One of the nice things about the IRS pushing back the tax filing deadline is that I have an extra few weeks to publish brief articles like this discussing actions that, if you’re still working, you can take now to improve retirement later.I recently had a conversation with a friend who has seen their income grow significantly over the past 36 months. To say he was desperate is a bit of an overstatement but suffice to say he was eager to learn of any way he could legally protect more of his income from taxes. Both fortunately and unfortunately, he had been taking advantage of all strategies available to him.
We can all agree that saving early and consistently is the key to reaching your retirement goals. However if you are like my friend, someone who earns six figures or more, you may have encountered certain challenges. High-income earners face several financial hurdles when it comes to preparing for retirement, as their income often precludes them from the benefits of certain tax-advantaged retirement savings strategies. If you or you and your spouse earn six figures or more, you know you need to plan now in order to maintain your lifestyle through retirement.
Why Are High-Income Earners at a Disadvantage?
Through legislation, the IRS makes available to all taxpayers various tax-advantaged retirement savings options. Common among these options are some sort of income cap – meaning that if you earn a certain level of income, you’re disqualified or at least limited from enjoying these various tax-advantaged accounts. This makes it difficult for higher earners to save in a tax efficient manner. Not dissimilar from moderate to low income earners, high earners face the same challenge: sustain a similar lifestyle in retirement by maintaining financial independence.
When high earners are limited in their options for saving for retirement, it can make reaching their goals for retirement more challenging. With that in mind, below are a few ideas highly compensated executives and employees can consider in saving for retirement.
Retirement Saving Strategies
Strategy #1: Contribute to a 401(k)
If you aren’t doing so already, contributing to an employer-sponsored 401(k) plan is an effective place to start saving for retirement. You may defer up to $19,500 (or $26,000 if you’re 50 or older) of your pre-tax earnings toward your employer-sponsored 401(k) plan.1 Many employers will offer matching contributions as well, up to a certain percentage of your contributions. The total contribution limit for a 401(k) plan in 2021 is $58,000 (plus an additional $6,500 for those 50 and older) or 100 percent of an employee’s compensation, whichever is lower.1
The salary limit for deferring compensation is $280,000 for 2021. If you make more than this amount, this doesn’t mean you can’t contribute to your 401(k) plan. Employees can defer compensation to their 401(k) plan throughout the year, until their year-to-date earnings reach $280,000. Once that maximum is reached, employees can no longer defer earnings toward their 401(k) plan.1
As a high earner, your 401(k) will likely offer the highest contribution cap for tax-deferred retirement savings – making it an important cornerstone of your retirement saving strategy.
Strategy #2: Traditional IRA
Roth IRAs allow retirees to make tax-free withdrawals in retirement, meaning they can be appealing for those saving for retirement. Unfortunately, it may not be an option for some high-earners. If your modified adjusted gross income is more than $140,000 as a single filer or $208,000 as a joint filer, you are not eligible to contribute after-tax dollars to a Roth IRA account. If you make between $125,000 and $140,000 as a single filer or $198,000 and $208,000 as a joint filer, you may be eligible to contribute a reduced amount.2
A traditional IRA, however, does not have an income limit, which makes it an available option for high earners. The only prerequisite is that you earn any income at all. It’s important to note, however, that you may be limited to how much of your IRA contribution you can deduct on your tax return.
How much you are able to deduct from your taxes will depend primarily on two things:3
- Your modified adjusted gross income
- Whether or not you actively contribute to your employer-sponsored retirement plan (such as a 401(k))
Strategy #3: Backdoor Roth IRA
Building on the strategy above, those interested in tax-free withdrawals in retirement – but aren’t eligible to utilize a Roth IRA – may benefit from a backdoor Roth IRA. As the name suggests, this strategy offers high-income earners a roundabout entrance into placing their after-tax dollars into a Roth IRA account.
This is a process that requires some coordination so I’d be happy to help with it. By way of an overview, to execute a Backdoor Roth IRA contribution you need to do the following:
- Open and contribute to a traditional IRA account.
- Have an account administrator provide the paperwork and instructions for converting your traditional account into a Roth IRA.
- Prepare to pay taxes on the money in the account and any gains it may have incurred. If the conversion from a Traditional IRA to a Roth occurs simultaneously then this is almost a moot point.
If this sounds like an option you may be interested in pursuing contact me so that we can discuss it in more detail as it pertains to your specific circumstances. There is some nuance to this process, especially if you’ve previously rolled over an old 401(k) into an IRA. Nevertheless this may be a strategy worth exploring if you are otherwise disqualified from making Roth IRA contributions.
Regardless of your income level, but especially if you’re earning six figures or more working with a financial advisor may be useful in helping you understand how to effectively leverage the various savings options available to you. Whatever approach you opt to take, be certain to stay up-to-date on contribution limits and eligibility requirements. This can help you and your retirement savings avoid any surprise tax bills now or toward retirement.
This content is developed from sources believed to be providing accurate information, and provided by MBAM, LLC. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.