01 Apr In Through The Out Door
“You can turn away from fortune, fortune, cause that’s all that’s left to you
It’s lonely at the bottom, man, it’s dizzy at the top”
– In The Evening; In Through The Out Door by Led Zeppelin; 1979.
For the past 3 months we’ve talked about the “average American” and how that person can manage their personal finances to become wealthy. Now let’s talk about “high income Americans” and how they can do the same thing, because high income Americans have the same goals and the same problems as average Americans.
Some of you are thinking; “If they’re high income, then they’re already wealthy.”. Not necessarily. We discussed that in our 12/04/2017 article, Income Is Not Wealth.
Others are thinking; “They’re high income earners, they already know what to do with their money.”. Not necessarily. High income earners tend to be very intelligent people, but they are not experts at everything. They are usually experts at something other than finance. For example, I am an expert at personal finance, but I know nothing about designing bridges or creating software. One the other hand, a civil engineer may be an expert at designing bridges, but know nothing about personal finance. An IT expert may be an expert at creating software, but know nothing about personal finance.
High Income American Profile
How much does the “average high income American” earn?
The Tax Policy Center reports that on average, the top 10% of tax payers pay an effective tax rate of 26.7%. Under current tax brackets, that would translate into approximately a 24% effective income tax rate. So a family earning $168,500+ would be considered high income. Everything we’re going to discuss over the next few weeks would therefor apply to any family earning $168,500/year or more.
I’ve never seen a good profile of the “average high income American”, so for our purposes, we’ll say it’s a couple in the highest marginal income tax bracket (37%). Let’s say this couple earns $630,000/year ($315,000/year/spouse). That’s a combined $52,500/month.
High Income American Goals
Retirement is the #1 financial goal of most Americans by a very wide margin. In fact, it’s a landslide. Almost all Americans are focused on retirement. High income Americans are no different. They also want to retire and spend time with their loved ones doing they things they enjoy doing.
The rule for most people, save & invest a minimum of 10% in a retirement account also applies to high income earners; they need to save & invest at least 10% of their income, preferably in retirement accounts.
The High Income Problem
Here’s the problem for high income Americans; the 2019 401(k) contribution limit is $19,000. 10% of $315,000 is $31,500, which means high income Americans can only contribute 6% of their income to a 401(k) ($19,000/$315,000 = 6%). So how does a high income American save the remaining 4% for retirement?
They could make Traditional IRA contributions. The current Traditional IRA contribution limit is $6,000/year. Unfortunately, for those with an income of $137,000+ ($203,000+ for a married couple) who are also participating in a 401(k), the Traditional IRA contribution is not tax deductible. That’s problem #1.
Problem #2 is that upon withdrawal, the principal of a non-deductible Traditional IRA contribution is not taxed, but the earnings are. This means you’d have to keep track of Traditional IRA contributions over a very long timeframe, say 35 years (15 working years + 20 retired years). It is all but guaranteed that this will not be done correctly and you’d ultimately end up paying income taxes twice; once on the contribution and again on the distribution.
Problem # 3 is that at age 70.5 years, you have to begin taking Required Minimum Distributions (RMD). RMD’s can be substantial. We have customers pushing $100,000/year in RMD distributions. If your retirement planning was done correctly, you already have a six-figure retirement income. Add in another $100,000+ and you will spend retirement back in the highest marginal income tax bracket.
It’s easy to see that retirement saving problems for high income Americans can go on & on & on. So what can be done about it?
The Backdoor Roth IRA
A big part of the solution is to go in through the out door.
The IRS is not going to allow us to deduct our contributions. The 2nd best alternative is tax deferred growth & optional tax free withdrawal. That sounds like a Roth IRA. Unfortunately, at an individual income of $137,000+ ($203,000+ for married couples), the IRS will not allow us to contribute to a Roth IRA. …. But there is a way around that.
There is currently no income limit on Roth IRA Conversions; basically we can convert a Traditional IRA to a Roth IRA no matter how large our income. The only caveat is that we have to pay taxes on the amount converted.
So this is what we do:
Step 1 – Make a non-deductible Traditional IRA contribution. The current limit is $6,000/yr for those under age 50 and $7,000/year for those age 50 & older.
Step 2 – Immediately convert the contribution to a Roth IRA. There are no taxes due, because we did not allow the contribution time to grow.
Abracadabra, a high income American has established & is funding a Roth IRA aka a “Backdoor Roth”.
The money in a Roth IRA will grow tax deferred, just like a 401(k) or Traditional IRA. Basically, your wealth will grow faster since you aren’t having to pay taxes on the profits in your Roth IRA.
At age 59.5 or older, withdrawals from a Roth IRA are 100% income tax free. And you do not have to keep track of contributions from year to year.
Roth IRA’s do not have a Required Minimum Distribution (RMD), so you can control how much money, if any, you withdraw from your Roth IRA. This helps to control income taxes in retirement.
Roth IRA’s also come with a nifty feature not available with a Traditional IRA; after a Roth IRA has been established for 5 consecutive years, you can withdraw your contributions income tax & penalty free!
For those under age 50, maxing your 401(k) contribution & funding a Backdoor Roth IRA allows you to save $25,000/year. Over the next few weeks we’ll discuss how to make-up any shortfall you may have in reaching your minimum 10% saving rate.
For those age 50 or older, your 401(k) contribution limit is $25,000 and your Traditional IRA contribution limit is $7,000, meaning you can save $32,000/year. For most high income Americans $32,000 will meet or exceed a minimum savings rate of 10%.
A skilled & knowledgeable financial planner knows this and many other techniques to help high income Americans reach their goals. All you have to do is reach out & ask for help.
Sapiat Asset Management is a fee-only, independent registered investment advisor, specializing in goal oriented, financial planning & investment management for Gen X Individuals & Families, their Businesses, & the Trusts that benefit them.