burden will decrease upon retirement.

If you did a Traditional IRA to Roth IRA conversion in 2008, and have since suffered some significant losses, you may want to consider undoing the conversion now that it is 2009. Then, as long as you wait 30 days after that and still qualify, you can redo the conversion again. This way, you only owe income taxes on the lower amount.

This Roth IRA conversion “do-over” is discussed in this CNN Money article, which included a helpful example scenario:

One of the main considerations are that you want to make sure your losses are enough that they likely won’t be recouped in the 30 days you are “out” of the market. One option is to re-invest the money in a taxable account during that period, but you’d be subject to more potential losses, as well as taxes on gains.

Another consideration is that you are essentially doing a entirely new 2009 conversion. You’ll have to again meet the income limits, and make sure your new tax bracket is acceptable to you. I did a Traditional to Roth IRA conversion in 2007 and shared my decision process, including the eligibility requirements and how to pay for it. There are more details on reconversions in this Fairmark article.

Next up: Controversial ways to deal with other Roth IRA losses.