Help a Reader: Making Too Much Money

I received this comment recently from a reader:

For the next 3 years or so I will have the problem (don't hate me) of making too much money to use most retirement vehicles (probably have an AGI of around 180K a year, I am married to a stay at home mom). After this project ends, I will most likely go back to my normal salary of less than half of that (both the opportunity will likely end and the extremely high hours will make me ready for a change).

Given the short-term nature of this, I have not increased my standard of living (I realize that would just lead to disaster after this project ends) and so just want to use this as an opportunity to create a nice nest egg that will have another 20 years to grow and hopefully lead to an earlier and more secure retirement. The problem is I no longer have the options available to me to do this that I am used to. My 401K does not match, and I am an HCE that can only contribute 4% of my weekly pay to it. I do not qualify for an IRA. I have a HSA since I have to provide my own health insurance anyway and that seemed a good way to lower the tax bite even before this new job. So that leaves me with a $8K 401K contribution and a $5K HSA contribution for a total of $13K tax advantanged savings.

What should I do with the other $60K/year I should be able to save after taxes other than just invest in non-retirement account index funds as I have started doing? Any help is much appreciated, I've never been in the position of making too much before and don't want to blow this opportunity.

What would you tell him to do?

Comments

[AmandaD]

How do you not qualify for the IRA- are you referring to the income limit or some other qualification? I thought that everybody can contribute to the IRA (just not a Roth). We're doing a regular IRA at $5k/year/person & when the income limits expire in 2010, converting it to a Roth IRA. We just won't get any tax benefits this year for contributing to the IRA.

[Khyron]

If this project is self-employment, what about a Solo 401(k), SEP-IRA or similar. It doesn't sound like the opportunity is there, since you specifically mention that your employer doesn't match, but I felt irresponsible to not throw that into the ring.

That said, what about contracting to your employer so you can use one of the above methods?

It struck me that a lot of any advice would depend on what your current situation is (savings, debt, etc.) as well as what your "regular" income would be once this project is completed. I mean, we can't really assume that you have a solid emergency fund, fully funded children's education accounts (529s or less so, Coverdell IRAs), and have the debt situation managed.

Personally, I would just max out the savings and investing, if you feel comfortable with it. I'd probably go with something more aggressive, like Teresa Lo's Satellite Porfolio, over regular index fund investing. Sorry, I believe in alpha. Never said it was easy, but if all the basics are covered, and you feel comfortable with stepping out, then I think you should go for it.

http://invivoanalytics.com/portfolio-strategy/

At this point, specific measures to maximize tax advantaged saving are probably limited. Of course, I'm not a financial adviser either. You might want to take some of that loot and engage one, fee-only preferably.

What about gifting some funds? Hmm, maybe gifting to a child for college savings? The tax implications are worth studying.

There's the question of your housing situation. Rent or buy? Think you can get a decent return by prepaying your mortgage? And if your spouse doesn't work outside the house, are you funding her IRA? You can max her account with your funds, since she has no earned income. I'm guessing you file your taxes jointly, since the large income disparity should prevent you from getting hit with the marriage penalty. (According to Liz Pulliam Weston, anyway.)

Personally, I lean toward the absolute return school of investing. Whatever has the lowest risk and highest absolute return should be preferred. Without a fuller picture of where you're coming from, its hard to say where you should go. And again, I'm not a financial planner, I just play one on TV (which I don't watch unless its Bloomberg or CNBC).

[Khyron]

AmandaD:

There are income phaseouts for all IRAs - regular, Roth and non-deductible. He's definitely over the limit.

He shouldn't forget about contributing to an IRA for his stay-at-home-mom wife though, since she has no income from outside the household.

[Khyron]

Forgot to ask about non-cash compensation with the position you're in. If you have restricted stock or other non-cash compensation, then you definitely want to find a pro to work with. You didn't state whether this is the case.

And don't forget to maximize your charitable contributions, if for no other reason than to reduce your AMT risk. I think 175K is the low end of the AMT realm these days. I don't know what state you're in and thus what potential deductions you might have (multiple children, high state income tax), but its something to consider.

[J.J. Merrick]

If you are looking for ways to not pay taxes on the money then you are are of luck :-)

I would just put the money in a money market and then after 3 years... when you are back to "normal" income levels just flow that money into an IRA and max out what you are saving. Say at normal levels you could only save some $3k a year into an IRA... fill up to the max with some money from the money market.

Unfortunately you are going to pay taxes on it but in the end after a few years you will probably come out on top.

[Strick]

Thanks for all your comments so far. I'm not sure what the limits are for the non-deductible IRA, admit I hadn't thought about that because I had assumed the Roth 2010 backdoor would be removed by then. Though, I guess its still giving tax deferred growth even if that happens, so I should look into it.

Nothing fancy in my work situation. I get a W-2 from my employer and they aren't interested in doing it any other way. No stock options or anything like that.

No debt to speak of. Mortgage on $200K house (low cost of living area - this is a large house we love and will likely grow old in) is down to about $50K now.

Khyron - I'm interested in what you said about IRA contribution for my wife. I assumed neither of us could since we file joint and AGi is over limit.

[cmadler]

Several ideas that don't work for most people, but might work in your case:

- Annuity. The next best thing to a tax deduction is tax-deferred growth. You're talking about saving for retirement, so the penalty on withdrawals before 59 1/2 shouldn't be an issue. Shop around for a variable annuity with good separate accounts and low internal fees.
- Variable Universal Life insurance. IF you need life insurance, you might consider using VUL (or shifting existing coverage to VUL). IF this is set up properly, it can provide tax-deferred growth, and a tax-free stream of income (in the form of loans). Again, shop around very carefully.

Both of these have a bad rap, because insurance salespeople get large commissions on them, but in your case they MIGHT make sense.

[mjmcinto]

Looking at from 590 from the IRS, I don't think there's an income limit to who can contribute to an IRA:
http://www.irs.gov/publications/p590/ch01.html#d0e951

The only income limitation I can find is dealing with whether or not the contribution is tax deductible.

I'm not a CPA or anything, but it looks to me as though you might be able to contribute to the IRA, just not get the tax advantages to it this year, and then roll it into a roth later. If I were you, I'd get a tax professional/financial adviser to make sure your on the up and up and don't run afoul of any strangeness.

Also, as cmadler said, a VUL might make sense. They do get a bad rap b/c of the fees associated with them...but it is good in *some* situtations.

[Kevin]

Strick - the income limits apply to both of you no matter what your wife makes (or doesn't make). Therefore, neither one of you would be able to deduct an IRA contribution. So you can either do a non-deductible contribution and have some tax-deferred earnings (just make sure to keep track of your non-ded contributions for when you start withdrawing) or put it in a regular taxable account.

If it were me I would do it in this order:
1) payoff mortgage
2) full nondeductible IRAs
3) full 529s for kids - assume you have kids since wife is a SAHM(you can put up to $60k each immediately into these and elect to treat it as contributed over 5 years to avoid gift tax concerns)
4) other low cost taxable investments (index funds of course)
5) buy a new pet (just kidding, FMF)

[Rob G.]

You mentioned that your employer restricts you from contributing more than 4% into the 401(k) plan. You may want to ask them why they do this since it is a not the IRS limit. Most employers limit the HCEs contribution to help with discrimination testing but at the end of the day, it has no effect on the end results. You should ask if they can either raise the 4% limit or eliminate it completely. If so, you could then contribute up to $15,500 ($20,500 if you are over 50).

[Strick]

Thanks again for all the comments.

Rob G - not sure I understand this but I'll definitely ask if the 4% limit can be lifted (unfortunately its a pretty large company, so I'm not sure one voice can get something like that changed).

Khyron - the increasing charitable contributions advice is excellent. Makes me think that I should even "pre-pay" my tithe (FMF, you'll have to let me know if that is an oxymoron). I'd much rather give my 2012 tithe now and be able to take the deduction while in the higher tax bracket. (Keeping the tax savings or giving it away as well are both desirable to giving it tto Uncle Sam).

Kevin - I also like the idea of paying off the mortgage (my asset allocation is one pushing the riskier side, so the prepaying on the mortgage I've been doing helps me feel like I'm balancing that risk. I'm nowhere near wealthy enough to add another pet though :)

[FMF]

Strick --

A tithe is 10% of your earnings, so that's what you'd give this year. If you want to give more, you certainly can, but I wouldn't count it as a pre-pay on future years' tithes.

[RC0]

I often hear Suze Orman talking about municipal bonds (not municipal bond funds). I think the interest income is exempt from federal income tax, and in many cases, state and local taxes as well.

[Nicole]

As others have said, you can contribute to a non-deductible IRA - just make sure you file the tax form with your tax return each year that reports your contribution as non-deductible. in 2010, all IRA's can be converted to Roth IRAs regardless of income. I have been doing this for three years, and will convert in 2010.

[Nicole]

just read through some of the comments - there are no income limits for non-deductible IRAs. this is one of the problems with getting PF advice on-line. always check the information :)

[Meg]

I would put half in a money market fund and half in either a) The Vanguard LifeStrategy Growth fund (a collection of mostly index funds; 10% bonds 90% equities) or b) one third Vanguard Total Stock Market Index, one third Vanguard Total International Index, one third Vanguard Total Bond Market Index (you can adjust those percentages to your taste of course).

Index funds are the most tax-efficient way to invest outside of tax-advantaged accounts. Their low turnover yields low capital gains and distributions. Also, the fees can't be beat. And Vanguard is an industry leader with a great reputation of performance and low fees.

Plus the argument can be made that you might be better off with a mix of taxable accounts for retirement because the long term capital gains tax could end up being lower than the income tax rate at which 401k distributions would one day be taxed.

[John]

I am in a similar situation. My strategy:

1- Pay off credit card debt (if you haven't already)
2- Establish an emergency fund (if you haven't already)
3- Max 401k
4- Max IRA
5- Invest the rest in a tax-managed mutual fund or tax-exempt bond fund

Note on #4: There is no income cap on Traditional IRAs. There is an income cap on deducting your contribution, but your earnings are still protected under the IRA until withdrawal.

Note on #5: I believe this is the best way to grow wealth while minimizing tax impact along the way. Check out Vanguard's Tax-Managed Balanced Fund. If your asset allocation supports it, consider a tax-exempt bond fund.

Finally, I know this is an endlessly debatable point, but I chose not to pay down my mortgage during this period. I am locked at a pretty low rate (5.75%) and my equity position in my home is already heavy in terms of my overall net worth. Your mileage may vary.

- John

[Tom]

First I wanted to say that I basically agree with John at least on his points 1-4
My thoughts on his point 5 are different

First let me say that I believe in risk free strategies for at least a significant portion of ones assets.

Why not look into Tax Deferred Savings retirement vehicles
Current yields for an individual over age 40 can be as high as 7.2% per year guaranteed. Rule of 72 says that every 10 years you will double your money. contribute $60,000 now wait 20 years and you will have an extra $240,000 in savings that could then be turned into a lifetime income stream that you or you and your spouse cannot outlive. If you do this for each of the next three years and you will have a guaranteed $750,000 in your retirement account.
If you wanted to diversify you could contribute1/2 this way and position the other 1/2 somewhere else.
Remember these points.
1. The alternative I am thinking about is contractually guaranteed by one of the largest financial companies in the world.
2. There is no risk to principal.
3. Taxes are deferred until you begin withdrawals
4.You would have penalty free access to a portion of your funds every year without penalty or surrender charges.
5. Any time you needed to begin the income stream you could convert the asset value into a LIFETIME income stream.

[Tom]

p.s.

Other great alternative may not have a guaranteed 7.2% but may offer slightly more upside potential. Different products may be appropriate for other people depending on details of their financial situation.

[John]

Tom, can you be more specific about what you are recommending? I've never heard of such a vehicle...

[BenG]

Vanguard sells Variable Annuities. Their costs are ridiculously low compared to your typical Bank/Insurance Company VA. If you need a place to put post-tax dollars for tax-free growth, this may be a good option.