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Let's say I make about $200,000 annually (married w/ kids). I have a $600K house on which I owe about $350K, and I have no other debt. I'm very thankful that I'm in a pretty good position right now, and I want to make smart retirement plans.

I max out my employeer-sponsored Roth 401K each year, but I'd like to save another $20K each year. I have about 30 years until retirement. My question is: where should I save an extra $20K each year?

Some of my random thoughts on the topic:
- My employer offers an after-tax 401k option that I can put this $20k in. I think it's basically like a traditional IRA but with a higher limit. This is simple, so I'm leaning toward this option (Roth 401K + after-tax 401K).
- I want the investment(s) to be simple; hopefully just check on it once/twice a year.
- I make too much for a Roth IRA; I could do a traditional IRA then convert to Roth, but not sure if I should
- Should I just put all $20K each year into a Target 2040 retirement fund? Will I owe taxes each year on this?
- Should I just pay off my house quicker?

Where should a "high-income earner" put their money?

Thanks in advance.
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I am a firm believer is diversification - so I favor some funds in a traditional investment account. Right now 401K and other tax sheltered accounts have advantages. But I think it very likely some significant changes in the tax code will happen in the next 4 to 6 years. If Congress for example does away with most deductions and lowers tax rates, a traditional brokerage account would look better for those who do not want mandatory 401K withdraws. Also you can put your funds where you want - even invest in items which are not allowed for IRA/401K accounts. If you go this route, obviously it makes sense to purchase investments that do not throw off a lot of cash.

Gordon
Atlanta
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If you have reasnable choices in your 401(k) and are comfortable with them, that is surely the easiest way to go. Just sock the money away and forget about it. The "after tax" component will be described in some dusty paperwork as "basis", which means it will not be taxed again, just like a ROTH. (This will involve a bit more time on your tax form and when you withdraw the monies, but not really all that much.)

Understand that the funds that you are offered are charging a fee for their "expertise", and the 401(k) management company is also charging a fee, so you are probably kicking off 3% a year to fees, which ain't cheap. Compounded over your savings-lifetime, that's probably $100,000 you won't have.

Most 401(k)s have pretty limited options, and if you see an impending crash coming (1. Ring me up and let me know, and) 2. You may not have much of an exit strategy, whereas with an IRA of any flavor you would. (You can go to 'cash', which most 401(k)s don't offer.)

$20,000 is a good amount; it's enough to do something with, but not so much that you need to be overwhelmed trying to figure out what to do with it.

If it were me (and it is not, obviously), I would do as much as I could with an IRA (in your income bracket that will be dicey, if not impossible) but I would still open a brokerage account and fund one or two companies each year, until you get a few years down the road and have a semi-diversified portfolio, at which time I'd just plunk the $20k down on one and wait for another year.

Mutual funds have a very nasty habit of buying and selling, and at the end of every year you end up with "capital gains", even if your fund actually went down the for year. Strange, but true; been there, done that. It's irritating, to say the least. Buy a block of a company you like, that's stable, trustworthy, and not some shoot-the-moon thing you heard about at the water cooler and you should be fine.

My history was to start as you are: 401(k)s with limited choices, and some after-tax investments with a broker. After I left the company I rolled everything into an IRA and began making my own choices. Here's one telling of the history, if you care:
http://boards.fool.com/you-should-honor-your-friendship-that...

As I got more comfortable making these decisions, I took everything back from "the broker" and "the 401(k) manager" and began doing it all myself. No, it's not a full time job, and yes, you can keep up with it with some simple reading of the daily newspaper and perhaps a board or two at the Motley Fool and perhaps BusinessWeek or other business publication that you probably already read.

I was in almost the same situation (salary a bit higher, house a bit lower, but otherwise, pretty close.) And when it was done I was phat.

Incidentally, that $20k a year is a bit less than a year of college, so if you have "kids" and plan on college for them, that $20k won't really amount to anything - and what you'll have is whatever you're socking away in the 401(k). But you likely already knew that.

Anyway, two choices: easiest to just add to the 401(k), a bit more effort, but more flexibility and fewer fees to DIY.

Good luck.
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Here is what I do, but things are a little different since I'm a self-employed high earner.

I max out my Roth 401k. I then max out my self contributing pension plan (this is my main difference from you probably). I then contribute to a traditional IRA (and no I have not and will probably not convert to a Roth IRA). After that, I put extra monies into a taxable brokerage account. (All of this is done assuming no debt and the establishment of a 6 month living expense emergency money market/CD account)

DW and I paid our house off about 5 years ago. My previous house I paid off the mortgage with the extra monies before doing taxable brokerage.

Where to put your monies? The obviously simplest thing to do would be put 60% in a stock index ETF and 40% in a bond index ETF and re-balance yearly. To me, target dated funds charge you too much for one simple act.

Or, you could pick some good dividend paying stocks (Google Dividend Champions and Dividend Achievers and well as utility companies) and DRIP (Dividend ReInvestment Plan) the dividends. You might think "crap, I'm only getting 2-3% yield", but 30 years from now, due to constantly increased dividend payout and DRIP, your yield your original investment could easily be in the 20% range. Food for thought. This is what I'm currently doing.

JLC
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Good advice from others. Couple of points.

1. I do NOT like tax-deferred accounts for after-tax money. I'm not sure it does anything for those in high tax rates other than make for excessive record keeping AND have you hope for future tax legislation breaks (neither of which is likely to happen IMO).

2. While I'm a largely index and mutual fund investor for most of my funds I do keep a "sandbox" of individual stocks that generally is less than 10% of my total portfolio and never more than 20%, and most times in my taxable account.

In my taxable account I like to keep non or low-dividend paying stocks (counter to what most suggest these days). My favorite is Berkshire-Hathaway, but there are other quality examples. Not only do they appreciate tax-free until retirement, but they also serve as a very nifty charitable donation for your future gifts. THAT gift makes the taxes magically disappear. There are similar low-turnover mutual funds, and many index funds or ETFs can apply.

Hockeypop
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There are a number of mutual funds that are designed to be tax efficient. Likewise some ETF's have low dividends and rarely buy or sell stocks so they are naturally pretty tax efficient. Buying one of these and holding it for decades can work out well. The capital gains tax rate on these could be lower than the tax rate you would pay on the non-deductable retirement account. Under the current tax laws if these go to your estate they will go at a stepped up cost basis and the capital gains tax may never be paid.

For most people having a paid off house when they retire is good plan so you might want to consider the question of paying off the mortgage more of a question of "when" instead of "if". The last I saw about a third of all houses are owned without a mortgage.

I didn't see any mention of college savings plans, if you are eligible for one that would be worth looking into for the tax advantages.

You didn't mention your spouse's retirement savings. Even if your spouse does not have any income you can still usually fund their retirement accounts if you are eligible.


Greg
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1. I do NOT like tax-deferred accounts for after-tax money. I'm not sure it does anything for those in high tax rates...

In my case (and I'm sure in plenty others), if I get sued for malpractice or other reasons, tax-deferred accounts (retirement accounts) can't be taken from me. Sadly enough, my taxable account (also part of my retirement planning but not viewed so officially by law) is about to be 1/2 my total retirement accounts and by the time I get there, probably 3/4 or more.

JLC
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...In my case (and I'm sure in plenty others), if I get sued for malpractice or other reasons, tax-deferred accounts (retirement accounts) can't be taken from me. Sadly enough, my taxable account (also part of my retirement planning but not viewed so officially by law) is about to be 1/2 my total retirement accounts and by the time I get there, probably 3/4 or more....

Once in a blue moon the much (rightfully) maligned annuity can be a good choice because of the tax and legal protections in some states. Definitely a situation that would take expert advice to avoid the annuity ripoffs.


Likewise your home may also be protected so having a paid off house might be more desirable.

Greg
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In my case (and I'm sure in plenty others), if I get sued for malpractice or other reasons, tax-deferred accounts (retirement accounts) can't be taken from me. Sadly enough, my taxable account (also part of my retirement planning but not viewed so officially by law) is about to be 1/2 my total retirement accounts and by the time I get there, probably 3/4 or more.

JLC


Good point. While there is nothing wrong per se with a high percentage of after-tax accounts, the issue of liability protection is a specialized discussion about which I assume you and business owners are necessarily well aware. I cover that with a $2 million umbrella liability policy, but that's little good for you I'd imagine. In today's litigious society, God bless you for what you do!

Hockeypop
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unixjunkie,

I am in a very similar situation. Not married here though, and no kids. But income between my partner and myself is about the same as yours. We owe more on our house. Between 20-30 years to retirement depending on our health outlook.

1) The after-tax 401k option is a good one. It is indeed like a non-deductible traditional IRA.

My employer lets me withdraw the after-tax funds and associated earnings every 12 months. These can then be rolled over to a Roth IRA.
I just scheduled that annual roll-over this morning. See if your 401k plan allows the same option. It is a very good one. Tax is only due only on the earnings at conversion time.

2) For the same reason, there is no reason not to make non-deductible traditional IRA contributions, and roll over the funds the next day to a Roth IRA. This is basically a loophole to contribute to a Roth IRA. Use it while it's available.

3) Investment options within the plan are a matter separate from taxes. Taxes depend on what plan the funds are invested in, and when the withdrawal is made. In 401ks and IRAs, there is no tax due annually until withdrawal. This is not dependent on what fund you invest in.

Do you have an aversion to the pre-tax 401k option ? I'm in a higher federal tax bracket than you since I can't get legally married to my partner, so I believe my federal tax rate will go down over time when it becomes legal. Also, California has a high state income tax also so that's another incentive for me to contribute pre-tax.

I'm currently putting annually :
$16500 in pre-tax 401k
$6500 in employer match (roughly)
$23000 in after-tax 401k (rolled over to Roth IRA annually)
$5000 to traditional IRA (rolled over to Roth IRA annually)

After the 2 annual rollovers are done, this leaves me with 2 plans.

1) 401k plan which contains only pre-tax money, from pre-tax contributions and employer matching contributions, as well as earnings.
Tax is due on all withdrawals during retirement.

2) Roth IRA, which contains only after-tax money, and earnings.
No tax is due on any withdrawals during retirement.

This means that in retirement, if I retire after 59 1/2, I will be able to do my tax planning by choosing which plan to withdraw from, depending on what's most advantageous and the tax situation at the time.

Most likely, I will retire before 59 1/2 though, and elect section 72t distributions from one or both plans.
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TwoCybers,

With IRAs, you can choose the custodian and invest in what you want that way. What things are you forbidden to invest in IRAs ?

With 401k you are usually restricted to employer-selected funds. However, I have never seen a 401k that didn't have a money market fund, which, while not cash, is close.

Some employers also offer self-directed brokerage options within 401k, if you don't like the employer's choice of funds. Or you can buy stocks and options. You will pay commissions on trades, however.

Regarding tax changes, it's hard to imagine that the IRA/401k could ever end up being taxed more than after-tax investments accounts are today.

I have to admit that I don't worry about 401k and IRA RMD since there is little chance that I will live past 70.
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madbrain: "What things are you forbidden to invest in IRAs?"

"Investment in Collectibles:

If your traditional IRA invests in collectibles, the amount invested is considered distributed to you in the year invested. You may have to pay the 10% additional tax on early distributions, discussed later.

Collectibles. These include:

Artworks,

Rugs,

Antiques,

Metals,

Gems,

Stamps,

Coins,

Alcoholic beverages, and

Certain other tangible personal property.

Exception. Your IRA can invest in one, one-half, one-quarter, or one-tenth ounce U.S. gold coins, or one-ounce silver coins minted by the Treasury Department. It can also invest in certain platinum coins and certain gold, silver, palladium, and platinum bullion."

http://www.irs.gov/publications/p590/ch01.html#en_US_publink...

And to invest directlyin real estate, you need to find a trustee who will allow it, have an IRA big enough to cover costs, and avoid all prohibitted transactions.

"Prohibited Transactions:

Generally, a prohibited transaction is any improper use of your traditional IRA account or annuity by you, your beneficiary, or any disqualified person.

Disqualified persons include your fiduciary and members of your family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant).

The following are examples of prohibited transactions with a traditional IRA.

Borrowing money from it.

Selling property to it.

Receiving unreasonable compensation for managing it.

Using it as security for a loan.

Buying property for personal use (present or future) with IRA funds.


Fiduciary. For these purposes, a fiduciary includes anyone who does any of the following.

Exercises any discretionary authority or discretionary control in managing your IRA or exercises any authority or control in managing or disposing of its assets.

Provides investment advice to your IRA for a fee, or has any authority or responsibility to do so.

Has any discretionary authority or discretionary responsibility in administering your IRA."

Id.

Regards, JAFO
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What things are you forbidden to invest in IRAs?

Gold coins and art for a couple. You can read the list if you google.

it's hard to imagine that the IRA/401k could ever end up being taxed more than after-tax investments accounts are today.

All tax deferred IRA funds are taxed under current law as ordinary income. Last time I checked capital gains and dividends for most companies were taxed at lower levels than ordinary income. And marginal income dollars can be taxed at rates in the range of 50% for those of us who are over 65. That happens since the portion of Social Security subject to tax increases with income.

So when you hit 70 and have an RMD that can easily have an unintended impact. It for just for that reason we are moving some money this year from a traditional IRA into a Roth. My wife is not yet drawing social security.

Gordon
Atlanta
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However, I have never seen a 401k that didn't have a money market fund, which, while not cash, is close.

My wife has worked for Westinghouse, for Scripps-Howard, and for a national television shopping network. All three had 401(k) programs. None of them had "money market" or anything similar as an option.

The closest was Westinghouse, which would let you put the money in a bond fund, which was not really a bond fund, but was a fund of bonds, purchased and never traded, with the coupons funding redemptions. (Of course that would have to change if they got a sudden run on the fund, at which time the bonds might or might not pay out at par.)
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Goofyhoofy,

I guess tech companies must be an exception. I have been in 7 different 401k plans since 1996 (not all different employers, there were mergers and custodian changes involved). And I said they all had money market account. In fact this was usually the default investment options if you didn't make your own elections.
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TwoCybers,

Thanks for the list of forbidden IRA investments.

All tax deferred IRA funds are taxed under current law as ordinary income.


Yes, but I wasn't only referring to the tax-deferred plans. If you also consider Roth 401k and Roth IRA options, I don't see the benefit of having a taxable account, unless you are already maxing out all the pre-tax and Roth plans already. I don't see how the Roth could end up with worse tax treatment than taxable accounts.

Last time I checked capital gains and dividends for most companies were taxed at lower levels than ordinary income.


At the federal level yes, but some states don't have special rates for capitals or dividends. In California this would mean a 9.55% state income tax rate currently.


And marginal income dollars can be taxed at rates in the range of 50% for those of us who are over 65. That happens since the portion of Social Security subject to tax increases with income.


Why over 65 ? I thought you could start drawing SS retirement at age 62 ?
I have a slightly difficult time figuring out what situation would bring you to a 50% marginal tax rate. I just glanced over publication 915. It appears that in the worst-case scenario, 85% of the social security benefits amount is taxable. The maximum monthly benefit for a single person is $2346 or $28152 annually. 85% of that would be $23929 per year taxable income.
Using the least-favorable tax table for single in 2010, this yields a federal tax of $3170.63. This would be 13.2% of the taxable benefit amount, and 11.2% of the total social security benefits received. I believe that's the highest taxation rate possible.

Even if you then decide to "assign" all that tax to the dollars in your top income over your SS benefits, that income would have to get to its own marginal tax rate of 36.8% in order for your marginal tax to reach 50%. But the current marginal tax only goes to 35%. So I don't see how you could exceed 48.2%. And you would have to have that rate on the top $23929 of income over $373650, ie. your income would have to exceed $397,579.

But I don't think it would be fair to assign the whole tax on your SS benefits only on your top income. It probably should be spread out. Especially if you are talking about other income that's 13x the benefit amount, the marginal tax rate doesn't mean very much anyway.
The numbers would change if there is state tax .
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Goofyhoofy,
I guess tech companies must be an exception.


Westinghouse was a heavy industry manufacturer, making warships for the defense department, electric generators for places like Niagra Falls, and building planned communities through its credit division. We were in the broadcast division, which accounted for about 3% of their total sales. (The plan was the same throughout all divisions.) The plan was administered by Mellon Bank.

Scripps-Howard was a newspaper publisher and television station owner. The third, the shopping network, was a stand-alone unaffiliated business with around 2500 employees. I forget who administered the plan.

I don't know if you count those as "tech" companies, but our experience was that there was noplace to put the money except their choice of a half-dozen stock funds and a bond fund or two. The all provided a company match, which was good, but limited selection, which was bad.
 
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Goofyhoofy,

I probably would count Westinghouse as tech, not the other two. The companies I have worked for have had from 250 to 60,000 employees. Names include AOL, Cisco, Computer Associates, Edify, Netflix, Netscape, Sun Microsystems. All tech.
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