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Hierarchy of Tax-Preferenced Savings Vehicles for High-Income Earners Thumbnail

Hierarchy of Tax-Preferenced Savings Vehicles for High-Income Earners

For high-income earners that are looking to minimize taxes and maximize savings, here's a Hierarchy of the Tax-Preferenced Savings Vehicles. Generally, your savings strategy should begin with Tier 1 and work your way up to Tier 7, however, this will depend on your individual situation. You can find the full and original article on Kitces.com.


Before you begin utilizing tax-preferenced savings vehicles, you should have an adequate Emergency Savings Fund. Your Emergency Savings should be between 3-6 months of non-discretionary living expenses. Non-discretionary living expenses consist of expenses that you must continue to pay, even if you were to leave your current job. I.e. rent, utilities, car payment, food, insurance, etc. If you're leaving your career to start a new business, you should have a Job Mobility / Business Startup Fund that consists of 18 months of expenses.

Of course, before you begin to save for your Emergency Savings Fund or Job Mobility Fund, you should pay off any high-interest debts such as credit card bills.


The first and best place to save for long-term tax-preferenced savings for high-income individuals is a Health Savings Account (HSA). This is the only triple-tax-free option available that provides an upfront tax-deduction, tax-deferred growth, and tax-free distributions (limited to medical-related expenses).

For 2018, the maximum contribution is $3,450 for Individuals or $6,850 for families (plus a $1,000 catch-up contribution for those age 55 or older). 

The key to maximizing the HSA is to pay all actual medical expenses out of pocket. This will allow time to grow your contributions tax-deferred and tax-free. As Kitces points out, the only caveat to having an HSA is that it's only permitted for those who have a high-deductible health plan (HDHP).


After the triple-tax-free Health Savings Account, the next tier of savings are the double-tax-preferenced retirement accounts. These are tax-deferred on growth and either tax-deductible upfront or tax-free on distributions at the end.

Traditional & Roth-Style 401(k) Salary Deferrals (401(k), 403(b), 457, and SARSEPs) have a $18,500 individual limit plus a $6,000 catch-up contribution for 2018. For most cases, it's actually better for high-income earners to take advantage of Traditional 401(k)'s, rather than Roth 401(k)'s as this will enable you to receive an upfront tax deduction at your current high tax bracket. You can then do partial Roth conversions later after your wage/employment income ends and your tax bracket drops.

Traditional & Roth-Style IRAs have a $5,550 maximum contribution limit and a $1,000 catch up for those over 50 for 2018. Be aware that for high-income earners, there are IRA deduction phase outs for active employer retirement account participants and Roth IRA phaseouts.

For 2018, the pre-tax IRA deduction phaseout for active participants for Individuals is $63,000 - $73,000, Married filing Jointly $101,000 - $121,000, Married filing Separately $0 - $10,000, and Non-Active Participant Married to Active Participant $189,000 - $199,000.

The Roth IRA phaseouts are $120,000 - $135,000 for Individuals and $189,000 - $199,000 for Married filing Jointly.

Deferred Compensation based on available income to defer.

529 College Savings Plans for those who are saving for children's college education. Leveraging a 529 allows you to maximize tax-free growth and benefit younger children that can benefit from tax-deferred compounding growth. The 529 plan's maximum account limit is determined based on the state and the beneficiary can always be changed in the future to other family members.


For high-income earners that are already maximizing their pre-tax retirement accounts and unable to make pre-tax contributions to a Traditional IRA or contribute to a Roth IRA, you can make an After-Tax Contribution to a Non-Deductible IRA ($5,500 individual limit plus $1,000 catchup). This will help you avoid the 3.8% Medicare surtax on investment growth and allow for tax-deferred growth (single-tax-preferenced).

You'll then convert these non-deductible IRA contributions into a backdoor Roth contribution, which have no income limits for doing a backdoor Roth conversion. It's important to understand the IRA aggregation rule that can cause a non-deductible IRA contribution to become partially taxable and to wait a reasonable time period between the non-deductible IRA contribution and subsequent conversion to avoid the step transaction doctrine.


After-Tax 401(k) Contributions (To Be Roth Converted) is the next best option, which is also called the "mega-backdoor Roth". If your 401(k) plan allows for it, you can make after-tax contributions to your 401(k) plan, above and beyond the traditional salary deferral limit that can be done pre-tax, and later convert these to a Roth.

The mega-backdoor Roth contribution starts above the $18,500 pre-tax salary deferral limit ($24,500 if above age 50), and extends up to the $55,000 contribution limit for total dollars into any defined contribution plan. This means the potential maximum mega-backdoor-Roth contribution can be as high as $36,500 for 2018.

The after-tax contribution will grow tax-deferred until plan separation (retirement or leave employer), at which point, all growth will be rolled into a Traditional IRA and continue to grow tax-deferred and the initial after-tax contribution amounts can be rolled into a Roth to grow tax-free.

Several big caveats:

  • Tax-free Roth status does not begin until the dollars are actually converted to a Roth.
  • Employer retirement plan must allow after-tax contributions (not all do).
  • The $55,000 limit for all contributions into defined contribution plans includes the $18,500 salary deferral limit, after-tax contributions, and any profit sharing or other employer pre-tax contributions.
  • Some risk that Congress will change the rules to eliminate the ability to convert after-tax dollars during the time period between making after-tax contributions and subsequent Roth conversion.


The next tier of high-income savings vehicles are those that do not provide any upfront tax deduction or any kind of tax-free distributions. They do allow for tax-deferred growth.

Non-Qualified Deferred Annuities when held outside of a retirement account, can provide tax-deferred growth. The biggest caveat with annuities are that retirement income guarantees and "tax-deferral wrapper" add to the annuities cost. For high-income individuals who just want tax-deferral, look for "Investment-Only Variable Annuity" contracts. These have very few guarantees and lower their costs (sometimes 0.50%/year or lower).

A Buy & Hold Tax Deferral (Long-Term Capital Gains Treatment) strategy in a "taxable brokerage account" can also be an effective option for tax-deferred growth because capital gains aren't taxable until sold. A zero-dividend growth stock that is held until liquidation gets the same "tax-deferral" treatment as an annuity, but without the added annuity wrapper costs. For most high-income individuals, the Long-Term Capital Gains rate is 15%, however it can be as low as 0% or as high as 20% depending on taxable income.


A Grantor Dynasty Trust is simply a trust that is designed to last for multiple generations by utilizing the lifetime gift tax exemption and the generation-skipping-tax exemption to allow assets in the trust to avoid future estate taxes.

The grantor of the dynasty trust will remain in the same tax position as before and will pay the taxes on the growth, however the dynasty trust will effectively grow "tax-free" (both income-tax free and estate tax free) which can help accelerate the tax-free growth for future generations' family wealth.


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