When it comes to saving for retirement, business owners & independent contractors get to have all the fun. For those folks, there are a myriad of ways we can structure one or more retirement plans and stuff them full of possibly hundreds of thousands of dollars per year. It’s a proverbial buffet of options.
However, if you’re a high-income W-2 employee (meaning you receive a W-2 from your employer each year), your options for accelerated retirement planning are much more limited. Instead of a buffet, your menu is more like that of a ball-park food stand. You can order anything your heart desires, as long as it’s a hot dog or nachos.
Why is this is hard:
This is a real issue for folks making $250,000+ as a W-2 employee – a common situation for doctors, engineers, IT pros, executives and etc.
Let’s say for example that I’m a successful executive making $300,000 per year and I’d like to save 15% of my income towards retirement, and let’s assume that my employer offers a 401(k) w/ Profit Sharing program. For you math majors, we're aiming for a $45,000 annual savings.
Well, the maximum I’m allowed to save into that 401(k) is $18,500 (or $24,500 if I’m over 50). If my employer matches up to 4%, I’ll get an additional $11,000 (there's an IRS limit at play here) for a grand total of $29,500 into the plan. Altogether, I’m about $15,000 short of my savings goal with no more room to run; I've maxed out what I can do in my employer's plan.
If I was able to save the full $45,000 in a tax-deferred account, I would accumulate a sum of $3,289,767 in 25 years assuming I could earn 8% on average. However, since I’ve hit my contribution limit and I’m forced to save the rest of my goal in a regular taxable account, my 25-year sum will come add up to a little less at $2,965,271.
So, hitting the limit in the 401(k) has cost this executive around $324,496 at retirement!
Pump the brakes a sec.
First of all, please consider your individual situation when thinking about accelerating your retirement savings. Not everyone should accelerate.
If you do not have adequate short-term savings, if you have an inappropriate level or type of debt, if you have short term personal or business goals which require capital – all of these are great reasons not to tie up your extra money for the next 25 years into a retirement plan.
How much should you save for retirement?
In my example above, we used a 15% mark as our retirement savings goal. I’ll continue to harp on this with each article I post – financial advice is very general unless you go through the process to apply it to your situation.
A figure of 15% may be too much or too little depending on your individual situation. The best thing you can do is crunch these numbers with your professional financial advisor.
What can a W-2 employee do?
There are a few options here. First, let’s remember that it is not the end of the world if we cannot get all of the money into a qualified plan. I know I've just got done telling you it will end out with less money, but a qualified plan it is not without its own disadvantages. Money in taxable account is more liquid – freely available without penalty or income tax issues.
Have a great business opportunity come up that you want to participate in? You can’t use your retirement funds (other than a small 401(k) loan, which usually isn’t a good idea), but you can use your taxable brokerage account!
Find that dream vacation home? Same deal.
As a general rule of thumb, for our clients, we do not commit our full retirement savings goal to a qualified account for exactly these reasons.
That being said, there are definitely still situations where we need to be creative to get more money in. In that vein, let’s talk about a few moves. I’ll go in order of palatability:
If you can’t go in the front door, try the back
So let’s go back to the example above with our $300,000 per year executive and let’s further assume he’s married. One route would be to consider using a Backdoor ROTH IRA strategy. Basically, this is a way for people who otherwise have too much income to do a regular ROTH contribution to sneak around the fence and join the party.
Generally, both the husband and wife would make a non-deductible contribution to a traditional IRA and then convert that into a ROTH afterwards. There are some special rules to be aware of here, namely the IRA Aggregation rule, timing considerations and some special forms to file at tax time. So, again, be careful to seek professional advice before prescribing this solution for yourself.
A ROTH is an amazing tool for retirement – you don’t get the tax deduction today but you have tax-deferred growth along the way and no taxes at distribution. Furthermore, ROTH IRA’s are not subject to the “Required Minimum Distribution” rules that traditional IRA’s (and other qualified plans) are.
ROTH IRA's can also be used for qualified education expenses, and the contributions can generally be withdrawn at any point without penalty, making this about the most flexible & liquid retirement plan not he market!
For our executive, assuming he’s not older than 50, he (and his wife) would’ve been able to contribute another $5500 each in the backdoor ROTH strategy, for a total of $11,000 of additional retirement contributions.
Get your tax advantage somewhere else
There are a couple of other accounts which have tax-advantaged growth – an annuity and a life insurance policy.
Now, let me put up the “Danger: Riptide” sign here before you kick off your sandals and jump in the water. You need to be really careful where you swim here.
For every good annuity or life insurance contract on the market, there are 9 crummy ones (I’ll be sure to cover this in a separate article).
I’m serious. The ratio is about 1/10. Broken record time: a fiduciary advisor should be able to help you navigate this rough water.
Generally, we're talking about either a no load, fee-based (or flat fee) variable annuity or a participating whole-life insurance contract. The fee-based annuity will function similar to any other advisor-managed investment account and will offer you a wide array of very competitive investment choices with relatively low fees.
In annuity-world, a no-load, fee-based annuity is much, much different than an annuity offered through an insurance company where the salesperson is paid a commission.
Insurance company annuities are chock full of fees and additional riders that you most likely do not need. In the annuity, your growth is deferred from a tax standpoint just as it would be in a qualified account. When you take distributions, you’ll receive back a mix of taxable & non-taxable money.
A participating whole life insurance policy will typically pay a dividend and, over time, should provide a bond-like return. So, if you’re incorporating this as an asset class in your portfolio you’ll want to adjust the overall allocation of your other accounts to make room for this bond-like component.
In the life insurance policy, your growth is also deferred but you are not subject to age-based penalties like you are in the annuity (or IRA or qualified plan). Beyond that, if you do it right, you can actually take distributions from a life insurance contract which are never taxed. Obviously a life insurance policy is quite different from a normal investment account, so you’ll definitely want to consider this within the overall framework of your personal financial situation.
Ask them to stop paying you!
Often times a high-earning W2 employee is in a position of influence with his employer. One thing we’ve seen successfully implemented from time to time is for the W2 employee to ask his/her employer to start a “Deferred Compensation” program.
It’s basically just what it sounds like – the company will “defer” paying you a portion of your salary and save it into an account. Typically, you’ll have a menu of investment options just as you would in a 401(k) plan. If held to retirement, for all intents and purposes, the financial outcome for you is very similar to that of a qualified plan.
There are a couple of important differences here, though.
First off, you need to be confident in the stability of your employer. Deferred compensation plans are typically subject to the claims of your employer’s creditors (while qualified plans like 401(k)s are not). So, if your employer goes belly up your funds could be at risk.
Also, depending on the rules of the plan, distributions may be automatically triggered if you leave the employer or change jobs. This probably is not what you want to have happen – you may not even be close to ready for that money to come in (and be taxed).
Third, you normally have to pick your distribution options at the beginning (or defined intervals) and often times you cannot change them later on. So, what can seem like good timing at the beginning sometimes ends up being not-so-good.
In Conclusion
I love the backdoor ROTH strategy, but you have to be careful if you have lots of existing IRA’s due to the aggregation rule and you also need to be careful with timing. Sometimes we can roll existing IRA's into a new employer qualified plan and get around it, but it just depends on your situation.
Life insurance and annuities can be a viable route as well, but you’ve got to pick a good product from a good carrier and do it within the context of everything else you’re doing. This is an area unfortunately where a lot of folks get "sold" something inappropriate or just plain bad.
Deferred compensation is also a solid option, but it has its own risks and peculiarities so it’s not normally a good home for “lots” of your money.
As always, the intent of this article is to provide general financial advice which may or may not be applicable to your personal financial situation. If you want to reach out, I’d love the opportunity to talk about your individual options.