For High-Income Investors, 'the Max' Might Not Be Enough

Many investors take it as an article of faith that contributing the maximum allowable amounts to their tax-sheltered accounts, both company retirement plans and IRAs, is a hallmark of financial wellness.

And there can be no doubt about it that for some households, even middle- and upper-middle-income ones, filling those baseline accounts up to the limit each year and earning a moderate return is enough to help them maintain the same standard of living through retirement that they enjoyed while they were working.

But for high-income investors, those basic tax-sheltered account contributions--even if they reach the tippy top of what the IRS allows each year--probably aren't going to result in sufficient funds for retirement to maintain their standards of living. They'll have to save and invest in additional accounts in order to build up sufficient assets for retirement. On the short list of investment types that higher-income folks should consider once they've maxed out their 401(k)s and IRAs are aftertax 401(k)s, health savings accounts, and taxable accounts.

Higher Incomes = Higher Savings Need The reason that making the maximum allowable contributions to 401(k)s and IRAs can result in sufficient assets for some retirement savers and not for others boils down to income-replacement rates. At the risk of stating the obvious, someone who's retiring from a position with a very high salary is going to want and need more money in retirement to maintain her standard of living than is the case for a worker with a lower income.

To use a simple example, someone contributing today's maximum allowable amounts to both company retirement plans and IRAs and earning a 4% annualized return over 44 years (for example, from age 21 to 65) would amass $2,780,522 by the time she hits age 65. (I factored in extra catch-up contribution amounts that are available starting at age 50.) Assuming those contributions were all made to traditional tax-deferred accounts and the investor's tax rate is 24% at the time of withdrawal in retirement, the value of the account would drop to $2,113,197 on an aftertax basis in retirement.

That's certainly a healthy chunk of change: Using the 4% guideline, a starting balance of that size would support an annual withdrawal amount of more than $84,500 in year one of retirement. That dollar amount would then get inflation-adjusted slightly as the years go by.

But is that enough? That depends on a few variables: an individual's working income, the percentage of that income he or she expects to spend in retirement, and how much of that in-retirement income is going to come from nonportfolio sources like Social Security. (Of course, it's also possible that the investor might earn more than my assumed 4% on his or her money during the accumulation horizon, which in turn would allow for a higher sustainable annual payout than $84,500.)

To use a base case, let's say someone earns $150,000 on an aftertax basis from his job, and is using an extremely modest 70% income-replacement rate assumption to shape his in-retirement income needs, resulting in an in-retirement income need of $105,000. Let's say he's also eligible for the maximum allowable Social Security benefit of roughly $34,000. In that instance, he would need to pull $71,000 from his portfolio each year; the $84,500 he can reasonably pull from his retirement accounts will be more than adequate.

Holding those same assumptions steady but nudging up the working income, however, may well mean that the $2,113,196 aftertax balance that one could amass by making maximum allowable contributions would result in an income shortfall in retirement. For example, with a working income of $250,000, a 70% income replacement rate results in a $175,000 income need in retirement. Assuming, again, that $34,000 of that amount will be provided by Social Security, that necessitates a $141,000 annual portfolio withdrawal in retirement. That's well short of the $84,000 per year afforded by making the maximum annual 401(k) and IRA contributions and earning a 4% return. Even a working salary of $175,000 would necessitate a higher withdrawal amount than could reasonably be supported by the balance that would be built up after making the maximum allowable IRA and 401(k) contributions each year.

Of course, income-replacement rates of 70% or 80% of working income are at best rough estimates, and retirees' own spending could trend well below that. As Morningstar Investment Management's head of retirement research David Blanchett wrote in this paper, actual income-replacement rates varied considerably from household to household, ranging from 54% to over 87%. Notably, Blanchett found that households with higher working incomes tended to have lower in-retirement income-replacement rates than was the case with lower working incomes. In large part that was because the higher-income workers were saving more of their paychecks on an ongoing basis. This article discusses how to customize your in-retirement income needs estimate using your own situation.

Additionally, workers may have other sources of retirement income, such as pensions, in addition to what's afforded by their portfolios and Social Security. In such cases, contributing the maximum allowable amounts to their 401(k)s and IRAs may afford them with all the income they need and then some, because so much of their income is coming from certain lifetime sources of income. That's a shrinking pool of the population, however.

Where to Go Next? Yet the exercise is a reminder that high-income folks may need to aim higher in their savings rates than simply making the maximum allowable 401(k) and IRA contribution limits. Such investors may have deferred compensation setups that are specific to their employers: stock options, restricted stock, and so forth; those assets can certainly help plump up their core retirement accounts.

In addition, high-income folks should consider taking advantage of the following vehicles for extra retirement savings.

Health Savings Accounts I've heard health savings accounts described as "single-purpose Roth IRAs," the single purpose being to cover healthcare costs. But the tax benefits of HSAs are even better than IRAs': The investor contributes pretax dollars (or takes a deduction) to the HSA, enjoys tax-free compounding, and can take tax-free withdrawals for qualified healthcare expenditures. Those three tax benefits make HSAs especially attractive for high-income folks who can afford to cover their healthcare expenses by using non-HSA/taxable assets, thereby leaving their HSA assets to grow, as discussed here. Worst-case scenario and you oversave in an HSA, those assets can be withdrawn for any reason without penalty once you pass age 65. Money withdrawn to cover non-healthcare expenses, even after age 65, will be subject to ordinary income tax, however.

After-Tax 401(k) Contributions Not to be confused with Roth 401(k) contributions, aftertax dollars contributed to a 401(k) don't begin racking up tax-free earnings from the get-go. Rather, once the employee leaves the company plan due to retirement or separation from service--or is able to take an in-service distribution--the aftertax contributions can be rolled over to a Roth IRA account, whereas any investment earnings that have accumulated must be rolled over to a traditional IRA. For high-income folks, the great thing about aftertax 401(k) contributions is that the total contribution limit to the plan--including employee contributions (pretax, Roth, and aftertax), employer contributions, and forfeitures--is $55,000 in 2018, and $61,000 for folks over 50. That provides a great opportunity for high-income investors to turbocharge their 401(k)s, as discussed here.

Taxable Accounts Both health savings accounts and aftertax 401(k) contributions come with tax benefits, which is why high-income investors should consider them before turning to a plain-vanilla taxable account for extra savings. Yet taxable accounts carry their own attractions. They key one is liquidity and flexibility; money in these accounts can be invested in anything and can be withdrawn at any time and for any reason. Income and capital gains distributions are taxable as they're incurred, even if they're reinvested, while capital gains on assets held for more than one year are eligible for the lower long-term capital gains tax, ranging from 0% to 20%. Moreover, it's not that difficult to build a portfolio that limits the drag of income and capital gains distributions on an ongoing basis, as discussed here.