Retirement planning can be challenging for high-income earners. Contributing $18,000, or $24,000, or even up to $60,000 a year to a retirement plan may not be enough for a person earning $300,000 or more a year who wants to enjoy the same quality of life in retirement.
You may find, like many high-income earners, that the annual compensation limit stymies your ability to put sufficient money aside for retirement. For 2017, that limit is $270,000, which is the point where the IRS caps the compensation that can be used in employer-matching contributions. That means if you earn $400,000 per year, $130,000 of your salary will not be factored into the tax-deductible employer contributions that you may receive.
Even without such caps, however, the yearly elective deferral limit of $18,000 (plus the $6,000 catch-up contribution allowed for those age 50 and over) is usually insufficient to support the lifestyle in retirement that high-income earners had during their working years. Consequently, you may want to consider alternative investment options, some of which we outline below.
Invest in an After-Tax Brokerage Account
After-tax brokerage accounts can be attractive to high-income earners because of their flexibility. Add to that the fact that dividends and capital gains qualify for a special 15% tax rate (20% for very high-income earners) and these accounts can be very appealing. However, there are pluses and minuses to consider.
In the plus column, although you make the initial investment in after-tax dollars, you will not pay tax on the increase in value for your account as long as you are holding on to it. Additionally, you have no limits for withdrawing income, and you will not incur penalties for early withdrawals. When you decide to liquidate the account, you will pay capital gains taxes but at a favorable tax rate (which is lower than ordinary income for high earners) provided that investments are held for more than a year. If you incur a loss on your taxable brokerage account investment, you can sell it, claim it as a capital loss on your tax return and get a tax break.
On the minus side, since these accounts are readily available and not limited to post-retirement use, you may be tempted to use the funds during your working years. If you resist this temptation, however, a taxable brokerage account is one of the better retirement planning options for those whose income exceeds the $270,000 annual compensation limit. In most cases, such an account will be more flexible and beneficial than a nonqualified annuity account.
Look into a “Backdoor” Roth IRA
“Backdoor” Roth IRA plans will appeal to only a limited number of high earners since you cannot take advantage of one if you have IRA rollovers from previous employers or traditional contributory IRAs. However, if you have not changed employers or you have always been self-employed and have an individual 401(k) plan, this strategy may be right for you.
The backdoor strategy allows you to convert a traditional or nondeductible IRA into a Roth IRA. No income limits govern this conversion, and you can open a nondeductible IRA and immediately convert it into a Roth IRA with few or no conversion taxes. In contrast, conversions from existing traditional IRAs or IRA rollovers will likely involve tax implications.
Because there are some definite pros and cons inherent in this strategy, speak with your financial advisor before putting one into place.
Maximize HSA Contributions and Delay Withdrawals
Health savings accounts (HSAs) are attractive options for high-income earners, as they are the only type of account that is triple tax-free: Contributions are tax-deductible, earnings are tax-deferred and withdrawals are tax-free as long as they are used for qualified medical expenses such as physician visits, laboratory tests, medications, dental care and eye care.
HSAs are geared for those who have high-deductible health plans, with deductibles over $1,300 for individuals and $2,600 for families. As of 2017, individuals may deposit up to $3,400 per year into an HSA, and families may contribute $6,750. An optimal strategy for many high-income earners is to contribute the maximum amount allowed to a health savings account each year and refrain from withdrawing from the account while working. Instead, pay your medical bills out of your regular after-tax income, and allow the HSA to accumulate so it can be used as supplemental income in retirement for health expenses incurred at that time.
After age 65, you may withdraw HSA funds for nonmedical expenses, but that money will be taxed as ordinary income. Although HSAs can supplement retirement income, it is generally advisable to max out other retirement contributions before employing this strategy.
See If Your Employer Offers an After-Tax 401(k)
An after-tax 401(k) plan allows you to contribute after-tax dollars up to $54,000. Earnings from your after-tax 401(k) contributions will grow tax-free until you withdraw them, at which point they will be taxed as ordinary income.
Options for the Self-Employed
Unless your employer makes substantial contributions toward your retirement or will provide you with a pension (also called a defined benefit retirement plan), it may be to your advantage to work for them as an independent contractor rather than as an employee. Self-employed individuals can contribute up to $54,000 to a profit-sharing 401(k), which is quite a bit more than the $18,000 allowed for employees.
Those who are self-employed can also consider contributing to a personal defined benefit plan. With a defined benefit plan, you project your annual benefit during retirement and then calculate the annual contribution you need to make to reach that amount. In some cases, annual contributions for personal defined benefit plans may reach $100,000 or more, which allows small business owners to save more than what is allowed under other retirement plans. The caveat, however, is that defined benefit plans have setup and administration fees that other plans do not. Plus you are required to contribute to the plan for at least five years. Because of this, these plans are best suited for those who can contribute at least $80,000 annually.
Those who have businesses or earn consulting income outside of their regular jobs can open a Simplified Employee Pension IRA (SEP-IRA) or an individual 401(k) account. The latter involves greater administrative responsibilities but may allow for higher annual contribution levels for the same income level based upon how those contributions are calculated. This page on the IRS website outlines the specifications and requirements for each of these plan types.
The above investment options are a few of the ways in which high-income earners can maximize their retirement savings. Speak with your financial advisor about the pros and cons of these options to determine which ones would be best for you in light of your financial goals and needs.