Three-Legged Stool for High-Income Earners
A million years ago when I started in this confusing world that is the financial services industry I was taught about the “three-legged stool” for retirement. The three legs were Social Security, Pension and Personal Investments. I am not here to talk about this. Instead, I want to touch on the three-legged stool for high-income earners. Give me 3 minutes and it will make sense.
Background:
- I am seeing more potential clients come my way with a good problem. They have a significant amount saved in tax-deferred accounts.
- They followed all the advice the industry and their employers gave them.
- That advice is basically – save as much as you can in tax-deferred accounts (401ks and IRAs) and pay lower taxes now.
- With decades of accumulation and tremendous growth with the stock market they now have sizeable tax-deferred accounts.
The Problem:
- Again, a good problem. They have sizeable nest eggs for retirement.
- Unfortunately, the focus on reducing taxes has caused a potential problem with Required Minimum Distributions (RMDs).
- Basically, their RMDs often become larger than some of their best income-producing years.
- And in retirement there are fewer ways to reduce tax bills.
Potential Solutions:
- Forget the invitations to the dinner seminars that promise “tax-free income” in retirement. This often means someone has a high-commission product to shove you into.
- No, instead we start talking about filling up tax brackets, doing Roth conversions, planning charitable donations more strategically, and more.
- However, depending on what age/point you begin this journey the “tax-efficient” runway becomes shorter. It is much harder to accomplish these things when you have RMDs starting in a couple of years vs 15-20 years. Basically, you need to start on this approach by the time you hit 60. And if you can do it at 50 you are even better off. Again, more runway to get the 747 that is your retirement off the ground.
A Better Approach for Three Legs:
- I am an advocate of what I describe as the three-legged retirement stool for high-income earners.
- Instead of low tax bill now the focus is “Lowest Lifetime Tax Bill” wins. Think forest vs the trees.
- The legs of the stool include Taxable, Tax-Deferred and Tax-Free accounts.
- I will touch more on these legs in other writings, but below are highlights.
- Taxable accounts are things like Individual and Joint accounts. Here you need to be tax-efficient as Capital Gains and Dividends come into play.
- Tax-Deferred accounts are your 401ks, 403bs, IRAs and SEPs. Contributions go in before taxes and no taxes on growth. However, distributions are taxed as ordinary income.
- Finally, we have Tax-Free accounts such as Roths, Health Savings Accounts and Roth 401ks. For the Roths, money goes in after taxes, grows tax-free and no taxes upon distribution. HSAs have no taxes anywhere, as long as you follow the rules.
What’s My Point:
- My point is simply to step back and look at the forest. While the traditional advice for reducing taxes and maxing out 401ks is fine for most people, high-income earners have some additional considerations.
- Taxes should always be part of the filter in which you view your investment and retirement savings strategies.
- Your savings and retirement plan is like getting a 747 off the ground. The more runway you have the easier the takeoff.
- Take the time to build that tax-efficient retirement runway long before you plan on needing to take the plane into the air. Heck, even Maverick can’t save you as his specialty is F-14s doing control tower flybys😉