3 Stealth Retirement Savings Moves For The Wealthy
By: Rob Berger
High income earners can easily pay half their income at the margin in taxes. The top federal income tax bracket now stands at 39.6%. Add to that payroll taxes, state and local income taxes, alternative minimum tax, and loss of the value of deductions and exemptions, and many keep less than they pay in taxes above certain income levels.
As a result, it’s never been more important to shield as much income from taxes as possible. While tax-advantaged retirement accounts do help, they have their limits. With higher incomes, deductible IRA contributions and Roth IRA accounts are out of the question.
With these limitations in mind, here are three retirement savings moves for the well-healed.
1. Backdoor Roth IRA
High income individuals cannot open a Roth IRA. The actual income limits change each year. For 2014, individuals making more than $129,000 and married couples filing a joint return making more than $191,000 are ineligible to open a Roth IRA. There is, however, a way around these limitations.
Enter the backdoor Roth IRA. Since 2010, anybody regardless of income can convert a traditional IRA into a Roth IRA. While it seems silly that high income earners can’t open a Roth but can convert to a Roth, the explanation is really quite simple. It is silly. But ours is not to reason why, ours is just to take advantage of every silly IRS rule we can.
As you consider whether a backdoor Roth IRA is right for you, consider two things. First, you must pay tax on any pre-tax contributions as well as any gains in the amount converted to a Roth. On the surface this may not seem like a concern if you’ve recently funded a non-deductible IRA for the purpose of converting it to a Roth. But that brings us to the second consideration–the pro rata rule.
When calculating the taxable income from a Roth conversion, you must consider all non-Roth IRAs in your name (including SIMPLE and SEP IRAs). This is true regardless of whether the IRAs are held at the same financial institution. Basically, one must divide the total of after-tax contributions by the total balance across all IRAs (excluding Roth IRAs) to determine the amount of the conversion that is not taxed.
2. After-tax 401(k) Contributions
The contribution limits to a 401(k) are well known. What’s less familiar to many is that some 401(k) plans permit employees to contribute after-tax dollars over and above this limit. In fact, for 2014 the total limit of all contributions is the lesser of $52,000 or 100% of your compensation.
After-tax contributions to a 401(k) work much like non-deductible contributions to an IRA. The contributions are taxed, but the earnings grow tax-deferred until withdrawn during retirement. At that time, the earnings are taxed as ordinary income.
In some cases, simply investing in a taxable account is preferable to after-tax 401(k) contributions. Long term capital gains currently are taxed at a lower rate than the upper tax brackets for ordinary income. Yet for those looking to eventually convert these after-tax contributions to either a Roth 401(k) or a Roth IRA, making extra contributions to a 401(k) may be a smart move. It’s important to remember, however, that the conversion will trigger taxes on any earnings in the account.
3. Personal Defined Benefit Plans
Finally, for self-employed individuals, a personal defined benefit plan may enable you to save more than $100,000 a year in a tax-deferred account. Defined benefit plans are significantly more complex and expensive than other more common alternatives, such as a solo 401(k) or SEP IRA. The potential tax savings during high income years, however, make this option worth considering.
Unlike 401(k), IRA, and other defined contribution plans, a defined benefit plan starts with setting a projected annual benefit at retirement. Once that benefit is determined, an actuary uses your current age, life expectancy, and return assumptions to calculate the annual contribution needed to achieve the defined benefit. In some cases, the annual contribution can easily exceed $100,000, allowing a small business owner to sock away far more than permitted with other retirement savings options.
As with other retirement options, there are several things to consider. First, defined benefit plans come with setup and administration fees not found with other more traditional retirement options. The annual administration cost can easily exceed $1,000, and there are additional fees if amendments need to be made to the plan. Second, once the plan is put in place, the annual contributions are required. You cannot simply decide not to contribute one year, as you can with 401(k) and IRA accounts. Generally speaking, one should be prepared to contribute to the plan for at least five years. Finally, according to Charles Schwab, these plans are generally best suited for those 50 or older who can make annual contributions of at least $80,000.
For those considering a defined benefit plan, seeking advice from a pension expert is a must.