Don’t Let Income Limits Limit You: Retirement Strategies for High-Income Earners

Saving for retirement can be a challenge for high-income professionals. Income limits applied to defined contribution plans like 401(k)s are $265,000 in 2016, so professionals who earn more than that should max out retirement plan contributions plus save more outside of traditional retirement plans in order to support the lifestyle in retirement that their high income has provided pre-retirement. Saving $18,000 to $24,000 in a 401(k) won’t suffice for someone earning $400,000 a year. To help you save for the retirement you envision, here are some options you can look into:

Maximize health savings account contributions and postpone withdrawals. Health savings accounts (HSAs) have become attractive to high-income earners. They are the only account that is literally triple tax-free: The contributions are tax deductible, earnings are tax-deferred and withdrawals are tax-free if used for qualified medical expenses, which include medical-related expenses, medications, consultations, dental care, eye care and more. To open an account, you first need to have a high-deductible health plan, which amounts to $2,600 per family or $1,300 per individual. Each year, you can deposit as much as $6,750 per family or $3,350 for an individual in your HSA. The optimum strategy is to contribute to your health savings account but not withdraw from it while you are working. Rather, pay your medical bills out of your regular after-tax income and let the HSA accumulate to be used as a supplemental asset in retirement for medical expenses. After the age of 65, you can withdraw money from your HSA for nonmedical expenses, though the money will be taxed as ordinary income. While HSAs can supplement your retirement income, it is usually best to max out your other retirement contributions first before employing this technique as a retirement income strategy. If you are not sure that a health savings account would be beneficial in the future, ask yourself, “Do I think Medicare coverage in the future will be better or worse for high-net-worth, high-income people?”

Consider working for yourself. In general, consider becoming self-employed rather than being a corporate employee, unless your employer makes large contributions to your retirement or has a defined benefit retirement plan. Depending on your situation, this can be accomplished by becoming an independent contractor rather than an employee. High-income self-employed people can contribute up to $53,000 to a profit-sharing 401(k) plan versus $18,000 as an employee only.

Contribute to a personal defined benefit plan. If you are self-employed, then you might consider a personal defined benefit plan. Compared with other defined contribution plans, this one begins by determining your projected annual benefit once you retire. You will then calculate the annual contribution you need to reach the defined benefit. This is based on your life expectancy, current age and return assumptions. Some annual contributions can reach more than $100,000, which allows small business owners to save more in this plan than in other retirement plans. Here’s the caveat: Defined benefit plans have setup and administration fees that you don’t find in other retirement contribution options. When the plan is in place, you are required to pay the annual contributions for at least five years. This plan is best suited for individuals who can contribute at least $80,000 yearly.

Opt for other retirement plans. If you have self-employment income outside of your regular employer income, such as consulting, consider opening a self-employed IRA (SEP-IRA) or individual 401(k) account. You can make “employer” retirement contributions separate from your primary job, but “employee” contributions have to be coordinated with your primary job retirement plan.

Consider a “backdoor” Roth IRA. A popular strategy for high earners is the backdoor Roth IRA, which allows you to convert a traditional or nondeductible IRA into a Roth IRA. One advantage to this strategy is that there is no income limit when converting a nondeductible IRA to a backdoor Roth IRA. If you don’t have an existing traditional IRA or IRA rollover from a previous employer, you can fund a nondeductible traditional IRA and convert it immediately to a Roth IRA with little or no tax upon conversion. If you’re converting an existing traditional IRA or have an IRA rollover from a previous employer, there will likely be a tax implication. There are definite pros and cons to this strategy—make sure to talk to your financial advisor to see if it’s right for you.

Save and invest in a taxable brokerage account. While taxable brokerage accounts don’t come with immediate tax benefits, they have other advantages that make them attractive to high-income earners. One thing you have to remember, though, is that the initial investment is paid in after-tax dollars; but your taxable brokerage account provides you flexibility thereafter. You don’t have to pay any tax on the increase in value of your asset as long as you’re holding on to it. When you decide to sell it, then you will pay capital gains tax at a lower tax rate than ordinary income. Qualified dividend income is eligible for a 15% tax rate, which is lower than ordinary income for high earners. There are no limits to withdrawing money on taxable brokerage accounts. You will not incur penalties for early withdrawals. If you incur a loss on an investment, you can sell it and file it as a capital loss on your income tax return and get a tax break. The downside is that since these accounts are easily accessible and not limited to retirement use, you may be tempted to use these funds prior to retirement. Nonetheless, a taxable brokerage account is one of the best options for those whose income exceeds the $265,000 limit for defined contribution plans. A taxable brokerage account is more flexible and beneficial than a nonqualified annuity account in most cases.

Talk to your boss about a safe harbor plan. If your employer’s 401(k) plan limits your contributions because you are deemed a “highly compensated employee,” ask your employer about a safe harbor plan. The IRS limits how much highly compensated employees can contribute to a standard 401(k) in comparison with the company’s other employees. You may not think you earn a lot, but the IRS defines employees who earn more than $120,000 to be “highly compensated” and potentially limited in retirement plan contributions. If you’re tied to the ceiling contribution, you can ask your employer about offering a 401(k) safe harbor plan. This plan permits you to contribute up to $18,000 per year or $24,000 if you are age 50 or older. Your company can opt for a non-elective contribution, in which the company contributes a minimum of 3% of compensation to each eligible employee, or a matching contribution, in which your employer will match 100% of a minimum of the first 4% of an employee’s compensation. A safe harbor plan may be a challenge to get your employer to agree to, as the company will incur additional expenses to pay more for matched contributions.

Explore if your employer offers an after-tax 401(k). Certain 401(k) plans allow you to contribute after-tax dollars up to $53,000 or 100% of your compensation. The earnings from after-tax 401(k) contributions grow tax-free until you withdraw them, at which point they will be taxed as ordinary income. However, if you’re maximizing your retirement contributions and still have extra money for investing, you may want to invest in something that you can eventually convert to a Roth IRA or Roth 401(k) such as an after-tax 401(k).

These are just some of the ways you can increase your retirement savings as a high-income earner. Your financial advisor can help you navigate the ins and outs of each option and assess which ones will best fit your current income and financial goals. The ideas in this article are general in nature and are not meant to be tax advice. You should consult with a qualified tax advisor about your specific situation.