Ask an Advisor: The Hidden Tax Problem With Maxing Out Your 401(k) as a Top Earner

Ask an Advisor: The Hidden Tax Problem With Maxing Out Your 401(k) as a Top Earner

You’ve worked hard to get here. A high income, a growing portfolio, and the discipline to max out your 401(k) every year. By most measures, you’re doing everything right.

But here’s a question worth sitting with: do you actually know what your tax bill will look like when you start pulling that money out in retirement?

For high earners in the top tax bracket, the 401(k) is a powerful tool. It’s also one that comes with a future obligation that’s easy to underestimate. Understanding both sides of that equation is where smart retirement planning starts.

The Hidden Tax Problem with Large 401(k) Contributions

As you’re probably aware, your 401(k) is funded with pre-tax dollars, meaning contributions reduce your taxable income in the year they are made. The money in your 401(k) grows tax-deferred as well, which is a notable advantage since funds stay invested, uninterrupted by tax withdrawals, until they’re used in retirement. 

Once retirement hits, however, you’ll need to start withdrawing from your account, either to fund your lifestyle or to fulfill required minimum distributions (starting at age 73, or 75 in 2033). Those withdrawals are taxable on both the principal and any growth earned in the account over time.

For high-earners facing today’s highest tax bracket, this future tax liability may be reason to pause and consider whether maxing out 401(k) contributions is worth it. But the larger issue at hand is about whether or not you have a strategic and proactive plan for managing those taxes come retirement, not how much you’re contributing today.

The Solution: Early Tax-Savvy Planning for Your Retirement Income

The traditional 401(k) contributions you make today lower your immediate tax bill—but they also create a future tax liability. Considering your lifetime tax obligations (not just the immediate tax savings) is the first step towards preserving more wealth in the long term. 

Your tax liability in retirement is based on how your various income sources are treated.

This is particularly important for high earners to consider. Even if you’re in the highest tax bracket today, you have some control over how you’ll build your own paycheck in retirement—meaning your future annual tax rate could be lower.

In many cases, shifting your thinking ahead of time can set you up for a more tax-advantaged outcome in retirement, given that many solutions can take several years to execute effectively. With enough time and consideration, we can work together to identify the right opportunities to reduce your taxable income. Some potential tax-focused strategies include:

Maximize Backdoor Roth Conversions

A Roth conversion or mega backdoor Roth conversion are commonly used to lower taxable income in retirement. A Roth conversion converts pre-tax 401(k) dollars into after-tax (and potentially tax-free) dollars for retirement. 

The challenge with Roth conversions is the more immediate tax liability they create. Any amount converted from a traditional 401(k) to a Roth account will be subject to ordinary income tax in the year the conversion is made. For this reason, it may take several years (even a decade or more) to strategically convert funds while keeping your lifelong tax liability in check. 

Utilize Tax-Aware Hedge Funds to Offset Income

Tax-aware hedge funds may also be used to pass through ordinary losses and offset the earned income recognized when we convert 401(k) funds to a Roth account. These funds are structured to manage taxable distributions strategically, making large Roth conversions more manageable over time.

Incorporate a Cash Balance Plan for More Savings

Since 401(k)s include annual contribution limits, they may not provide enough savings potential to address a high earner’s retirement income needs. If you’re maxing out your 401(k) contributions and still looking to set aside more tax-advantaged savings, we can explore additional opportunities to save.

A cash balance plan, for example, serves as a hybrid option between a defined contribution (401(k)) and a defined benefit (pension) plan. These are structurally complex plans that may not be right for everyone, but they allow participants to set aside $100,000 or more annually in tax-deductible contributions.  The tax treatment of these plans is very similar to a 401k and the Roth conversion and tax-aware hedge fund strategy can be used for cash balance plans as well, once you are no longer contributing to the plan.

Saving for Retirement as a High-Earner

Being a high-earner in the top tax bracket can present more challenges than most people realize, particularly when it comes to preparing for retirement. If you’d like to discuss your savings opportunities and challenges with a professional, reach out to our team of advisors anytime. We’d be more than happy to take a look at your current savings strategy and discuss opportunities based on your needs.

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This article was originally published on Wealthtender and is intended for informational purposes only and should not be considered financial advice. You should consult a financial professional before making any major financial decisions. Wealthtender earns money from financial professionals, which creates a conflict of interest when these professionals are featured in articles over others. Read the Wealthtender editorial policy and terms of service to learn more. Wealthtender is not a client of these financial services providers.

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