Five Ways for Executives to Save Beyond a 401(k)

By Kelly Metzler, CFP®

Most executives may be familiar with the tax benefits of saving to their company 401(k) account. But many don’t realize that just saving to their 401(k) may not be enough to maintain the comfortable lifestyle they’re used to in retirement. 401(k) contribution amounts are limited: $20,500 in 2022, or $27,000 for those age 50 and older. 

For an executive earning a few hundred thousand dollars, even if you max out your 401(k) each year, it likely won’t be enough to meet your retirement needs. However, there are other tax-advantaged ways to save and opportunities to invest to help you reach your retirement goals. In this article, I share 5 different ways:

1. Deferred Compensation Plans

Nonqualified deferred compensation plans are offered by some employers to executives and key employees. Deferred comp plans allow you to defer income, like your salary or bonus, and have it pay out at a specified future date, such as upon retirement. 

The benefit is that it defers the income tax to a later year. For high-income executives, this could also mean deferring income out of a high tax bracket, and receiving the income in a year when your tax rate is lower, like retirement. 

Unlike a 401(k), there are no IRS limits on how much can be contributed each year. Deferred comp plans often can be invested with a set of investment options like a 401(k), and can therefore have similar growth potential. 

Deferred comp plans require planning each year, as you must elect not only the amount to defer, but also the distribution date and payment schedule of each deferral. There's also a risk of loss of these funds as assets in the deferred comp plan still belong to the company and are subject to bankruptcy risk. 

So before contributing, you need to understand how (e.g., lump sum or installments) and when payments will be made in the future. You should also be aware of what potential events could trigger a distribution earlier than anticipated, such as separation or a change in control.

2. Brokerage Account

A brokerage account is a taxable investment account. Unlike a 401(k) that is tax deferred, you pay taxes on investment income – like interest, dividends, and capital gains – each year. However, there are no contribution limits and no restrictions on withdrawals. Brokerage accounts can therefore be used to pay for expenses prior to age 59 ½ since there is no early withdrawal penalty. 

One of the biggest advantages for executives to build up a brokerage account is to help control your tax bracket in retirement. If you only have investments in a tax-deferred 401(k) or deferred comp plan, every dollar of distribution will be taxed as ordinary income. Withdrawals needed for large one-time expenses could take a large bite out of your account balance. 

For example, a $100,000 home improvement expense might actually require a withdrawal of $150,000 from a 401(k) or IRA. And this would likely be on top of withdrawals you’re already taking for regular living expenses.

However, if you have a 401(k) and a brokerage account to withdraw from, you can come up with a coordinated withdrawal strategy to stay within a certain tax bracket each year. 

As a financial advisor, I have helped executives with similar scenarios to create tax-efficient withdrawal plans that incorporate all of their financial resources. 

3. Backdoor Roth IRA 

Executives are likely to be over the income limits to contribute to a Roth IRA. However, one potential strategy is a Backdoor Roth contribution. 

This is a two step process that involves making a non-deductible IRA contribution, and then doing a Roth conversion of those after-tax funds. Once converted to a Roth IRA, earnings can grow tax-free and qualified withdrawals are tax-free.

For this strategy to work, you shouldn’t have traditional pre-tax IRA assets, otherwise you'll run into the pro rata rule: if an IRA contains both pre-tax and after-tax funds, any conversion will be comprised of pro rata amounts of pre-tax and after-tax dollars. 

For example, let’s say you have a pre-tax IRA balance of $94,000 to start, and then make a non-deductible contribution of $6,000 to it. If you subsequently do a conversion of $6,000 to a Roth IRA, you’ll have to treat $5,640 (94%) as taxable income while only $360 (6%) will be tax-free. 

4. After-tax 401(k) Contributions

Some company 401(k) plans allow for after-tax contributions. For executives that are already maxing out the employee deferral amount ($20,500 or $27,000 if 50 or older), after-tax contributions would allow you to save even more to your 401(k). According to Vanguard, 21% of Vanguard plans offer after-tax contributions. 

You should know that investment earnings on after-tax contributions are considered pre-tax. So while the withdrawal of your after-tax contributions is not taxed, the earnings on those contributions are taxed as ordinary income.

Some 401(k) plans take it a step further by allowing in-plan Roth conversions of these after-tax dollars to a Roth account. This essentially allows you to get money into a Roth account, on top of your regular pre-tax deferral. Once the dollars are in the Roth account, earnings would grow tax-free and withdrawals would be tax-free (as long as certain conditions are met). 

You should understand the provisions of your company’s 401(k) plan, such as whether in-service withdrawals are allowed or what withdrawals are permitted if you change jobs or retire. 

Time horizon will also be an important factor in deciding whether after-tax 401(k) contributions would be beneficial or whether a better strategy would be saving that money into a taxable brokerage account instead.

5. Health Savings Account

Health Savings Accounts (HSAs) are triple tax-advantaged. You make pre-tax contributions, and investment earnings and withdrawals are tax-free if used to pay for eligible medical expenses. Unlike a Flexible Spending Account (FSA), HSA balances can be carried forward from year to year. This feature can make an HSA a beneficial retirement savings vehicle, as funds in an HSA can be invested and therefore get tax-free growth. 

HSA funds don’t need to be used just for current medical expenses. Executives who are eligible for an HSA should consider making that maximum contribution each year, paying for current healthcare expenses out-of-pocket, and allowing your HSA account to grow tax-free in order to pay for medical expenses in retirement. 

You must be enrolled in a high-deductible health plan to contribute to an HSA. The 2022 HSA contribution limit is $3,650 for an individual and $7,300 for families. Those age 55 and older can contribute an additional $1,000.

Conclusion

Beyond just saving to these various types of accounts, it’s important to have a plan for how these accounts will work together to fund your lifestyle in retirement, or possibly sooner. The tax implications and rules governing withdrawals may make some accounts more or less attractive given your particular career and retirement plans. As a financial advisor, I can help you craft a coordinated strategy, and revisit it regularly. If you’re ready to optimize your savings and make sure you’re on track for a successful retirement, schedule a call.