How High-Income Earners Can Protect Themselves From Rising Taxes

We recently received a question from a woman who was looking for more tax advantaged ways to invest since she is already maxing out her 401(k) and earns too much to contribute to a Roth IRA. With the Bush tax cuts currently scheduled to expire at the end of the year, more and more people are searching for ways to shield their investments from the prospect of higher taxes. This is especially true for households making more than $250k a year since the President’s new proposal doesn’t extend the Bush tax cuts on income above that amount. That’s also where the new 3.8% Medicare tax on net investment income starts kicking in next year for married couples filing jointly ($200,000 for single and head of household filers).  While you may not have control over tax policy, there are some steps you can take to reduce your future income taxes:

See if your employer offers a Roth 401k option
Like a Roth IRA, these accounts provide you with the ability to make after-tax contributions that can grow to be tax-free after age 59 1/2. Since they became available in 2006, an increasing number of employers have been offering them but they haven’t caught on as fast with employees. Fidelity, Schwab, and Vanguard found that only 6%, 15%, and 9% of their respective plan participants with a Roth option chose to take advantage of it.

 

There are a few reasons why a Roth might make sense for you though. First, if you’re saving a lot for retirement, you may actually find yourself in a higher tax bracket when you retire, especially if you’re currently benefiting from tax breaks you may no longer have in retirement like ones for dependent children and mortgage interest. Second, even if your taxable income doesn’t go up, tax rates might (someone has to pay for all that debt we’re accumulating). Finally, all things being equal, a Roth account will give you more bang for your buck if you’re able to max out your contributions. That’s because for a pre-tax account to give you the same after-tax income in retirement, you would need to invest your current tax savings somewhere else and that somewhere else is likely to be taxable.

For example, let’s say two people both contribute the maximum $17k per year to their retirement accounts and earn 6% over 25 years. The first person contributes to a Roth account and has $988,660 of tax-free money in retirement. The second person contributes to a pre-tax account and has the same amount but after a 25% tax rate it would only be worth$741,495. If the second person also invested their $4,250 of annual tax savings from making pre-tax contributions, that would grow to an additional $247,165 for a total of $988,660, the same as the first person. But when you subtract the taxes on that second pot of money, they would be behind.

Make a backdoor contribution to a Roth IRA
Another way to shield your investments from future taxes is to contribute to a Roth IRA. If your employer doesn’t offer a Roth option, it might be your only choice. The problem is that your ability to contribute begins to phase out once your AGI exceeds $110k as an individual or $173 filing jointly.

However, there is a way around this because there is no longer an income limit to convert a traditional IRA to a Roth IRA. That means you can make a nondeductible contribution to an IRA and then immediately convert it into a Roth. There is one little snafu though. If you have an existing traditional IRA, whatever percentage of all your IRAs is taxable is the percentage of your conversion that will be taxable. The good news is that there may be a way for you to get around this too.

For example, if you have $95k in a pre-tax IRA and you make a $5k contribution to a nondeductible IRA. Since 95% of your total traditional IRA balances is taxable, you’ll have to pay taxes on 95% of anything you convert. If you’d rather pay the taxes now anyway, this isn’t an issue. (If you change your mind on a Roth conversion, you’ll have until Oct 15th of next year to undo it.) Otherwise, you can avoid this tax by rolling any taxable IRAs into your employer’s retirement plan (if they allow it) since employer retirement plans aren’t counted in determining how much of your conversion is taxable.

Consider cash value life insurance
With a cash value life insurance policy, part of your premium goes into a cash account that can earn interest or be invested. You can accelerate the growth of this cash value by making paid-up additions and lowering the death benefit to reduce the cost of the insurance. This cash value can then be borrowed tax-free anytime and for any purpose, including as a supplement to your retirement income. Since there’s generally no required prepayment structure, the loan could be held until your death and then subtracted from the death benefit.

So what’s not to like? Cash value life insurance has generally been vilified by financial gurus and the media for their high costs and low returns compared to traditional investments. For example, the entire first year’s cash value can be eaten away by commissions used to compensate the agent that sells it to you.

Returns in the cash accounts are also generally lower than what you would have earned by investing the money in a balanced portfolio of mutual funds. A study by Mass Mutual showed actual historical growth over 28 years ranging from 4.49% to 6.52% depending on the scenario, compared to 8-10% you could have earned in the stock market. James Hunt, an actuary with the Consumer Federation of America, estimated that 20-year returns on whole life insurance policies from the best insurers to be about 4.5% after accounting for the value of the insurance and assuming dividend rates don’t continue to decrease.

However, they also come with less risk. Many insurers offer a minimum rate of 3-4%, which is higher than you can earn in almost any other guaranteed account and more than what bond funds are generally paying without the risk of falling bond values. While a lot depends on the insurer staying in business, insurance companies are typically known for their ultraconservative investment policies and many have been around for quite a long time. For these reasons, cash value life insurance might be a good fit as part of the conservative portion of your overall portfolio.

So could this make sense for you? First, max out your retirement plan contributions since those accounts tend to have lower fees and higher average returns over time. Second, you’ll want to make sure that the tax savings outweigh the higher insurance costs. This can work best for a young, healthy person in a high tax bracket who also has a need for life insurance. Good examples would be a high income, young professional with children. Finally, make sure you can afford to keep making the payments. Otherwise, the policy will eventually lapse and your earnings in the cash account will be taxable.

The bottom line
The bad news for many high income earners is that higher tax rates are likely on their way. The good news is that there are perfectly legal ways to protect your investments from them. You don’t need to flee the country and renounce your citizenship like Facebook‘s co-founder, at least not yet.
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Are you looking for an unbiased answer to your own financial question? Once a week, we’ll be responding on this blog to questions from our Financial Helpline or posted on our Twitter or Facebook site.
Erik Carter, JD, CFP® is a resident financial planner at Financial Finesse, the leading provider of unbiased financial education for employers nationwide, delivered by on-staff CERTIFIED FINANCIAL PLANNER™ professionals. For additional financial tips and insights, follow Financial Finesse on Twitter and become a fan on Facebook.