A lot of people contribute the maximum to their 401(k) each year in the belief that the savings they accumulate will last them throughout retirement. But the higher your income, the less effective the maximum will be. If your income is over $275,000, that is the maximum income level that the IRS considers for defined contribution plan limits in 2018, so you need to consider saving more. This is particularly true if your income is substantially higher, such as $400,000 or more.
And why is that? As a recent Morningstar article points out,¹ it comes down to standard of living, or lifestyle. “Someone’s who’s retiring from a position with a very high salary is going to want and need more money in retirement to maintain her standard of living than is the case for a worker with a lower income,” writers author Christine Benz.
This is a point we emphasize often with our clients. Contributing the maximum to a 401(k) or an IRA over the course of 30 or 40 years will amass a sizable nest egg by many people’s standards—but it will fall short of being enough if you enjoyed a very high income during your career.
Ms. Benz uses an example of someone who contributes the maximum to their company retirement plans and IRAs and earns a 4% annualized return over 44 years. By the time they reach age 65, they will have $2,780,622—or $2,113,197 on an after-tax basis.
That seems like quite a bit of money, but our lives are longer now, so our retirement funds have to stretch for longer periods of time. The article shows that, using a 4% guideline, the annual withdrawal amount would be roughly $84,500 in retirement (and increasing each year for inflation).
If you are a very high-income earner, you will probably find that amount insufficient. In the article’s example, someone earning $250,000 and expecting a 70% income replacement rate in retirement would need $175,000. Add to the $84,500 the maximum allowable benefit of $34,000 from Social Security, and the total still falls short. Your total pre-tax income would be $118,500 or about 47% of your pre-retirement income of $250,000. Do you want to live on less than half of your current income in retirement?
How much should you save if you are a high-income earner? Rather than the fixed dollar amount limits set by the IRS, you should look at your retirement savings as a percentage of your current pre-tax income. The amount you need to save may vary widely depending on a range of personal factors, including how early you started to save, but a good savings rate target for high income people is 15% to 25% or more of pre-tax income. The higher the income, the higher the savings rate needed. What’s your savings rate? Some financial planners use a savings rate calculation as a benchmark for a client’s financial health, much like a doctor measures blood pressure as a benchmark for physical health.
So what can you do? You can (1) pare down your lifestyle expectations in retirement or (2) find other ways to save for retirement now.
I’m assuming that you’d rather not scale down your retirement expectations. Let’s look at ways you can build a bigger nest egg so you can enjoy a comfortable retirement.
4 Ways to Save More
- Cut your spending: The higher one’s income, the easier it is to spend without really noticing it. Check out “Steps for High-Earning Professionals to Cut Their Spending, Save for Retirement” to learn how to get a handle on what you’re spending.
- Use an after-tax brokerage account: Brokerage accounts allow for control and flexibility since you select what you want to invest in. They also provide for liquidity since you can pull out the money whenever you need it. Plus, if you hold on to the investment for at least a year, then you will pay the long-term capital gains rate, which is lower than the ordinary income tax rate or short-term rate capital gain rate. However, the liquidity can also be a drawback. You may be tempted to use the money in your working years rather than let it amass for your retirement.
- Max out your HSA: A health savings account is attractive to high-income earners because it 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. If you use the money for any other reason, you will pay taxes and a 10% penalty before age 65 (a fact that may help you resist temptation to spend the money), or simply taxes and no penalty after age 65.
- Make after-tax contributions to your 401(k): If your employer allows it, then consider making after-contributions to your 401(k). For 2018, the limit is $55,000. Once you retire or leave the company, you can roll over your pre-tax contributions to a traditional IRA and your after-tax contributions into a Roth IRA. This so-called “backdoor Roth” is a commonly used method for high-income earners to take advantage of a Roth IRA’s benefits (including tax-free income in retirement), as a Roth’s income limitations normally preclude high earners from contributing to one.
- If all of your retirement saving is in employer qualified plans, you can open a traditional, non-deductible IRA, then immediately convert it to a Roth IRA.
This is also referred to as a “backdoor Roth” strategy, but it isn’t as effective if you have an IRA rollover or any IRA. For this strategy, you can contribute up to the traditional IRA limit, which in 2018 is $5,500 per person per year or $6,500 if you are over age 50.
If you’re a high-income earner, you may find that contributing the maximum to a 401(k) or IRA is a good start but insufficient for a retirement that supports your standard of living. Consider other options such as brokerage accounts, HSAs, and backdoor Roths to create a retirement nest egg that can better support you throughout your retirement.
 Christine Benz, “For High-Income Investors, ‘the Max’ Might Not Be Enough,” Morningstar, 26 April 2018, https://www.morningstar.com/articles/861218/for-highincome-investors-the-max-might-not-be-enou.html.