There were significant changes to the tax laws in 2019, but you still may not be able to contribute enough money to an IRA to provide a comfortable retirement income if you are a high-income earner. How can those with high income save enough for retirement without paying a significant chunk of it to Uncle Sam? What are some saving strategies you can employ to minimize tax payment during your retirement years and keep more of your own money? Let’s take a look.
The 2019 SECURE Act and How It Impacts Your Retirement Savings Strategies
If you haven’t heard of the SECURE act, you should familiarize yourself with it because it affects how you plan for retirement and your tax strategies. The Secure act or Setting Every Community Up for Retirement Enhancement Act of 2019 was approved in December of 2019. Some key points which may affect you:
- The age for required minimum distributions was increased from 70 and a half to 72.
- There are no longer age limits for traditional IRA’s
- Annual contribution limits to 401(K) plans have increased to $19,500, $13,500 for simple IRA’s; traditional and Roth IRA limits are still set at $6,000.
- If you earn more than $139,000 as a single person or more than $206,000 for a married couple filing jointly, you will not be able to contribute to a Roth IRA.
High income earners, generally defined as someone who earns at least $188,000 a year, still won’t be able to contribute enough to IRA’s to allow them to continue to live a similar lifestyle when they retire. You should plan to have at least 50-60% of your pre-retirement income, so that if you make $200,000 a year, you should plan on $100-120,000 a year. At this income level, your federal income tax would be 24%.
If you’re not careful, taxes will take a significant chunk of your money when you retire. You’re going to need tax-deferred and tax-free investments to reduce your current tax liabilities and tax payment. As high income earners, it is very likely that you will have to employ all saving and investment options available to maximize your retirement income. Let’s go over some of these options.
>>MORE: Tax-Free Savings vs. Retirement Annuity: Which is Better for You?
Retirement Plans
You won’t be able to contribute enough to completely fund your retirement, but if you have a 401(k) or 403(b) you should take advantage of this tax-deferred account. You contribute to these plans with pre-tax dollars, so you won’t pay taxes on the money until you withdraw it. While your pre-tax dollars are sitting in the account, they’ll earn dividends and interest.
You can contribute up to $19,500 to your 401(k) and workers over 50 can contribute an additional $6,000. That reduces your taxable income by as much as $25,500. If you earned $200,000 in 2020, your taxable income is reduced to $174,500.
If you own your own business, you can invest in a SEP IRA (simplified employee pension individual retirement account). This allows self-employed business owners to contribute up to $57,000 in this tax-deferred account. However, be careful: if you have employees, you must contribute on their behalf as well. It’s meant to serve as a pension fund for the self-employed.
Health Savings Account
You can contribute up to $3,550 for an individual and $7,100 for a family in 2020. You contribute to the account with pre-tax dollars, and if you use the money for qualified medical expenses, withdrawals aren’t taxed.
529 Plans
If any of your children are considering college, contributions to a 529 plan may be helpful in reducing taxable income. You’ll pay taxes on the contributions, but the money grows tax-free. If you use it to pay education expenses, withdrawals will be tax-free. There are no contribution limits, although contributions over $15,000 per beneficiary count against your lifetime estate tax exemption.
If your child decides not to pursue higher education, you can change the beneficiary to another child, a niece, nephew, or grandchild. If your child gets a full-ride scholarship, you can withdraw the money without penalty. Otherwise, you’ll pay state and federal income taxes on the withdrawals, plus a penalty. However, you could leave the money in the account. The beneficiary could use it later in life, or you could use it for education for yourself.
Indexed Universal Life Insurance (or IUL) For Saving for Tax-Free Retirement Income
Permanent life insurance with a cash value account attached is perfect for those looking for somewhere to park larger amounts of money. As a high income earner, if you’re in good health you’ll probably qualify for a life insurance policy with a death benefit between $1.5 and $2 million. You’ll pay premiums with after-tax money, but the cash value account grows tax-free. When you retire, you can withdraw money from the cash value account, completely tax-free.
The best policy for this purpose is Indexed Universal Life Insurance (or IUL), whose cash value account earns a high interest rate tied to the performance of an index, usually S&P 500. The cash value account of the policy is also protected with a floor rate, usually 0-2%. Essentially, the policy is designed to benefit from the upsides when the stock market performs well, but avoid the downsides when it declines. The interest rates vary by the IUL products and the insurance companies, but on average, they are usually 5-7%. Learn more about the nuts and bolts of why IUL policy is a great option for retirement savings.
>>MORE: Should I Invest in S&P 500 Index Through an Indexed Universal Life Insurance (IUL) Policy?
>>MORE: How Much Income Tax Will You Have to Pay in Retirement? A Case Study
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Buy Bonds
Interest earned on tax-exempt bonds is not subject to federal income tax. Bonds typically earn less than other types of investments, but if you’re looking to save money on taxes, they could be a worthwhile investment. Even the interest payments may be tax-exempt.
Backdoor Roth IRA for High-Income Earners
Since you’re a high income earner, the IRS does not allow you to contribute to a Roth IRA. The threshold is single filers earning more than $139,000 or a married couple earning more than $206,000. However, you can convert a traditional IRA to a Roth IRA. Since a Roth IRA uses after-tax dollars, the money you (eventually) withdraw is tax-free. However, you’ll pay taxes on the amount you converted, so be prepared for that tax bill. Also, the most you can contribute to any IRA is $6,000 for 2020.
Backdoor Roth’s can get extremely complicated. If you already have a substantial amount of money in traditional IRA, the upfront taxes might not be worth it. However, a Roth will allow you to enjoy tax-free withdrawals when you retire. A financial advisor would be a good idea in this situation.
As of 2018, you can no longer convert your Roth IRA’s back to a traditional IRA—once it’s done, it’s done. Make sure you’re comfortable with that.
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Last Thoughts
High income earners have a special set of circumstances to contend with when saving for retirement. You want to keep as much money for yourself as you can while still complying with tax laws. Luckily, there are a number of tax-friendly strategies you can employ. Saving for retirements and minimizing tax payment can be complex, so you might want to meet with a good financial advisor to figure out how to make the most of your high income and pay the least amount of taxes possible.