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Best Tax Savings Vehicles for High-Income Earners Thumbnail

Best Tax Savings Vehicles for High-Income Earners


I was reminded recently of a great article Michael Kitces of the Nerd’s Eye Blog wrote some time ago.   The article is titled “The Hierarchy of Tax-Preferenced Savings Vehicles for High-Income Earners.” Talk about a mouthful. If you are interested in reading the original blog post just click on the title.  Be warned – it is a longggggg article.  However, I wanted to take a few paragraphs to hit the highlights.

 

First on the hierarchy, so I guess the bottom of the pyramid, is Health Saving Accounts.   These are known as HSAs.  I’ve written before about how these types of accounts are the triple-threat when it comes to retirement savings.  This is because contributions go in before taxes, the balance grows without taxes, and qualified distributions are tax-free.   Now, qualified distributions are for health-related expenses, hence the title of the account.  You have to be a participant in the High Deductible Healthcare Plan in order to qualify to participate in an HSA.  While many people use these as glorified flex accounts (use the contributions to pay for healthcare expenses the same year the contributions are made), they can easily be used to save up money for healthcare expenses in retirement.  Some of the big brains have done the number crunching and it shows funding HSAs first may be more important than funding your 401k for retirement.

 

Next on the pyramid are a couple of double tax-free savings vehicles.  The first is the standard old 401(k), IRA and those types of retirement-related savings accounts.  These accounts are double tax-free because your contributions typically go in before taxes and the balance grows without taxes.  Unfortunately, Uncle Sam is waiting for your Required Minimum Distributions (RMDs) to get his taxes.  As Meat Loaf sang – two out of three ain’t bad.

 

The second of the double tax-fee savings vehicles is the Backdoor Roth.  Because there are income phaseouts, high-income earners are not able to take advantage of Roth IRAs directly.  However, where there is a will there is a way, right.  The Backdoor Roth is simply someone contributes after-tax dollars to a regular IRA.  The next step is they convert the funds in this IRA into a Roth IRA.  It is really not too complex depending on the situation.   The biggest issue with a Backdoor Roth is if you have an outside IRA that is funded with pre-tax money.  If so, the IRS requires you to combine the balances of the traditional IRA and the Backdoor Roth to determine how much of the Backdoor Roth will be subject to taxes, even though you already paid taxes on it.  A simple example is you have a traditional IRA with $95,000 of pre-tax money and a Backdoor Roth with $5,000.  Uncle Sam will say that 95% of your combined total has not been taxed so 95% of your Backdoor Roth will be considered taxable.  Again, topic to cover with your CPA.

 

The final level of the hierarchy is the Mega Backdoor Roth. I’ve written about this before and even did a video on it.  I first heard of this strategy from the WhiteCoatInvestor.  The keys here are if you are eligible, you can really sock away a ton into Roths.  However, your employer’s retirement plan has to be set up just right so you can execute the strategy. They need to allow after-tax contributions to your 401(k) and also in-service withdrawals.  Personally, I have not come across an employer set up this way, but they must be out there.

 

Now, I mentioned before I will be doing more videos this year.  I will go deeper into each one of these topics in an upcoming video.  I’m working with my video editor as we are trying some new things to improve the quality.  Most of it will probably involve not having to see my ugly mug as much in the videos.  Don’t worry as I will let you know once it is ready.