High-earners are in something of a Catch-22 when it comes to saving for retirement. On one hand, they have the extra income available to fully fund tax-deferred retirement vehicles — but that extra income often disqualifies them from the accompanying tax breaks.
The IRS limits tax-deductible contributions to Traditional IRAs to those individuals who earn $69,000 or less, and married couples who earn $115,000 or less. Roth IRA contributions are limited to individuals who are making less than $127,000, and married couples who are making less than $188,000.
So, what are the best investment options for these high-earners? Here are three ways high-income individuals and couples can still put away money for retirement — without feeling overwhelmed by the taxman.
1. Roth IRAs
If your income is above the Traditional IRA limit, but below the Roth IRA limit, this is an excellent option. The Roth version of this investment vehicle front-loads your tax burden. So, instead of funding the IRA with pre-tax dollars (as you do with a Traditional IRA) and then owing taxes when you withdraw the money, you put money you’ve already paid taxes on into the IRA, and owe nothing when you withdraw.
2. Non-Deductible Traditional IRAs
If you can’t contribute to a Roth IRA because your income is above that limit, you still have the option of contributing to a non-deductible Traditional IRA. Basically, you’ll be putting taxable income into the IRA; you can’t deduct your contribution, and will have paid taxes on the amount you contribute.
You’ll also owe taxes on the money you withdraw from your non-deductible IRA — but only on your gains. The original amount you contributed has already been taxed, so it’s safe from Uncle Sam’s tax bite.
This is better than a fully taxable brokerage account because your money does grow tax-deferred. So even though you’ll owe money on the gains you receive from your investments, you won’t be taxed until after your money has compounded over the years, thereby reducing your overall burden. Taxable brokerage accounts owe money to the IRS on interest and dividends each year, meaning there’s less money available in the accounts to benefit from compound interest.
3. Backdoor Roth IRA Contributions
The best option for many high earners will be using the backdoor provision for opening a Roth IRA. As of 2010, the government eliminated income limits for converting a Traditional IRA to a Roth IRA. This means that any high-income earner who’s priced out of opening a Roth account still has the opportunity to take advantage of one.
What you’ll have to do is open a non-deductible Traditional IRA account, and then immediately roll it over into a Roth IRA. Since you’ve already funded the non-deductible Traditional IRA with post-tax dollars, you’ll only owe money on any gains your investment has made — and if you do an immediate conversion, there should be no gains and therefore no tax bill.
Your money in the Roth account will then grow completely tax-free, and you’ll owe nothing when you withdraw it during retirement.
David’s Note: Be careful when you attempt a backdoor Roth conversion. It’s true that this maneuver can turn a non-deductible Traditional IRA contribution into money inside a forever tax free Roth IRA, but taxes on the conversion will be calculated based on all assets in your pre-tax IRAs (like a Traditional or a Rollover IRA). Before you consider such a move, make sure you don’t own any pre-tax IRAs first. Otherwise, you might get an unexpectedly large tax bill.
The Bottom Line
Having a high income is certainly a good problem to have, but that doesn’t change the fact that figuring out a tax-efficient way to save for retirement can be a headache. Any of these three options can help high-earners save for retirement and minimize their overall tax burden.
Have you tried any of these methods of saving for retirement?
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