- \ Gerard Gruber
- February 27, 2020
Saving and investing in a tax-wise way is a bit more complex for high-income earners than for the average American saver. Income caps and limits on annual contributions make traditional retirement accounts insufficient in isolation. The problem for individuals that have plenty to fund their primary retirement accounts is in deciding where best to save excess funds.
But with so many options to choose from, which accounts should be considered over others? Which accounts will allow for maximum long-term growth and minimum tax liability?
Types of Tax-Preferences
In order to encourage saving for retirement and other financial goals, the US government offers tax preferences on a handful of retirement accounts. Naturally, though, some get more preferential treatment than others.
Keep in mind, there are regulations on many on these accounts, such as rules on how the funds can be spent without penalty. Often, these rules are directly proportionate to the number of tax breaks they offer. The more perks associated with the account, the more stipulations attached.
Tax breaks are offered in three different ways:
- Tax-Deductible on Contributions: Annual contributions are tax-deductible, offering tax savings up front.
- Tax Deferred Growth: Investment growth is allowed to grow tax-free year after year.
- Tax-Free Distributions: Investments are not taxed upon distribution, offering tax savings on the tail end.
Types of Tax-Advantaged Accounts
Most every tax-advantaged account allows for the second tax break on the list, tax-deferred growth. Any gains made within the investment account that remain invested are not yet considered income and will not be factored into your taxes each year.
That being equal, we can divide other accounts into two main types: those that offer tax-savings up front on contributions and those that offer the tax-savings on the back end on distributions.
The former comprises what are known as “traditional” accounts. These use pre-tax money for contributions, allow for tax-deferred growth, and are then taxed upon withdrawal in retirement.
The latter are known as “Roth”-style accounts. Contributions are made with post-tax dollars, meaning there is no tax break on contributions, but offer tax-free withdrawals in retirement. This tax treatment also applies to 529 college savings accounts.
Even though high-income earners are not able to open Roth style accounts because of regulatory income caps, most will be eligible to perform Roth IRA rollovers multiple times over the course of their lifetime to take advantage of tax-free growth and distributions.
In essence, each of these accounts is double tax-advantaged.
Still, though, there is another option that offers all three tax-advantages: the Health Savings Account (HSA). This account is not only funded with pre-tax dollars, but allows for tax-deferred growth, and grants tax-free withdrawals when the funds are used for qualified medical expenses. These are becoming more popular savings vehicles for this “triple-tax-free” edge.
At the other end of the spectrum are non-qualified annuities and brokerage accounts. Non-qualified annuities are taxed differently than most investments. They only offer the advantage of allowing for tax-free growth, but contributions are not tax-deductible and payouts are taxed as ordinary income. Brokerage accounts are also taxed with post-tax dollars, but allow for tax-deferral as capital gains are only taxed upon liquidation.
Related: What You Need to Know About Estimating Taxes in Retirement
Most Tax-Advantaged Accounts to Least (Top to Bottom)
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The Approach
High-income earners must prioritize amongst the different vehicles for maximum total growth on invested assets. One approach is to max out contributions to the most tax-advantaged vehicles first, then move on to the subsequent accounts on the list. However, each individual will undoubtedly have different needs. While a deferred non-qualified annuity may beneficial to one individual, it may undermine the goals of another.
Of course, there are other options for high-earning individuals to build wealth, but the appeal of these accounts is their ability to help strategically coordinate tax liability now and in the future.
At Harbor West, we understand the importance of tax planning in your financial plan and work to help you limit those burdens as much as we possibly can. Ultimately, any money not paid in tax is money that can keep earning and working to reach your future goals.
Ready to set up a tax-advantaged savings plan? Call us today to schedule your complimentary Discovery Call. We’d be happy to help.