Second Thoughts – Tax Free Retirement

Yesterday I did something that I haven’t done in over a month. I woke up at 6:00 a.m., got dressed, and went to the office. Okay, let me stop lying. I haven’t done that in months. Even  when I had a job my mornings consisted of rolling out of bed around 7:59, scratching my ass, sleep walking to the second bedroom, and firing up my Surface. So why did I do without a job what I wouldn’t do with one? Because I had an interview.

Although I am currently without a job, I remain employed at my company for another three weeks and four days. During this “continuation” period I am able to apply for open roles, for which securing one would allow me to continue my employment uninterrupted. Unsurprisingly, many of my co-workers whose jobs were also eliminated have been scrambling over the last month to land another internal position. 

I have chosen to use my days in the productive pursuits of napping, keeping up with General Hospital, thinking about exercising (then deciding against it), finding free food, and napping some more. However, before this level of productivity could really take off I did apply for one job, a selling position on my mentor’s team for which he requested my application. I knew when I submitted my resume that I would make the final interview round. What I could not quite figure out was why. The role is not simply for sales. It’s technical selling, and while I have stellar chops at the latter requirement, that first part…

My mentor is a well respected person who has helped me navigate my career within a company and industry that were brand new to me. However, he is not the type to placate or throw bones. He knows as well as I do that my technical knowledge is pretty thin, especially when compared to my peers. With this in mind I didn’t think I had much chance of getting the offer. Add in the fact that a large part of me is disinterested in being employed and I admit that I did not expend as much effort as I normally would on interview preparation. Now, I do have a modicum of self respect so I watched a few product demonstration videos so as not to embarrass myself by looking completely incompetent.

As it turns out, my mentor did not get selective amnesia about my skillset when extending the interview invite. The job actually aligns very well with my previous experience and I have the resources to mitigate the gaps I do have while I fill them. 

Going into the interviews I knew that if offered the job I would have to take it lest I forfeit the severance package which not only includes enough pay to replace my salary for the rest of the year, but also six months of COBRA premiums (which ain’t cheap). When I thought that I was woefully unqualified for the job I figured I’d get through the interviews, get the “thanks but no thanks” response, and then ride off into the sunset of (f)unemployment to go do me for a few months. While I do not yet know the outcome of yesterday’s interviews, I would say that they went pretty well. Unlike before, I now reasonably believe that there is a good chance I will get an offer which would end my sabbatical before it could really start.

Although I would love to take the time to travel, build this site, and even open my own business, there are benefits to staying with my employer that I did not initially consider. Sure, there’s the paycheck, bonuses, and health insurance. However, those alone aren’t what is making part of me want to get an offer.

After tax 401K contributions, that’s what. Let’s talk retirement. For this discussion we’ll keep it simple and stick to saving for it. Unfortunately, Americans are woefully bad at this. The onus of remaining financially solvent through old age has fallen back to individuals, with tax advantaged brokerage accounts replacing pensions and retirement health plans. Although most employers no longer offer pension plans and Social Security benefits may not be guaranteed in the near future, almost 70% of people have $1000 or less in savings.

I am going to assume that if you’re reading Open Mouths Get Fed then you’re in the other 30% of the population and are saving for the day when you tell full-time employment to kiss your whole ass. Now the conventional wisdom is to contribute to the company 401K up until the match percentage is reached. For example, let’s say for every $1 you contribute to your 401K your employer will deposit $.50 into that account too, up to 6% of your salary. That means if you make a $75,000 salary then you can get up to $2250 in free money every year. Great! After saving enough to get all of the free money you can, the next step is to contribute to a Roth (or after-tax) retirement account up to the maximum of $5500/year. Once you’ve maxed out that savings vehicle you can then go back to your 401K and continue to make pre-tax contributions until you’ve saved $18,000. Across these two types of accounts a person under 50 years old can save $23,500/year toward retirement in tax advantaged accounts. Let’s say you start at 30 years old, at a conservative 5% annual return, by the time you retire at 60 you will have over $1.6MM. Alas, this savings strategy is not for everyone.

There are income limits for who can contribute to a Roth IRA. If you’re single and your AGI (adjusted gross income on your tax return) is $118,000 or more then that $5500 contribution limit is gradually reduced until AGI hits $133,000, at which point you can no longer contribute. For high income earners this leaves only pre-tax accounts (and whole life insurance) for tax advantaged savings. Or at least that’s what I thought until last week. I was reading Miss Mazuma’s latest post about early retirement and in-service rollovers (i.e. rolling over 401K funds to a traditional or Roth IRA while maintaining employment at the company). That post led me down a wondrous rabbit hole of links where I settled upon The Mad Fientist.

Okay, let me back up a second. So I know that I previously said that people with AGIs over $133,000 (single) and $196,000 (married filing jointly) cannot contribute to a Roth IRA to take advantage of tax free investment growth. Well, in actuality a lot of these people do so anyways through a “backdoor” IRA. Here is how it works. They’ll either 1) rollover funds from a traditional IRA or a 401K to the Roth and take the tax hit or 2) contribute after tax dollars to a traditional IRA or 401K and then roll those dollars into a Roth at a pro rata tax rate. Let me break down these options.

Option 1: Rollover funds from pre-tax retirement accounts to a Roth – Whenever money is withdrawn from pre-tax accounts (unless it’s going to another pre-tax account) then the withdrawal is taxed. If I withdrew $10,000 from my IRA in order to open a Roth, that withdrawal would be taxed as income at my marginal tax rate. Now once the money is in the Roth it can grow tax free.

Option 2: After tax contributions to pre-tax retirement accounts then rollover to Roth – Although the pre-tax contribution limit to a 401K is $18,000, the full amount of allowed 401K contributions per year (for a person under 50) is 54,000 and this includes employer and after tax contributions. So say you max out the pre-tax $18,000, your employer contributes another $6000 and you put in another $30,000 after tax, if you were to move the $30,000 into a Roth you would pay taxes on a pro rata portion of that money based on how much of your retirement account comes from post tax contributions. Let’s say this was your first year contributing to the 401K and your balance is that $54,000, 55% of of the money in your account is after tax contribution, 45% is pretax. When you roll that $30,000 in after tax contributions to Roth you would pay income tax on 45% or $13,500 of that money. As in Option 1, once those funds are in the Roth they will grow tax free.

Because of the tax hit I avoided after tax contributions to my 401K because they did me no good. The rollover to a Roth would trigger a taxable event, which at my income level is no bueno. And if I kept them in the 401K until retirement then I’d pay taxes again on the withdrawal. Until now. In 2014, the IRS released Notice 2014-54, which clarifies how after tax contributions should be treated. It is now possible to rollover the after-tax contributions (not the growth, just the principal) to a qualified Roth and not pay additional taxes.

Now the caveat is that your employer’s plan has to allow for after-tax contributions and in-service rollovers, but not many do. It just so happens that mine does. This means I could backdoor $27,000 per year into a Roth IRA to grow tax free until I retire. Mad Fientist explains it all in detail (with graphs to boot). This makes continuing employment much more appealing even if it’s only for a year or two. I currently have a traditional IRA which was rolled over from my first job. After raiding the 401K periodically over the years there was about $45,000 for me to move into the IRA. I did this in November of 2015 and have not put another dime into the account. As of today that investment has grown to about $52,600. That is roughly an 8% annual rate of return. If I made the maximum after-tax contribution to my 401K for two years and rolled over the principal to a Roth that I let sit for 20 years, then I’d have $251,692 at that same 8% annual return. Oh, and I could withdraw it all tax free.

Now this doesn’t mean that I have changed my mind about being (f)unemployed. I have not. What it does mean is that I wouldn’t be mad about going back to work for either. Having a plan makes having a job feel more purposeful than just working to pay bills. I don’t expect to get a definitive answer until the end of the week. I can’t say for which outcome I’m hoping, but I know that either way I’ll be 

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