While this may sound counterintuitive, saving and investing for high-income earners is no easy task. Sure, you might earn a hefty income, but what is the best way to invest it to prepare for a successful retirement?
401(k)s tend to be one of the most popular savings tools for a number of reasons. Not only do they generally come with an employer match when offered through work, but they are also tax-advantaged. Contributions made to 401ks grow tax-deferred and are tax-deductible if you make a pre-tax election. In some cases, your employer may offer a Roth 401k in which your contributions would not be deductible and taxed upon withdrawal.
But contribution limits on these accounts make them insufficient retirement savings vehicles for high-income earners. The challenge, then, is deciding where to invest next that will minimize your tax liability over time and maximize savings potential.
Mind Your Taxes
One way to prioritize savings vehicles is based on your current and future tax liabilities. In doing so, you’ll want to keep a long-term view in mind. Sometimes it may be best to prioritize tax savings upfront, while other tax breaks will be best to save for the future.
Essentially, each account falls into one of three categories:
(1) Taxable (bank accounts or brokerage accounts)
(2) Tax-deferred (such as traditional IRAs or 401(k)s and other employer plans)
(3) Tax-free (from Roth IRAs or Roth employer plans)
It’s typically best to spread your tax liability out over your lifetime, rather than becoming “tax-deferred rich” and footing the entire bill in retirement. So, once you’ve maxed out your 401(k), you may consider the following savings vehicles for their specific perks and tax advantages.
Health Savings Accounts (HSAs)
Health Savings Accounts (HSAs) are championed for their triple tax advantage. Not only can you fund this account with pre-tax dollars, but it allows for tax-free growth and tax-free withdrawals when spent on qualifying medical expenses. Because accountholders are not required to withdraw funds at the end of each year, these types of accounts can double as a retirement savings account.
Unfortunately, these accounts are only available to individuals with high-deductible health insurance plans, whether they access them through their employers or purchase them independently.
IRAs and Roth IRAs
Traditional IRAs and Roth IRAs both offer a tax-savings, but they differ in when that saving is realized. Traditional IRAs use pre-tax money for contributions, allow for tax-deferred growth, and are then taxed upon withdrawal in retirement. With Roths, contributions are made with post-tax dollars (meaning there is no tax break on contributions), but they offer tax-free withdrawals in retirement.
Roths are also attractive because there are no Required Minimum Distributions (RMDs). In other words, you don’t have to withdraw your money from this account if you don’t want to, making them great estate planning tools, as well. With pre-tax savings tools, on the other hand, account holders must begin taking RMDs from their accounts at age 72 whether they are in need of the income yet or not. For folks who aren’t fully retired or want to draw down their other sources of income first, RMDs can be somewhat of a tax nuisance.
Even though high-income earners are not able to open Roth-style accounts because of regulatory income caps, most will be eligible to perform Roth IRA conversions multiple times over the course of their lifetime to take advantage of tax-free growth and distributions.
Of course, taxable brokerage accounts are always available, as well. In fact, they can be an excellent supplement to retirement savings for many reasons. Although they are taxable, with careful planning and strategy, taxes can be controlled. Also, capital gains and dividends are typically taxed at lower tax rates, making brokerage accounts even more attractive. They are arguably the most flexible type of investment account with no income caps, contribution limits, or Required Minimum Distributions. Investors have complete control over how much and how often they contribute and/or withdraw without incurring costly penalties.
Not only does keeping a brokerage account give investors relatively easy access to funds in case of an emergency, but also prevents them from keeping a surplus of cash on hand in a low-yielding savings or money market account. Of course, brokerage accounts should not replace a robust emergency fund as selling securities is a taxable event and could increase your capital gains liability.
The longevity of your portfolio will largely depend on your ability to properly time withdrawals from each account in such a way that limits your long-term tax liability. In general, it is usually best to start depleting your taxable assets before spending from tax-deferred. Why? To allow your tax-sheltered accounts to continue to grow as long as possible and to decrease the amount of taxes paid.
Ready to prioritize your retirement savings? Call us today to schedule an introductory phone call. We can help you decide which savings vehicles will make the most “cents” for you.