It may seem counterintuitive, but saving for retirement as a high-income earner can be a bit trickier than it is for the average American worker. Not only are you tasked with saving more income to match or enhance your current lifestyle in retirement, but income caps and contribution limits on traditional and Roth accounts put hurdles in the way of saving enough to do so.
Of course, as you’ve probably heard, it is prudent to max our your 401k contribution first, at least up to your employer match. You’ll be hard-pressed to find another tax-deferred savings vehicle that offers this immediate and consistent perk; however, you won’t want to stop there. Even making the maximum annual contributions to a 401k won’t likely be near enough to generate a comparable income for you to live on in retirement.
So how should high-income earners prioritize their savings goals once they have maxed out their 401k contributions?
The answer is by working backwards, so to speak. Evaluate which accounts offer the most beneficial tax-advantages for your situation to guide you in the right direction. After all, the longevity of your retirement savings will partially depend on your ability to mitigate the taxes assessed on your income.
Essentially, there are three types of tax breaks on retirement savings vehicles and they are broken down as follows:
1) Tax-Free: Funds are taxed upon contribution and withdrawn tax-free. The tax break is offered on the tail end.
2) Tax-Deferred: Funds are allowed to grow tax-free year after year and are either taxed upon distribution or received tax-free if distributed from a Roth.
3) Tax-Deductible: Contributions are made pre-tax. That is, any contributions you make are deducted from your taxable income, but the income is taxed upon withdrawal. The tax saving is offered up front.
A sensible planning strategy is to take advantage of as many of these tax-breaks as possible. If you are able to generate income from some accounts that are tax-free, some that are tax-deferred, and some that are tax-deductible, you can work to spread your tax liability out over time.
Which accounts offer which tax-breaks?
Almost all retirement savings vehicles offer the second tax-break—tax-deferred growth. This is even true of brokerage accounts where taxes aren’t assessed on gains made within the account until the funds are distributed as income.
Deciding where to save your excess income, then, involves building a hierarchy of savings vehicles based on your tax planning needs. To do so, you will evaluate when you prefer to pay taxes—up front on the contributions, like in a Roth account, or upon distribution, like in a traditional IRA account. This will largely depend on which tax-breaks will save you the most money both now and in the future. Each individual’s situation will be unique, so you’ll want to consult with your financial advisor to help you decide the best mix of investment vehicles.
Tax Break in Retirement: Roth IRAs
As a general rule of thumb, contributing to a Roth-style account is the best first investment vehicle to choose after maxing out a 401k. Why? Most individuals anticipate earning a higher income in retirement due to their longevity in the workforce and growth of their investments over time. Having the tax-free income that the Roth affords can drastically decrease your taxable income and possibly even keep you in a lower tax bracket, as well.
However, there is one caveat. Most high-income earners make too much money to qualify to open a Roth IRA. You can, however, perform what are known as Roth IRA rollovers multiple times over the course of your lifetime to create that coveted tax-free investment income. Rollovers can be tricky, though, so consult with your financial advisor about the feasibility of including this in your plan.
Tax Break in the Working Years: Traditional IRAs
Traditional IRAs do not impose the same type of income caps as Roth style IRAs, but income from this source will be taxed in retirement, much like with your workplace 401k. While the contributions may offer a tax break in the present, this income source could cause your retirement income tax to spike, thus putting a drag on your take-home income. If, however, the tax break in your working years saves you enough money that you can invest more elsewhere, it may be wise to explore this option.
The Triple-Tax Break: Health Savings Accounts (HSA)
There is one special account known as an HSA, or Health Savings Account, which offers all three tax-advantages. HSAs allow you to make pre-tax contributions, enjoy tax-deferred growth, and withdraw the money tax-free when the funds are used to cover qualified medical expenses. While this sounds like an amazing deal, it is only available to individuals who carry High-Deductible Health Plans (HDHP).
An added bonus is that HSAs aren’t tethered to your current employer. Even if you open your HSA while participating in your current employer’s HDHP, but switch places of employment down the road, you won’t lose access to your HSA or the funds invested in it. The funds you invest in your HSA will reduce your taxable income now, allow for tax-free growth, and provide a great source of income to cover medical expenses in old age when those costs (and the need for care) tend to rise the most.
Thinking Outside the Box
Of course, retirement accounts aren’t the only way for high-income earners to save and build wealth for the future. Brokerage accounts, life insurance policies with cash value, real estate investments, and trusts are also excellent wealth-building options to add to your portfolio. And for those individuals with a significant legacy to bequeath, dynasty and grantor trusts can be set up to provide tax-free growth for future generations.
Each investor will begin the savings process with different resources, needs, and goals than the next, which is why major money moves such as these should never be made in isolation, but in the context of your overall financial framework.
Unsure how you should prioritize investments outside of your 401k?
RiversEdge Advisors can help. Visit our website today to schedule a complimentary Discovery Call. See if our RiversEdge team could be the right fit for you in fulfilling your retirement and financial planning needs.