Save Early For Retirement If You're A High Earner

By Mark P. Cussen, CFP®, CMFC, AFC | December 23, 2012 AAA

High earners and wealthy taxpayers are going to feel the bite of upcoming tax hikes. Therefore, 2013 could be a good year for you to beef up your retirement savings.

The Time Is Now
If you are a high-income earner and are participating in any type of employer-sponsored plan, you may be wise to divert whatever portion of your earnings you can. However, it is possible that your contributions may not be deductible this year or they may no longer grow tax-deferred. If you received a Christmas bonus this year, then your retirement plan may be a good place to put that bonus.

Roth Conversions
If your income is too high to allow you to contribute to a Roth IRA, you can get around this in some instances by contributing to a non-deductible IRA and then converting it to a Roth IRA. This is a relatively simple process if you don't have any other traditional tax-deferred IRAs or retirement accounts, but if you do, then the balances of those accounts will be added to any investment gain that you incurred in the non-deductible IRA before you converted it. Then the total amount is compared to the total of those amounts plus your non-deductible contribution to compute how much of your contribution is taxable.

Example
Bill has $75,000 in an old traditional 401(k). He now earns $300,000 a year as a doctor and makes a non-deductible contribution of $5,000 into a traditional IRA. The IRA balance grows by $2,000 before he converts it to a Roth IRA. Bill will calculate the taxable portion of his $7,000 conversion by adding the $2,000 gain to the $75,000 pretax balance in his old 401(k) to get $77,000. Divide $77,000 by $82,000 (the previous total plus the amount of his original contribution) to get 93.9%. This is the percent of the conversion that must be taxed. Bill will therefore owe tax on $6,573 of the $7,000 conversion balance.

If you like the idea of converting your non-deductible contributions into a Roth IRA but don't want to have to factor all of your previous traditional retirement plan and IRA balances into the equation, you can roll all of them into your current retirement plan first. Then immediately convert your contribution before any investment growth takes place. This will allow you to proceed with the conversion strategy with no tax implications from your other retirement savings. You may also want to consider dipping into your cash fund and paying the tax bill up front to convert your traditional retirement balances into Roth accounts.

Other Strategies
If you have already made the maximum possible contributions to your retirement plans and converted everything that you can or want to into Roth accounts, then you can still turn to the usual traditional alternatives for taxpayers in your situation. You can invest in one or more annuity contracts, which grow tax-deferred regardless of whether or not they are used inside a retirement plan until withdrawal at age 59 1/2. Annuities do not have contribution limits, although you can never take a deduction for contributing to them outside a retirement plan. You can also buy and hold shares of individual stocks. While you will most likely have to pay a higher rate of tax on any dividends that you receive, you can still defer tax on any gain you realize when you sell it - possibly until a time when capital gains tax rates improve. ETFs are a great option since they can accomplish the same objective with greater diversification.

The Bottom Line
Tax changes are coming this year. This is the time to prepare yourself and shield as much of your income and assets as possible from Uncle Sam. For more information on how you can lower your tax bill, consult your tax or financial advisor.

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