How Can High Income Earners Optimize Their Retirement Savings?
Young professionals and business owners dream about the day when they finally make it into the “high income earner” category. In their minds, the label will mark them as being in the financial security zone for the rest of their lives.
However, there’s an important distinction that many don’t see until it’s too late. High income doesn’t automatically equal financial security in retirement! Making a significant income year after year is great, but only if you also make smart choices about that money.
Here are three important factors that can help high income earners make the most out of the money they’ve worked so hard for.
The number one factor is lifestyle choices. If a family brings in $300K+ a year and spends most of it, they may be enjoying a fun lifestyle — but they are not building their long-term financial security.
What does a “reasonable” lifestyle look like? The answer will depend on the family. Where do they live? What is most important to them about money? What financial commitments do they have to extended family members, local community, and each other?
While the answers will look different for every family, there’s an important common thread among the families that choose to take charge of their money. They don’t allow social pressure to push them into lifestyle decisions that go against their values and long-term goals. Yes, the proverbial keeping up with the Joneses can certainly prevent high income earners from reaching their full financial potential!
Understand the full range of savings accounts
From the financial planning standpoint, the beauty of a high income-reasonable lifestyle combination is that there’s plenty of money left over for saving. That means being able to cover all the bases — with the luxury of doing it in the most tax-efficient way.
We will address the relative tax efficiency of various account in a few moments. For now, let’s focus on outlining the range of categories available.
To start, there are traditional savings accounts. These are often your emergency savings accounts. They hold funds you will access when you need to pay for something outside of the “normal” family budget.
It’s critically important to get this savings balance to a comfortable point. That can be 6-12 months’ worth of family expenses or higher, depending on your situation and comfort level. Without a properly funded emergency savings account, the family would have to dip into other saving, which can trigger penalties and taxes. Alternatively, they would have to resort to credit cards.
Most high income earning families have a healthy emergency savings account. Those that don’t can build one by making different lifestyle choices and adopting a disciplined savings habit.
Beyond emergency savings, here are some other savings accounts that may be relevant for your family.
A 401(k) or similar account is a retirement savings account offered by your employer.
Traditional or Roth Individual Retirement Accounts (IRAs) can be used in addition to your 401(k). Small business owners have access to similar plans in the form of SEP or SIMPLE IRA.
529 plans are used to save for education expenses. A recent tax law change expanded the use of 529 plans to include primary education, which gives you more options.
Health Savings Accounts (HSAs) are available to those who have a high-deductible health insurance plan. Used strategically, HSAs can become your secret weapon for optimizing taxes and savings for retirement.
Discounted employee stock purchase plans.
Taxable brokerage accounts.
Choose the right mix of accounts — in the optimal order
Not all savings accounts are created equal. When a family has a tight budget without much “leftover” cash at the end of the month, their choices must be driven by contributing to the emergency savings account, and then allocating the rest towards whatever savings goals are most urgent.
High income earners have the good fortune of making allocation choices based on which accounts offer the best tax advantages.
Unfortunately, not everyone thinks it though from the tax perspective. Many high earning families make their savings account contributions in a given order — simply because that’s how they’ve always done it. If that “legacy” hierarchy was created years ago when the family wasn’t as comfortable financially, doing the same thing today fails to maximize the use of high income.
How should you think it through? Here are a few things to consider.
The most tax-advantaged account from the list above is the HSA. Contributions are tax-deductible. Account growth is tax-free. Finally, withdrawals for permitted purposes (i.e. paying for qualified medical expenses, now or in retirement) are also tax-free. So, those who are eligible to use an HSA receive a triple tax benefit. HSA contribution limits for 2019 are $3,500 for an individual and $7,000 for a family.
The next tax-advantaged group of accounts includes 401(k), traditional IRAs, Roth IRAs, and 529 plans. Traditional accounts offer tax savings at contribution time, and any growth in the accounts is tax-free. However, you will have to pay taxes when you withdraw the money later. Roth accounts and 529 plans are a little different: contributions are made from post-tax dollars (i.e. you pay taxes today), growth in the account is tax-free, and distributions for qualified purposes are also tax-free.
Here are the contribution limits for these accounts, listed for 2019.
401(k): $19,000 per individual. For those aged 50 and older, there’s also the catch-up contribution of $6,000.
Traditional and Roth IRA: $6,000 per individual. For those aged 50 and older, there’s also the catch-up contribution of $1,000.
SEP IRAs and Solo 401(k)s for the self-employed: $56,000 per year.
SIMPLE: $13,000 per year. The catch-up limit is $3,000.
529 plan: Contributions to a 529 plan are considered gifts for tax purposes. The annual tax-consequence-free gift limit is $15,000 per giver/recipient combination. In other words, if you have 3 kids, then you can contribute up to $45,000 (or $90,000 if your spouse also contributes). There are no annual contribution limits set by the 529 plans, but there is a maximum aggregate limit (i.e. the balance cannot exceed the expected cost of the recipient’s education). Limits vary by state; you can check yours here.
Keep in mind that the Back-Door Roth contribution strategy may also be an option. However, it’s important to understand the technical details, timing, and other restrictions that go along with this strategy. Be sure to work with a qualified financial planner to get this right.
Finally, there are employee stock purchase plans that allow participants to buy company stock at a discount and can, if used strategically, offer tax advantages as well. And, of course, there are taxable brokerage accounts.
High income earners: what’s the bottom line?
Building a tax-efficient savings algorithm is a complex project. High income earners need to understand that their first priority should be to dial in their lifestyle choices. Without this, their ability to optimize the rest of their financial plan is severely limited.
With lifestyle choices dialed in, the next order of priority is emergency savings. Many high earning families already have a healthy balance in their emergency savings account, but it’s important to re-assess family needs and comfort level periodically. Changes in health, economic downturns, and new career choices can impact the amount that will provide proper financial security.
Next, it is important to make retirement and other savings account contributions in order of their tax advantage. Remember that most accounts have contribution limits, and that your family’s savings sequence will be driven by family goals. Work with a financial planner who understands your big picture and can help you figure out the right algorithm for optimizing your taxes and building a strong financial legacy.