What high earners need to know about retirement planning
Retirement calculations get more complex the more money you make — and planning gets more complicated. Here are three reasons why:
Retirement account limits can be too low
When you earn $200,000 a year, maxing out your 401(k) and an IRA puts you above the commonly recommended savings rate of 15%, before even considering employer contributions. Many workers who earn less than that spend years working their way toward maxing out.
But as your income grows, the limits those more common retirement accounts impose can actually become restrictive and start to stifle your savings rate. Add that to the fact that many financial advisors recommend an even higher rate for high earners — up to 20% or 25% of income per year — and you may find you need to turn to other accounts or more advanced strategies. This is when careful tax planning and optimization can come into play.
Many people turn to taxable brokerage accounts when they've maxed out a 401(k) and IRA. These don't offer the tax advantages of designated retirement accounts, but they can introduce some tax diversification in retirement — and have fewer rules on when and how you can withdraw the money, which is especially important for those who want to achieve financial independence a little (or a lot) early.
If you own your own business or even do consulting on the side, you may be able to explore other tax-advantaged retirement accounts that could potentially let you stash away more than the typical 401(k) and IRA combo — examples include a SEP IRA or solo 401(k). There are also the backdoor and mega‑backdoor strategies, which involve moving funds from a traditional IRA or after-tax 401(k) into a Roth IRA, where investment growth may be tax-free and distributions typically aren't taxed as income in retirement. And if you have a high-deductible health plan, the HSA and its triple tax benefit — tax-free contributions, tax-free growth and tax-free eligible withdrawals — can be valuable despite low contribution limits.
Tax optimization matters
Whenever you have a mix of different accounts with different tax treatments, you want to dial in on asset location strategies — in other words, putting the right investments in the right accounts to maximize tax efficiency.
Examples of what that can look like: investment earnings in a taxable brokerage account can generate capital gains, which are subject to either long-term capital gains taxes (more favorable) or ordinary income tax rates, depending on how long you've held the investment. This generally means you may want to put tax-efficient investments in these accounts — things like municipal bond funds, index funds or exchange-traded funds, or tax-efficiency-focused mutual funds, as examples.
On the other side, you might use your tax-advantaged accounts to hold investments that are likely to trigger a tax burden. These are often investments that generate income, like high-yield bonds or dividend stocks, real estate investment trusts or actively managed mutual funds.
If you're not sure, this sort of guidance should be part of any financial advisor's strategy. And when you've entered this stage of complexity with your finances, working with an advisor can be beneficial.
Social Security becomes less meaningful
Your Social Security benefit in retirement is based on "average indexed monthly earnings," which essentially translates your annual earnings into today's wages, and then takes the average of the highest 35 years. There's also a maximum taxable income each year, and only income up to that threshold is counted in this calculation.
On top of that, the program is designed to help lower earners fund their retirement, and so the benefit formula is progressive, meaning the percentage of your salary that Social Security can replace gets smaller at higher incomes. For maximum earners, the latest figures say it will replace about 28% of benefits.
That doesn't mean you should ignore Social Security benefits in your calculations — there's a reason we included other monthly income in the calculator. Even relatively small amounts can change your projections and the amount of savings you need to accumulate. But keep in mind that Social Security is likely going to be a small part of your strategy.