A Primer on 401k's for High Earners
Today, we're going to do a quick primmer on 401k's for high earners. Lots of people have access to a 401k through their employer, and when you're young, you're thinking about putting money away for when you're 30, or 40, or 50 years old. It can be seemed kind of daunting.
As you enter the ranks of high earners, the rules of 401k's get more complicated. A few key principles can help you find your way to optimal decision making. To help provide some clarity, I want to go from kind of "401k 101" planning all the way up to high income folks who may be interested in more strategic thinking about your 401k.
Hidden 401k Rules for High Earners
First, when it comes to investing in your 401k, you're typically putting money in on a tax deductible basis, You're also usually getting some kind of a match from your employer. The match typically will be somewhere between 50-100% on the dollar up to some percentage, maybe it's 3% or 6%.
That's a nice gesture from the individual company that you work for. It's fair to all employees in that they have to do the same match for all employees across the board - a good leg up for the little guy!
For higher income employees though, there's a few important facts that are "behind the curtain" on the employer side. In fact, the IRS only allows companies to match compensation up to what's called the internal revenue code income threshold. (Leave it to the IRS to come up with words and phrases like that.)
Why contributing early is key for high earners
The internal revenue code income threshold right now (June 2021) is around 285,000- $290,000. So if you make more than that in base and bonus, you could end up actually getting stiffed by your employer because they're actually not allowed to match contributions on your compensation above that threshold.
This means contributing early is really key, contributing up to the threshold that you can to make sure you're getting all of your company match.
Should High Earners Always Take the Tax Deduction?
Here's the next thing. I mentioned that most of us put money away on a pre-tax basis here - if you are married, filing jointly and you make less than $300,000 a year in adjusted gross income, you may want to consider not taking the tax deduction right now.
Now people would say, "Wayne, are you crazy? I'm in the 24% tax bracket and you're telling me I shouldn't take the tax deduction. And you want me to go ahead and pay taxes on money that I'm putting away for 20, 30, 40 years?"
The short answer is "yes".
Exploring Roth 401k Contributions
Here's my logic. Historically, we're in a pretty low income tax environment, and if you like me think that our government is spending too much money, then the likely scenario down the road is that income tax rates probably gravitate up.
That means you may be taking a tax deduction today, getting tax deferred growth on that money for that 20 to 40 years and then when you go to take that money out, you're going to end up paying income taxes potentially at a higher rate on all of it.
The IRS is giving you a tax deduction on the seed, tax deferred growth on the crop, and then they're going to tax the entire harvest.
Take this another step - if you die without pulling it all out and you leave it to your kids, the current tax law is your kids have to take it all out within 10 years. Think about that for a minute. That could push your children into much higher tax brackets if they have to drain all your retirement savings in a finite period of time.
Identifying the Best Decision for High Earners
Now, the right answer is not, "Do nothing and die poor." That's not the right solution here. The right solution is to utilize that Roth 401k especially if your income is below about that $300,000-$305,000 (married filing jointly).
Your income is not going to be taxed at above 24% right now. Take advantage of that. Go ahead and pay the tax rate, the known tax rate of 24% right now. Get tax deferred growth and tax free withdraws on all of the growth on that money.
Now, if your income is above that $300,000, here's some strategic planning for you that's along the same line.
Let's say you're making more than $300,000 a year, and you're kind of easily getting to that $20,000+ matching contributions on your part. Maybe you get to 50 and you're doing your catch-up contributions.
You're doing all of those things, and that's 101 planning, 201 planning, 301 planning, now it's graduate time. Now it's time to think big picture.
Can you can afford to put after tax money into your 401k even after you've matched either the pre-tax amount or the Roth amount? If you can afford to put more money in, do it and put after tax money into your 401k after you've hit the contribution limits if your plan will allow it. Here's why.
Contributing After Tax Dollars
If you were able to afford to do that, you're probably in one of those higher income tax brackets and the conversation's going to come back. But, "Wayne, now I'm in the 32, or 35, or 37% bracket and you're telling me to put after tax money in my 401k."
And I'm going to say yes, because you probably don't qualify to do a Roth IRA out of your savings. In that case, if you make under a certain threshold, you do qualify to do a Roth IRA contribution outside your 401k.
But if you're in those higher income tax brackets, you don't qualify. The IRS won't let you. But here's a graduate level secret in tax planning.
All of that after tax money that you jam in your 401k, when you leave your company or when you retire under current tax law, you can roll that money directly into a Roth IRA.
So for those of us who are in those higher income tax brackets, that after tax money into the 401k becomes a fantastic planning tool for us to get Roth contributions set aside today, we're planning strategically ahead.
Closing Thoughts on 401k's
To put a neat bow on these 401k thoughts, here's a review:
- 101 Planning: Participate in your 401k, and make sure you're getting the match contributions.
- 201 Planning: Think about doing Roth contributions instead of pre-tax contributions.
- 301 Planning: Make sure that you're regularly rebalancing your 401k. Also make sure that you are doing the catch-up contributions if you've hit 50 and above.
- 401 Graduate Level Planning: If you can afford to, put all of the contributions that you already have and more and jam after tax money into your 401k so that you can preemptively prepare. Alternatively, roll that money into a Roth IRA upon retirement or separation from your company.
As always, we here at Vizionary Wealth Management are here with perspective for the decisions ahead. If we can help you with this or any other area of your planning, please don't hesitate to reach out. Have a great day.