Tax-advantaged Savings Accounts for High-Income Earners
Saving for retirement requires planning and, to some extent, strategizing on a multitude of levels, this is especially so if you’re a high-income earner. If you’re a high-income earner, in particular, one of the most important strategies you’ll need to implement is a tax strategy that maximizes the benefits provided by different types of retirement savings accounts.
These accounts encourage individuals and households to save toward their retirement goals. For more affluent households, however, there are more options available regarding which accounts to allocate savings to. So, the question becomes, how can you maximize the tax benefits of various retirement savings accounts when your high-income status allows you the ability to contribute to several different accounts simultaneously? We’ll discuss your options below.
Tax-advantaged Savings Accounts in Brief
When it comes to tax-advantaged retirement accounts, there are typically two types. The first is a more “traditional” account, which provides a tax deduction for any contributions, but you’ll pay income tax on future distributions. The second is a “Roth”-style account, which is funded with after-tax dollars, but future distributions are tax-free.
Broadly speaking, these tax-advantaged retirement accounts are considered “double-tax-advantaged” accounts – they either offer a tax-deduction upfront on the contribution or a tax-free distribution in the future, and they also receive a tax-deferred status on assets within the account.
Which Account is Right for You?
Typically, your retirement account choice will be based on which financial goals matter the most to you. For example, if you anticipate high medical expenses and health insurance deductibles, you might choose an HSA.
Sometimes, your choices may be narrowed down simply by your household’s cash-flow. If your earnings are limited, options for retirement savings may be more restricted. If your household is higher-income and you are earning enough to establish an emergency fund, plan for your kids’ college expenses, and live comfortably month to month, there may be more options that work for you. In this scenario, it’s likely that your focus is on saving for retirement and maximizing family wealth. In this situation then, the question isn’t which tax-advantaged savings account you should use or not use, but rather, how best to prioritize among the different accounts in order to make your money go further. This is where creating a hierarchy of savings accounts may become necessary.
Breaking Down the Savings Account Options
While it may seem easiest to simply keep your savings in a bank account or traditional investment account, these options won’t provide you with a smart tax strategy. The best way to be sure you’re taking advantage of the myriad accounts available to you is to educate yourself on the tax implications of each tax-advantaged savings account.
Triple-Tax-Free Savings Accounts
Based on the sheer number of benefits, the first and best place for high-income individuals to choose for long-term tax-advantaged savings is a Health Savings Account (HSA). That’s because an HSA provides a tax-deduction upfront on contributions, tax-free growth within the account, and tax-free distributions, making it the only triple-tax-free option available. Currently, these benefits are available for up to $3,450 for individuals or $6,900 for families, along with a $1,000 catch-up contribution.
The catch to an HAS is that, in order to qualify for tax-free distributions, the money must be used to cover qualified medical-related expenses. This means that it’s impossible to fully receive the tax-deferred and tax-free benefits of an HSA unless it’s been given time to grow. So, if you want to maximize your HSA as a savings account, you need to pay all your current medical expenses out of pocket, while simultaneously contributing to your HSA for potential future medical expenses.
Ultimately, this means that an HSA should be seen as a supplemental retirement savings account, with the intention that the money saved will be used as tax-free funds to cover any medical expenses in retirement, including medical procedures, prescriptions, co-pays, and even most long-term care expenses.
It’s important to note that an HSA is only available for those who have a high-deductible health plan (HDHP). If you’re a high-income earner, you should have this kind of health plan anyway, since you have the cash-flow needed to cover the cost of a high deductible and the funds to self-insure a larger deductible.
Double-Tax-advantaged Savings Accounts
There are also various double-tax-advantaged retirement accounts for high-income earners to consider. Traditional or Roth-style retirement accounts are both tax-deferred on growth within the account and either tax-deductible on contributions or tax-free on distributions.
Often, it is more beneficial for high-income earners to contribute to a traditional account rather than a Roth-style retirement account so that they can receive the upfront tax deduction at those current high/top tax rates. This is because Roth-style accounts really only work as desired for those who are not just in the top tax bracket now, but in the top tax bracket for life – which often translates into a net worth of $15M+ or more. The reality is that a Roth retirement account is better in relation to a traditional account only if the tax rates at the time of distribution are higher than the tax rates at the time of contribution, and for those who are in the top tax bracket, this is unusual. So, for most high-income individuals, it’s best to get the tax deduction at the beginning, at top rates, and then do partial Roth conversions later after the tax bracket drops.
Tax-Free Roth Accounts
As we stated earlier, it’s best for high-income individuals to maximize pre-tax retirement accounts first, and it’s best to only contribute to Roth-style accounts later via a partial Roth conversion. However, for high-income individuals who aren’t business owners, you may end up stuck with $18,500 of 401(k) contributions (plus catch-up contributions), and once in that situation, you may not be able to make a pre-tax contribution to a traditional retirement account at all.
In these situations, you still have a viable option of making an after-tax contribution to a non-deductible IRA, which would allow you to avoid the 3.8% Medicare surtax on your investment growth. Since these accounts are only a single-tax preferenced account (they have tax-deferred growth, but no deduction on contribution or option for a tax-free distribution), it may be more appealing to convert those non-deductible IRA contributions into a backdoor Roth contribution instead.
On the plus side, there are no income limits when it comes to doing a backdoor Roth contribution, though it should still come after maximizing an HSA and the $18,500 pre-tax contribution limit to a 401(k) plan. However, it’s important to keep in mind the IRA aggregation rule that can ultimately cause non-deductible IRA contributions to become partially taxable, meaning you may want to wait a year between the non-deductible IRA contribution and a subsequent conversion. Furthermore, thanks to the Spousal IRA rules, single-earner high-income couples should keep in mind that a stay-at-home spouse can make non-deductible IRA contributions that are subsequently converted to a Roth, as well.
Deferred Mega Backdoor Tax-Free Roth Contributions
Once you’ve maximized what you can with a backdoor Roth contribution, the next option available is a deferred Roth contribution, sometimes called the mega-backdoor Roth contribution. This is accomplished by making after-tax contributions to a 401(k) plan, on top of the traditional salary deferral that can be done pre-tax, and then later converting to a Roth once the money can be rolled out of the plan.
The main benefit of the mega-backdoor Roth is that the contribution limits start above the $18,500 pre-tax salary deferral limit and extend all the way up to the $55,000 contribution limit. However, there are rules and regulations to this kind of contribution that reduce its overall appeal. Specifically, although converting these after-tax contributions to a Roth account is permitted under IRS Notice 2014-54, the tax-free Roth status doesn’t take effect until the money is actually converted to a Roth, meaning you have to get it out of the employer retirement plan. So, the mega-backdoor Roth doesn’t come until you retire, unless the plan happens to allow in-service distributions, which is rare. Another issue is that your employer retirement plan must allow after-tax contributions, which isn’t always the case.
Additionally, you want to keep in mind that there is a $55,000 limit for all contributions into a defined contribution plan, which includes the $18,500 salary deferral limit, any other after-tax contributions, and any profit-sharing or other employer pre-tax contributions. This means that ultimately, employers who make profit-sharing or salary matching contributions are reducing the availability you have to make after-tax contributions.
Basic Tax-Deferred Growth
The next option in the hierarchy for high-income individuals is a saving account that doesn’t provide any up-front tax deductions or any tax-free distributions, but does allow for tax-deferred growth within the account. The most common of these accounts is the non-qualified deferred annuity, which provides tax-deferred growth when outside of a retirement account.
The biggest concern with non-qualified annuities is that they come with an additional cost for the annuity guarantees and the tax deferral wrapper. However, if you’re a high-income earner who is solely interested in tax-deferral, Investment-Only Variable Annuity (IOVA) contracts are on the rise and they have very few guarantees, meaning they’re ultimately a low-cost option. With low enough costs, it can end up being a worthwhile endeavor to pay the annuity costs so that you can get the tax-deferral treatment, especially for tax-inefficient, high-return investments that are otherwise being taxed at top-tier tax rates.
Another account that fits into this category and is a good option for long-term growth assets, is the old-fashioned taxable brokerage account, where capital gains aren’t taxable until assets are sold. In these accounts, a zero-dividend growth stock that is held until liquidation not only gets the same tax-deferral treatment as an annuity but without the annuity costs. It also gets preferential long-term capital gains rates at distribution. The downside to this option is that some investments can experience enough tax drag to make them less appealing to hold in taxable accounts, such as investments with a modest level of ongoing turnover.
Concluding Thoughts on Selecting the Best Tax-advantaged Accounts for You
Trying to navigate the various options discussed above can be an incredibly difficult and complex process. For high-income individuals who want to maximize their earnings and minimize their tax burden, choosing the right accounts is a critical part of the tax planning process.
As we approach tax season and the dreaded deadline of April 15th, now is a great time to begin your research on which tax strategy and tax-advantaged savings accounts are best for you and your family. If you’re a high-income individual wishing to make your earnings count, contact us today for professional guidance.
Paces Ferry Wealth Advisors, LLC is a registered investment advisor with the U.S. Securities and Exchange Commission (“SEC”). This material is intended for informational purposes only. It should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney or tax advisor.