Retiring early is a dream for many, and for individuals between the ages of 40 and 60, their income tends to be at its highest. It's during the last 15 to 20 years of your working career that you have a golden opportunity to make this dream a reality. By this age range, your children have likely left the nest, freeing up more of your hard-earned cash to invest in your future.
Let's explore some strategies for how you can make the most of these high-income years by maximizing contributions to both qualified retirement plans and non-qualified investment accounts. And if you've already done this? There are some ways to invest even more if you have the means.
Qualified Retirement Accounts
First and foremost, focus on maxing out all available qualified retirement accounts. The term "qualified" refers to the eligibility of these accounts to receive certain tax advantages. Contributions made to qualified retirement accounts are typically tax-deductible in the year they are made, meaning they can reduce your taxable income for that year. Additionally, the investment earnings within these accounts can grow tax-deferred, meaning you don't pay taxes on the gains as long as the funds remain in the account.
However, taxes are usually due when you withdraw money from these accounts in retirement. The idea is that you will likely be in a lower tax bracket when you retire, so you'll pay less in taxes on the withdrawals than you would during your working years.
Qualified accounts include:
401(k)
403(b)
457 deferred comp plan
Traditional IRAs
Roth IRAs
Contribution Limits
If you're under age 50, the maximum contribution for a 401(k) in 2024 is $23,000. If you're 50 or older, you can contribute an additional $7,500 as catch-up contributions. The total limit for a combined employer plus employee contribution is $69,000, or $76,500 for those over 50 (includes the $7,500 catch-up amount).
Once you've hit the limit on your employer-sponsored plan, focus on your personal retirement accounts such as your Traditional IRAs and/or Roth IRAs. The 2024 contribution limit for those under 50 is $7,000, while those over 50 can contribute up to $8,000.
Now, if you've achieved a high level of financial success, too significant of an income can limit your ability to contribute to Traditional and Roth Individual Retirement Accounts (IRAs). These income limits are set by the Internal Revenue Service (IRS) and are adjusted periodically. Let's talk a little about that because it can get a bit confusing.
Traditional IRA Income Limits:
For a Traditional IRA, the ability to deduct contributions from your taxes can be affected by your income level, especially if you (or your spouse) are covered by a retirement plan at work. If you or your spouse participate in an employer-sponsored retirement plan, such as a 401(k), the deductibility of Traditional IRA contributions can be limited based on your modified adjusted gross income (MAGI).
As of 2024, if you are covered by a workplace retirement plan, such as a 401(k), and you are a single filer, the deduction begins to phase out at a MAGI greater than $77,000, but less than $87,000, and is fully phased out once you get to or above $87,000. For married couples filing jointly, if the spouse making the IRA contribution is covered by a workplace retirement plan, the phase-out range is from $123,000 to $143,000.
Here is a more detailed article explaining more:
If you earn above these income limits, you can still contribute to a Traditional IRA, but the contributions will not be tax-deductible. However, the earnings within the IRA will still grow tax-deferred until you begin withdrawing them in retirement.
Roth IRA Income Limits:
For a Roth IRA, income limits determine whether you can contribute directly to the account. These limits are based on your MAGI as well.
For example, in 2024, single filers' ability to contribute to a Roth IRA begins to phase out at a MAGI of $146,000 and is fully phased out at $161,000. For married couples filing jointly, the phase-out range is from $230,000 to $240,000.
Again, looking at a pre-made graph is easier than reading through all of the possible outcomes:
If your income exceeds these limits, you are not eligible to contribute directly to a Roth IRA. However, there is a strategy known as a "Backdoor Roth IRA" where you contribute to a Traditional IRA (which has no income limits for contributions), and then convert that contribution to a Roth IRA. This workaround allows high-income earners to still benefit from the advantages of a Roth IRA.
Mega-Backdoor Roth
For high-income earners with access to this option in their employer-sponsored plans, the mega-backdoor Roth offers significant benefits. By making after-tax contributions, individuals can contribute beyond traditional limits and convert these amounts to Roth for tax-free growth. Here's how the Mega Backdoor Roth strategy generally works:
Step 1: Employer-Sponsored 401(k) Plan
Contribute to a Traditional 401(k): The first step is to contribute the maximum amount allowed to your employer-sponsored Traditional 401(k) plan.
After-Tax Contributions: Some 401(k) plans allow you to make after-tax contributions on top of your regular pre-tax contributions. These after-tax contributions are different from Roth 401(k) contributions, which are limited to a separate annual cap.
Step 2: Convert After-Tax Contributions to Roth IRA
Convert After-Tax Contributions to Roth IRA: Here's where the "mega backdoor" part comes in. You can periodically (usually once every 12 months) convert the after-tax contributions you've made in your 401(k) to a Roth IRA. This conversion can typically be done within the same plan or by rolling the after-tax contributions into a Roth IRA outside of the plan.
Just like regular Roth IRA contributions, the funds in your Mega Backdoor Roth IRA grow tax-free, and qualified withdrawals in retirement are also tax-free. By having both pre-tax and Roth retirement savings, you create tax diversification in retirement. This flexibility allows you to strategically withdraw funds from accounts based on your tax situation in retirement.
Nic does a good job at visually showing us how a Mega Backdoor Roth works within an employer-sponsored plan.
Non-Qualified Investment Accounts
Once you've maxed out your qualified accounts, consider investing in non-qualified accounts. These could be individual brokerage accounts or joint investment accounts. While they don't offer the same tax advantages, non-qualified accounts allow for flexibility and access to funds at any time. Since there are no penalties for withdrawing money from a non-qualified account, it can be a good option if you anticipate needing access to your funds before retirement age (you'll just have to be aware of the capital gains taxes you may incur from holding any investments within these non-qualified accounts).
Closing
Investing in a combination of qualified and non-qualified accounts provides a balanced approach to retirement planning. With careful strategy and diligent saving during your high-income years, you can pave the way for an early and comfortable retirement.
By drawing on funds from non-qualified accounts, such as taxable brokerage accounts, individuals can avoid early withdrawal penalties that typically apply to retirement accounts. This dual strategy allows for early access to funds while minimizing tax implications and maintaining a balance between taxable and tax-advantaged investment vehicles.
However, it's essential to carefully plan and consult with financial advisors or tax professionals to ensure proper execution and adherence to IRS rules and regulations...
Have questions? Use our "Ask the Experts" feature on our home page and we'll get to you as soon as we can. Thank you for reading, and here's to a financially secure retirement!
Disclaimer: The information provided in this blog post is for educational purposes only and should not be considered financial advice. Individual circumstances may vary, and it's recommended to consult with a financial advisor for personalized guidance.