5 Investment Options for High-Income Earners
Discover top investment choices for high income earners! Explore 5 strategies to grow wealth effectively.
INVESTMENTS
As the leader of your retirement journey, the responsibility falls on your shoulders to make the right decisions. If you follow our advice, part of that responsibility involves investing 15% of your income into retirement accounts that come with tax advantages, such as 401(k)s and IRAs.
However, if you find yourself in the enviable position of being a high-income earner, you may encounter a unique challenge. Your substantial income may exceed the contribution limits of these tax-favored accounts, leaving you wondering how to proceed.
But fear not! You have various alternatives at your disposal to continue building wealth, even with a significant paycheck. Nevertheless, it's essential to remember that saving for retirement is one of the important steps in our financial planning. Before you embark on this phase of investing 15% of your income into retirement accounts, it's crucial to eliminate your debts (except for your mortgage) and establish a fully funded emergency fund. Now, let's explore five investment options designed specifically for high-income earners, allowing you to make the most of your income.
#1. Backdoor Roth IRA
A backdoor Roth IRA serves as a clever strategy to take advantage of the tax benefits associated with a Roth IRA. Normally, individuals with high incomes face restrictions when attempting to open or contribute to a Roth IRA. In 2023, for instance, if you are an individual earning $153,000 or more, or a couple with a combined income of $228,000 or more, you would typically be ineligible to contribute to a Roth IRA.
However, there exists a legal workaround to this income-based rule. The federal government permits the conversion of a traditional IRA into a Roth IRA, regardless of your income level. Here's how this method operates: You can make contributions of up to $6,500 in 2023 (or $7,500 if you are 50 years of age or older) to a traditional IRA. Once these funds are deposited into your traditional IRA account, you can promptly convert them into a Roth IRA. During this conversion, you will be required to pay taxes on the converted amount, so it's crucial to ensure you have the necessary funds to cover this tax liability.
It's worth noting that you can also convert existing IRAs, such as Simplified Employee Pension (SEP) IRAs or Savings Incentive Match Plan for Employees (SIMPLE) IRAs. However, if you choose to convert an existing IRA to a Roth IRA, you will be liable for taxes on the entire balance in that account, including any accrued growth.
The tax bill associated with this conversion can be substantial, depending on the size of your IRA and your current tax rate. It's important to be aware of this upfront and refrain from making the conversion if you lack the financial means to cover the tax obligation.
Here's the exciting part: When you withdraw money from a Roth IRA in retirement, those withdrawals are entirely tax-free. This feature makes the backdoor Roth IRA strategy particularly appealing. Furthermore, you can repeat this process year after year: Invest, convert, pay the taxes on the contributed amount, and then watch your investments grow tax-free.
Nevertheless, there may be potential income tax implications if you find yourself in a higher tax bracket during the year you decide to convert an IRA to a Roth IRA. Therefore, it is advisable to consult with a tax professional before proceeding with any conversions.
Now let's examine the advantages and disadvantages of the backdoor Roth IRA:
Advantages of Investing in a Backdoor Roth IRA:
Tax-Free Retirement Income: One of the most significant advantages is the potential for tax-free retirement income. When you contribute to a backdoor Roth IRA and follow the conversion process, your investments can grow over time without incurring any further taxes. This means that when you withdraw funds in retirement, you won't owe any income taxes on your contributions or the investment gains, provided you follow the IRS rules regarding qualified withdrawals.
No Income Limitations: The backdoor Roth IRA allows individuals with high incomes to access the benefits of a Roth IRA. Unlike traditional Roth IRAs, which have income limits that restrict eligibility, the backdoor Roth IRA strategy is available to everyone, regardless of their income level. This opens up tax-advantaged retirement savings to high earners who would otherwise be excluded.
Diversification of Tax-Advantaged Accounts: By utilizing a backdoor Roth IRA, you can diversify your retirement savings portfolio with both tax-deferred and tax-free accounts. This diversification can provide flexibility in managing your tax liability in retirement and help you optimize your tax strategy.
Estate Planning Benefits: Roth IRAs offer estate planning advantages as they allow you to pass on tax-free assets to your heirs. This can be a valuable tool for wealth transfer and legacy planning, ensuring that your beneficiaries receive the full value of your assets without tax consequences.
Flexibility in Contributions: While there are annual contribution limits for IRAs, contributing to a backdoor Roth IRA allows you to maximize your retirement savings. This is especially beneficial for those who have already maxed out their contributions to other retirement accounts like 401(k)s.
Disadvantages of Investing in a Backdoor Roth IRA:
Immediate Tax Liability: One of the significant drawbacks of a backdoor Roth IRA is the immediate tax liability it incurs. When you convert a traditional IRA to a Roth IRA, you must pay income taxes on the converted amount in the year of the conversion. This tax liability can be substantial, particularly if you're converting a large sum or if your tax bracket is high.
Lack of Liquidity: Converting a traditional IRA to a Roth IRA requires you to use funds from your own resources to pay the associated income taxes. If you don't have enough cash on hand to cover these taxes, you may need to dip into your savings, which could affect your liquidity and financial flexibility.
Potential for Higher Taxes: Depending on your current and future tax situation, converting to a Roth IRA might result in higher taxes. If you expect to be in a lower tax bracket during retirement, paying taxes now at a higher rate could be disadvantageous.
Loss of Tax Deferral: Traditional IRAs offer the advantage of tax-deferred growth, meaning you don't pay taxes on your contributions or earnings until you withdraw them. When you convert to a Roth IRA, you lose this tax-deferral benefit since you've already paid taxes on the converted amount.
Limited Annual Contributions: Like traditional IRAs, Roth IRAs have annual contribution limits. As of 2023, you can contribute a maximum of $6,500 per year (or $7,500 if you're 50 or older). This limitation can be a disadvantage if you're looking to invest larger sums for retirement.
#2. Real Estate Investment
Investing in real estate is a highly popular strategy that, when executed correctly, can yield favorable returns on your capital. The initial step in real estate investment often involves homeownership, and it's advisable to pay off your primary residence before venturing into other real estate investments.
Real estate investments typically demand a significant amount of hands-on involvement and can be quite time-consuming. Therefore, it's essential not to jump headfirst into the world of real estate unless you have a genuine passion for it. Prior to making any purchases, thorough research is crucial. Seek advice from individuals who have experience in this field as they can provide valuable insights into what the experience truly entails.
Additionally, consulting with an insurance agent is advisable to determine the necessary coverage, particularly if you plan to invest in rental properties. Calculating your potential profit after accounting for expenses, such as taxes, utilities, and maintenance costs, is essential. It's vital to emphasize that borrowing money to invest in real estate is generally discouraged; instead, it's preferable to purchase investment properties using cash.
Another approach to real estate investment is buying land, which typically requires less direct involvement. In areas where the housing market is booming, purchasing land on the outskirts of town can be a promising option, as these areas may develop into new subdivisions in the future. As with any investment, conducting thorough research before acquiring land is essential, and it's advisable to work with a reputable real estate agent when you decide to make a purchase.
Advantages of Real Estate Investment:
Potential for Appreciation: Real estate properties have historically shown the potential to appreciate in value over time. This means that the property you purchase today could be worth more in the future, allowing you to build wealth passively.
Rental Income: If you invest in rental properties, you can earn a steady stream of rental income. This income can provide financial stability and may even cover your mortgage and expenses, resulting in a profit.
Tax Benefits: Tax benefits for real estate investors can include mortgage interest, property tax, and depreciation write-offs. Your overall tax liability may be lowered thanks to these deductions.
Portfolio Diversification: Your investing portfolio can be diversified with real estate. As the real estate market frequently behaves differently from other asset classes like stocks and bonds, diversification helps to spread risk.
Hedge Against Inflation: Real estate is considered a hedge against inflation. As the cost of living rises, rental income and property values tend to increase, helping you preserve and potentially grow your purchasing power.
Disadvantages of Real Estate Investment:
Illiquidity: Real estate investments are relatively illiquid compared to other asset classes like stocks or bonds. Selling a property can take time, and it may not be easy to convert your investment into cash quickly, which can be problematic if you need immediate access to funds.
High Initial Costs: High initial costs: Investing in real estate often involves a significant initial outlay. Closing costs, real estate taxes, insurance, and upkeep expenditures all add up in addition to the purchase price.
Ongoing Expenses: Owning real estate comes with ongoing expenses, including property taxes, maintenance and repairs, insurance, and possibly property management fees if you own rental properties. These costs can eat into your potential profits.
Market Risk: Real estate values can be sensitive to economic conditions and market trends. Economic downturns can lead to a decrease in property values, potentially impacting your investment's worth.
Management Responsibilities: If you own rental properties, you'll have management responsibilities, including finding and screening tenants, handling maintenance requests, and addressing tenant issues. Being a landlord can be time-consuming and challenging.
#3. After-Tax 401(k) Contributions
In 2023, the maximum contribution limit for a traditional 401(k) with pretax dollars is $22,500 (or $30,000 if you're 50 years old or older). However, some employers offer the option of making after-tax contributions once you've reached the pretax contribution limit.
If you choose to take advantage of this option, you can contribute a maximum of $66,000 in 2023, combining both pretax and after-tax funds (or $73,500 if you're 50 or older).
This combined limit includes the initial $22,500 you contribute with pretax dollars, any contributions made by your employer, and any additional after-tax contributions you make. For instance, if you contribute the full $22,500, and your employer matches with $5,000, totaling $27,500, you can still contribute an additional $38,500, reaching the overall pretax and after-tax contribution limit of $66,000.
When you retire or leave your current employer, you have the option to transfer your after-tax 401(k) funds into a Roth IRA, allowing your wealth to continue growing tax-free.
Before opting for taxable 401(k) contributions, it's advisable to maximize your contributions to other tax-advantaged accounts, such as your IRA or Roth IRA. Here's a brief overview of the advantages and disadvantages of after-tax 401(k) contributions:
Advantages of After-Tax 401(k) Contributions:
Flexible Savings: After-tax 401(k) contributions provide flexibility, allowing you to save more for retirement beyond the limits of pretax contributions. This can be especially advantageous if you have the financial capacity to save more for your retirement years.
Tax-Free Growth: While your contributions are made with after-tax dollars and don't provide an immediate tax deduction, the growth of your investments within the after-tax 401(k) account is tax-deferred. This means that you won't pay taxes on the earnings until you withdraw the funds during retirement, potentially leading to greater long-term growth.
Diversified Retirement Income: Having a mix of both pretax and after-tax retirement savings can provide you with greater flexibility during retirement. You can strategically choose which accounts to withdraw from based on your tax situation in any given year, potentially minimizing your overall tax burden.
Roth IRA Conversion: After-tax 401(k) contributions can be converted into a Roth IRA when you retire or leave your job. This conversion allows your retirement savings to grow tax-free, and qualified withdrawals from a Roth IRA are entirely tax-free, providing a valuable source of tax-free income in retirement.
No Required Minimum Distributions (RMDs) for Roth IRAs: Roth IRAs do not have required minimum distribution (RMD) requirements during your lifetime. This means you can let your investments continue to grow tax-free for as long as you like, offering greater control over your retirement income strategy.
Disadvantages of After-Tax 401(k) Contributions:
No Immediate Tax Benefits: Unlike traditional pretax 401(k) contributions, after-tax contributions do not provide any immediate tax deductions. This means that the money you contribute to your after-tax 401(k) is taxed at your regular income tax rate, reducing your take-home pay.
Limited Investment Flexibility: While after-tax contributions allow you to invest in the same mutual funds as your pretax contributions, you may have limited control over the investment options available within your employer's 401(k) plan. This lack of flexibility can limit your ability to diversify your investment portfolio according to your preferences.
Complex Taxation Upon Withdrawal: When you withdraw funds from your after-tax 401(k) in retirement, the taxation can be more complex than with traditional 401(k) contributions. Only the earnings on your after-tax contributions are tax-free, while the original after-tax contributions are not taxed again. Managing the tax implications during retirement can be intricate and require careful planning.
Lower Contribution Limits: While after-tax contributions offer an opportunity to save beyond the pretax limit, the overall contribution limit of $66,000 (or $73,500 for those 50 and older) is still capped. This limit may not be sufficient for individuals with higher income levels who wish to save more for retirement..
Employer Restrictions: Not all employers offer after-tax 401(k) contributions as an option, limiting your ability to take advantage of this retirement savings strategy. Even if your employer does offer it, they may impose certain restrictions or conditions that can affect your ability to contribute.
#4. Health Savings Account (HSA)
A Health Savings Account (HSA) can be an attractive investment option for high-income earners due to its unique tax advantages and potential for long-term wealth accumulation. It serves as a dual-purpose financial tool, combining elements of both a savings and investment account while offering three distinct tax advantages when used strategically. Think of it as a hidden gem within the world of investing.
You must be enrolled in a high-deductible health plan in order to be eligible for an HSA. In the short term, an HSA acts as a tax-advantaged emergency fund for healthcare expenses. You can utilize the funds saved in your HSA to cover costs related to doctor visits, prescriptions, and various medical bills.
The remarkable feature of an HSA lies in its triple tax benefits. Firstly, you can contribute money to your HSA before taxes, reducing your taxable income. Secondly, any growth in your HSA account occurs tax-free. Lastly, when you use these funds for qualified medical expenses, you can withdraw them without incurring any taxes. It's a triple win!
However, if you shift your perspective from the short term to the long term, you can transform your HSA into a "health IRA." This means that beyond saving, you can also invest the money within your HSA. Once you've accumulated a certain amount, usually around $1,000 to $2,000, you can begin investing these funds in mutual funds within your HSA.
By making wise investment choices now, your HSA can potentially grow into a substantial nest egg, helping you cover healthcare costs during your later years. Keep in mind that today's average retiring couple can expect to accumulate $315,000 in healthcare expenses, not including long-term care costs. And once again, as long as you use the money for medical expenses, including the growth from your investments, it remains tax-free!
Once you reach the age of 65, you gain the flexibility to withdraw money from your HSA and use it for any purpose, much like you would with a 401(k) or traditional IRA. However, please note that you will be subject to taxes on these withdrawals.
Advantages of investing in an HSA:
Triple Tax Benefits: High-income earners often face higher tax rates, making tax-efficient investments essential. HSAs provide a triple tax benefit:
Pre-Tax Contributions: Contributions to an HSA are made with pre-tax dollars, reducing your taxable income. For high earners, this means potentially lowering your tax liability.
Tax-Free Growth: Any investment gains within the HSA grow tax-free. Unlike taxable investment accounts, you don't owe capital gains taxes on earnings, dividends, or interest.
Tax-Free Withdrawals: When you use HSA funds for qualified medical expenses, withdrawals are entirely tax-free. This can lead to significant tax savings, especially if you have substantial healthcare costs.
High Contribution Limits: HSAs have relatively high contribution limits, allowing high-income individuals to maximize their tax advantages. As of 2023, you can contribute up to $3,850 individually or $7,750 for a family. This flexibility enables you to build a sizable investment portfolio within the HSA.
Investment Opportunities: Unlike a standard savings account, HSAs allow you to invest your contributions in a range of investment options, typically including stocks, bonds, mutual funds, and more. High earners can benefit from the potential for substantial returns over time, growing their HSA into a significant financial asset.
Long-Term Wealth Accumulation: While HSAs are often used for immediate healthcare expenses, high-income earners can leverage them as a "health IRA." By contributing regularly and investing wisely, you can accumulate a substantial nest egg over the years. This money can serve as a tax-advantaged source of funding for healthcare in retirement, where medical costs tend to increase.
Portability: HSAs are not tied to an employer, making them portable. High earners who frequently change jobs or have multiple income sources can continue to contribute to and manage their HSA regardless of their employment situation.
Disadvantages of investing in an HSA:
High-Deductible Health Plan Requirement: To be eligible for an HSA, you must have a high-deductible health plan (HDHP). These plans typically come with higher deductibles and out-of-pocket expenses before insurance coverage kicks in. This can be a disadvantage if you anticipate needing a lot of medical care and cannot afford the upfront costs.
Limited Coverage for Certain Services: HDHPs often cover preventive care with no or low out-of-pocket costs, but they may not cover certain services or medications until you've met your deductible. This means you may have to pay for some medical expenses entirely out of your HSA until you reach the deductible threshold.
Tax Penalties for Non-Qualified Expenses: While HSAs offer tax benefits for qualified medical expenses, if you withdraw funds for non-medical purposes before age 65, you'll face both income tax and a 20% penalty. This penalty can be a significant drawback if you need the money for non-medical expenses.
#5. Brokerage Accounts
Brokerage accounts, also known as taxable investment accounts, offer the opportunity to invest in a wide range of assets, including stocks, bonds, mutual funds, and exchange-traded funds (ETFs).
Once you've maximized your contributions to tax-advantaged retirement plans like a 401(k), 403(b), or IRA, a brokerage account becomes a smart choice for further financial growth. While it doesn't provide tax advantages, it enables your money to grow rather than sitting idle in a checking or savings account.
Opening a taxable investment account can be done directly through a bank or brokerage firm, and you can even set up automated transfers from your bank account into your investment account on a regular basis.
There are several advantages and disadvantages associated with taxable investment accounts:
Advantages Investing in a Brokerage Account:
No Contribution Limit: Unlike tax-advantaged retirement accounts, there are no annual contribution limits for taxable investment accounts. You can invest as much as you desire.
Flexibility: Taxable accounts offer flexibility in terms of withdrawing funds. You can access your money at any time for any purpose without facing penalties. This flexibility is valuable, especially if you plan to retire early and require a steady income stream.
No Required Minimum Distributions (RMDs): Unlike retirement accounts, taxable investment accounts do not mandate specific withdrawal schedules or amounts. You have the freedom to choose when and how much you want to withdraw.
Disadvantages of Investing in a Brokerage Account:
No Tax Breaks: Investments in taxable accounts are funded with after-tax money, and you're subject to capital gains taxes when you sell investments and realize gains. Additionally, any dividends you receive are taxable, even if you choose to reinvest them.
Liability: Unlike investments held within a 401(k) or similar retirement account, assets in taxable accounts may not be shielded from legal liability in the event of a lawsuit. This is why it's advisable to consider additional protections like umbrella insurance to safeguard your wealth.
Collaborate with an Investment Expert
No matter if you have a substantial income or are at the beginning stages of your career, it's crucial to consult with a financial expert before making any investment choices. If you don't currently have a financial advisor, consider reaching out to an expert investment Professional. These professionals are well-equipped to assist you in exploring all available investment options tailored to your income and financial objectives. They possess a deep understanding of IRS regulations regarding income limitations, contribution caps, and additional investment opportunities. When it comes to such crucial decisions, seeking professional guidance is essential; going it alone may not be the wisest choice.