In order to prepare for a solid financial future, you should invest 15% of your household income to build wealth. You’re the CEO of your retirement—it’s up to you to take charge! But if you’re a high-income earner, you find yourself in a unique situation. You max out your contributions to tax-favored accounts—like a 401(k) or an IRA—before you reach the 15% mark.
Are you stuck with only contributing to tax-favored accounts? Nope! There are plenty of options for you to keep building wealth if you bring home a big check. Here are five investment options for high-income earners.
1. Backdoor Roth IRA
A backdoor Roth IRA is a convenient loophole that allows you to enjoy the tax advantages that a Roth IRA has to offer. Typically, high-income earners cannot open or contribute to a Roth IRA because there’s an income restriction. Here are the numbers for 2020: If you earn $139,000 or more as an individual or $206,000 or more as a couple, you cannot contribute to a Roth IRA.1
Be confident about your retirement. Find an investing pro in your area today.
But there’s a way around the rulebook—and it’s perfectly legal. 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 $6,000 a year (or $7,000 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, you can 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 Simplified Employee Pension (SEP) IRAs or Savings Incentive Match Plan for Employees (SIMPLE) IRAs. But if you’re converting an existing IRA, 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. 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.
Here’s the part that should make you excited: When you take money from a Roth IRA later on, it comes out tax-free! We like the sound of that! 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.
Let’s summarize the pros and cons of the backdoor Roth IRA.
Advantages of Investing in a Backdoor Roth IRA:
- No income limit: Everyone earning an income is eligible for a traditional IRA—no matter your income limit.
- Tax-free gains and withdrawals: If you convert your traditional IRA to a Roth, you pay the taxes up front and get to enjoy tax-free growth and withdrawals (once you reach age 59 1/2).
Disadvantages of Investing in a Backdoor Roth IRA:
- Income taxes: When you convert from traditional to Roth IRA, make sure you have the cash on hand to pay income taxes.
- Contribution limits: You cannot invest more than $6,000 in an IRA each year ($7,000 if you’re 50 or older)
2. Health Savings Account
A health savings account (HSA) is both a savings and investment account that gives you not one, not two, but three tax breaks—if you use it right! It’s like a hidden gem of investing. To qualify for an HSA, you must have a high deductible health plan. In the short term, an HSA acts as a tax-advantaged emergency fund for healthcare expenses. You can use the money you save in your HSA to pay for doctor’s visits, prescriptions and a whole bunch of medical expenses. Here’s what's so great about the HSA: You contribute pretax money, enjoy tax-free growth, and withdraw from it tax-free when used for medical purposes. It’s a win-win-win!
But if you shift your thinking from the short term to the long term, you can use your HSA as a “Health IRA.” In addition to saving, the HSA offers you an opportunity to invest. Once you’ve contributed a certain amount (usually between $1,000–2,000), you can start investing that money into mutual funds inside the HSA. And if you invest wisely now, this account can grow to be a big ol’ pot of money that will help you cover the cost of medical expenses in your later years. The average couple retiring today will rack up $285,000 in healthcare expenses (and that doesn’t include long-term care costs).2 Once you turn 65, you can take money out of your HSA and pay income taxes—just like you would with a 401(k) or traditional IRA—and spend it on whatever you’d like.
To sum up, here are the pros and cons of investing in an HSA.
Advantages of Investing in an HSA:
- The “Health IRA”: Save money for what could be your biggest expense in retirement—healthcare.
- Triple tax break: You can invest in an HSA with pretax money, enjoy tax-free growth, and avoid taxes if you use the money in retirement for qualified medical expenses. If you use the money on other expenses, you’ll pay regular income taxes, just like you would with a traditional IRA or 401(k).
- No required minimum distributions (RMDs): Traditional 401(k)s and IRAs require you to take a certain amount of money from your retirement accounts every month (Uncle Sam wants his share of that tax money!). But there are no RMDs for an HSA. You can withdraw money on your own schedule.
Disadvantages of Investing in an HSA:
- Conflict with Medicare: Once you enroll in Medicare, you can’t contribute to an HSA since it’s a high-deductible plan. But you can still use the money you’ve saved!
- Contribution limits: For 2020, the IRS has set the individual contribution limit to $3,550 and the family contribution limit to $7,100
3. 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 ($19,500 plus $6,000 for those age 50 and older). If you decide to go this route, in 2020, you can contribute a maximum of $57,000 of both pretax and after-tax dollars (or $63,500 if you’re 50 or older).3
Now, that limit includes the pretax $19,500 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 $19,500, and your employer matched $5,000 (for a total of $24,500), then you could contribute an additional $32,500, for a total pretax and after-tax contribution limit of $57,000.
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.
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. Here’s a quick recap of the pros and cons of after-tax 401(k) contributions.
Advantages of After-Tax 401(k) Contributions:
- Automated contributions: Every time you get paid, you can sweep some of that money into your investment account. Putting your savings on autopilot is a great way to consistently build wealth.
- Access to mutual funds: Invest in the same mutual funds where you invested your pretax dollars.
- Simplify your life: Keep all (or most of) your investment dollars in one convenient location—your 401(k).
Disadvantages of After-Tax 401(k) Contributions:
- No tax break: Any of your contributions above $19,500 are not tax-deductible.
4. Brokerage Accounts
Brokerage accounts—also called taxable investment accounts—allow you to purchase basically any type of investment: stocks, bonds, mutual funds and exchange-traded funds (ETFs).
Once you’ve maxed out your tax-favored plans, like your 401(k), 403(b) or IRA, you can still spend your money wisely by investing it in a brokerage account. Sure, you won’t get a tax advantage. But you’re still getting more for your money by growing it instead of letting it gather dust in a checking or savings account!
You can 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.
Advantages of Investing in a Brokerage Account:
- No contribution limit: With a taxable investment account, you can invest as much as you want each year.
- Flexibility: You can take money out at any time for any purpose without having to pay income taxes or penalties. This flexibility is important if you want to retire early and need an income stream.
- No required minimum distributions: You get to decide when and how much you want to withdraw.
Disadvantages of Investing in a Brokerage Account:
- No tax breaks: You invest with after-tax money, and you pay capital gains taxes when you withdraw money.
- 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.
5. Real Estate
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. We 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.
Advantages of Investing in Real Estate:
- Tried-and-true investment: If you play it right, real estate can become a wonderful source of income. They’re appreciating assets, and you can make good passive income from rental properties.
- Diversify your portfolio: Diversification (spreading out your money over different types of investments) is one of the most important ways to build wealth while minimizing risk.
Disadvantages of Investing in Real Estate:
- Time consuming: Real estate is a hands-on, all-consuming investment.
- Liability: Just like the stock market rises and falls, the value of your property can change depending on what happens in the area surrounding it.
Work With an Investment Professional
Whether you're a high-income earner or just getting started in your career, 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. These decisions are too important to go it alone.