If you’re a high-income earner, you might find yourself in a unique situation: You max out your contributions through normal channels like a 401(k) or an IRA before you reach the 15% mark—which is the amount you need to invest every month to ensure a solid financial future.
Are you stuck with only contributing to tax-favored accounts? What if you need to put away more?
The good news is that you can invest large amounts of money even if you’re in a higher income bracket. Here are a few smart ways to do that.
Backdoor Roth IRA
For 2018, if your adjusted gross income (gross income minus specific deductions) is $135,000 or more as an individual, or more than $199,000 as a couple, you can’t open or contribute to a Roth IRA.(1) You want to invest in a Roth IRA because the growth is tax-free, and you’re not taxed on the withdrawals later. There’s a way around this income rule, though, and it’s absolutely legal. It’s called a backdoor Roth IRA.
The federal government says you can convert a traditional IRA into a Roth IRA regardless of your income. Here’s how it works: You can contribute up to $5,500 a year (or $6,500 if you’re 50 or older) to a traditional IRA or open a new IRA. As soon as that money posts to your traditional IRA account, ask your financial professional to convert that IRA into a Roth IRA. When you do that, you’ll pay the taxes on that money, so make sure you have the cash on hand to pay Uncle Sam.
You can also convert already-existing IRAs, like SEP or SIMPLE IRAs. But if you’re converting an existing IRA (say, one you opened when you turned 18), you’ll pay taxes on all the money in that account, including any growth that has occurred since you opened it. Depending on the size of your IRA and your tax rate, that could be a pretty hefty bill. Know that up front. Don’t make the conversion to a Roth IRA if you don’t have the cash to pay the tax bill.
But here’s the good news: When you take money from a Roth IRA later on, you’re not taxed on that money because you’ve already paid taxes on it. And you can repeat this process year after year. Invest. Convert. Pay the taxes on the money you invested. Then watch it grow tax-free. Repeat every year.
Now, there may be some income tax implications if you’re in a higher tax bracket during the year you convert an IRA to a Roth IRA, so make sure you talk to a tax professional before you do any conversions.
If you’re not sure which investment accounts can be rolled over into Roth options, the IRS has a section on its website dedicated to this topic. But always check with your investing pro before you convert any accounts.
After-Tax 401(k) Contributions
Some employers will allow after-tax contributions to their 401(k) plans in addition to the maximum pretax amount you can contribute ($18,000 plus $6,000 for those age 50 and older). If you decide to go this route, you can contribute a maximum of $55,000 of both pretax and after-tax dollars (or $59,000 if you’re 50 or older).(2)
Now, that limit includes the pretaxed $18,000 you put in, plus the money your employer put in and any after-tax contributions you make. For example, if you contributed your maximum of $18,000, and your employer matched $5,000 (for a total of $23,000), then you could contribute an additional $32,000, for a total pretax and after-tax contribution limit of $55,000.
When you retire or when you leave a company, you can take that after-tax 401(k) money and put it in a Roth IRA where you can continue to grow wealth.
Here’s the drawback—any contributions above $18,000 are not tax-deductible. But it does allow you to invest a lot more every year. Before you go with the taxable 401(k) contributions, make sure you max out your other tax-favored accounts, like the IRA or Roth IRA.
Taxable Investment Accounts
A lot of people think that once you’ve maxed out your contributions to tax-favored plans like a 401(k), 403(b) or IRA, you can’t invest anything else. That’s not true. You can actually open a taxable investing account with a bank or brokerage firm directly, and you can even set up automatic withdrawals from your bank into that investment account each month.
There are some pros and cons to taxable investment accounts. Here are a few to think about:
- No contribution limit. With a taxable investment account, you can invest as much as you want each year. Since you’ve already paid income taxes on the money (from your paycheck), the government doesn’t care about how much you invest. And the government will hit you with capital gains taxes later, so they’ll gets their taxes anyway.
- Flexibility. You can take money out at any time for any purpose without having to pay income taxes or penalties. You will have to pay short- or long-term capital gains taxes. This flexibility is important if you want to retire early and need an income stream.
- No required withdrawals. With a 401(k) or IRA, the government requires you to withdraw a minimum amount (called RMD) each year (so Uncle Sam can get his money). However, if you have money in a taxable account, you can leave it there to grow indefinitely.
- No tax breaks. Sorry, but the government limits the tax breaks you’ll get, and once you max out an IRA and 401(k) (or something like it), any other investments are taxable.
- Liability. Investments made in a 401(k) (and other similar accounts) are protected from a lawsuit. That’s not the case with a taxable account. That’s why you need umbrella insurance. If you’re a high-income earner, you need an umbrella policy anyway.
Just like a 401(k), you want to spread your investments across four different kinds of funds: growth and income, growth, aggressive growth, and international. This minimizes risk because the funds’ growth and losses balance each other out. And just like other investing options, think long term. Don’t chase after “hot” performers. Slow and steady growth wins the race. Every time.
Another investment option many people choose is real estate. This kind of investment is the most hands-on and time-consuming of your investing options. I wouldn’t recommend real estate unless you have a real passion for it. Before you buy, do your homework. Talk to people who’ve done it. They’ll tell you what it’s really like.
Also talk to an insurance agent about any liabilities you might have, especially if you invest in rental property. Do the math to see how much money you’d actually make after expenses, including taxes, utilities and other costs. And never, ever borrow money to buy real estate. Only purchase it if you have the cash on hand.
A middle-ground option for real estate is purchasing land. If you’re in an area where the housing industry is booming, purchasing land on the outskirts of town might be a good option. The outskirts may become a new subdivision before you know it! As with investments, do your homework before you purchase land. And be sure you’re working with a top-notch real estate agent when you’re ready to buy.
Always talk with your investment professional before you choose any of these investing options. They will help you determine the best options based on your income and investing goals. They know the IRS rules for income restrictions, contribution limits, and catch-up options for investing.
Regardless of how you invest, you need to go in with eyes wide open. It’s your money, so you want to play it smart.
If you need help finding an advisor, check out our SmartVestor service. Give us basic information and we’ll give you a list of investment pros in your area who are ready to work with you!
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