Evolving Your Savings Strategy in Peak Earning Years
As your income rises, it naturally creates additional complexity in your financial life. We have written a lot about this over the years, and as you experience income jumps that are common in your 40s, you need to mind your personal savings gap. Your savings gap is how much of your household income you need to save or invest to reach your financial goals versus what you are saving.
As your household income starts to rise above $250,000 - $300,000/year, a simple rule of thumb is that you should strive to save around 1/3 of your gross income. When your annual income is less than that, for the most part, you can automate your way to reach your savings goals through your workplace retirement plans. In your 30s, it could be a struggle to hit this higher savings target due to things like childcare and student loans eating up any free cash flow you may have used for savings. However, as your income starts to make leaps higher in your late 30s through your early 50s, it requires more intentional planning. Contributing just to your 401(k) alone will not be enough to achieve your financial goals. You will need to actively contribute to a different investment bucket to reach your goals. Keep in mind that as you become accustomed to a higher spending rate in your 40s and 50s, you will more than likely want to maintain that same income in retirement, requiring you to save more knowing your future income need has likely increased as well.
Let's walk through an example of Brittney and Patrick’s savings strategy now that they have entered their peak earning years. They each make $225,000 per year. This has grown significantly from just a few years ago. If they both max out their 401(k)s, contribute to a family health savings account, and contribute $6,000 per year to a 529 for each of their two kids. Their contributions sum up to $66,300. While this was a great savings strategy 5 years ago when they were each earning $120,000, this is less than half of what they need to invest to reach their new future spending goals.
Savings gaps can happen because of lifestyle creep. As you earn more money, you must decide how you will use the additional income. Items that used to be luxuries may now be considered essentials to your daily life and this can create a savings gap. If you recognize that you have a savings gap, what are some strategies to bring you back on track? Let’s look at a few ideas.
Lump Sum Contributions: Many of our clients elect to set lump sum targets they should invest each year. They know they have an annual goal they need to work towards to make their financial plan work. Our business owners typically allocate a set dollar amount from their business distributions to meet their annual targets. For clients who receive a large percentage of their income through bonuses or commissions, we use the same strategy to ensure the lump sum savings contributions happen at the times of large cash infusions.
Manage RSUs: Restricted stock units (RSUs) have replaced or supplemented cash bonuses for many of our clients working at publicly traded companies. We find that a lot of clients with RSUs have not considered a plan for what to do with these funds after their shares vest. Thinking of these vested shares the same way as your annual cash bonus (because they are taxed in the same manner) creates an opportunity to manage your savings gap by allocating these funds towards your future retirement income strategy.
Recurring Contributions: For those who don’t have a lot of income complexity, setting up recurring contributions is the simplest way to close your savings gap. Take your annual savings goal and break it into manageable monthly or quarterly amounts. Some of our clients elect to pair this strategy with the ones above to reach their goals. The key here is to automate these investments, so you eliminate the need to decide each month. Think of this strategy the same way that you systematically contribute to your 401(k) account with each paycheck.
Now that we have reviewed a few strategies, where are places to invest your contributions outside of your workplace retirement plans?
Future Opportunity Fund: The most common place for our clients to make their investment contribution is into their Future Opportunity Fund. This a brokerage account we set up for clients meant to invest money you won’t need in the next two years. There is no cap on how much you can contribute, which provides much flexibility for your financial plan.
Back Door Roth IRA: As your income grows above the income thresholds imposed by the IRS, you will no longer be able to make direct Roth IRA contributions. Making a Back Door Roth IRA contribution could be a solution to close a portion of your savings gap. This is not the right strategy for everyone, and you are limited on how much you can contribute ($7,000 in 2024), but it is an efficient way to slide more funds into your Roth IRA to grow tax free future income. Because there are a lot of regulations in implementing this strategy correctly, we highly recommend consulting a professional to execute this appropriately.
After Tax 401(k): An increasing number of 401(k) plans are allowing participants to make after tax 401(k) contributions. These are contributions you make to your 401(k) plan that are made with after tax dollars after you’ve already contributed the $23,000 pre-tax deferral limit (2024). These are different from Roth 401(k) contributions. You can add a total of $69,000 between your contributions, company match, and your after-tax contribution. The after-tax contributions can be converted to your Roth 401(k) or Roth IRA within your plan. In our experience, this takes more effort to manage than your normal 401(k), but it could be a great tool to close the savings gap.
ESPP: Employee stock purchase plans (ESPP) are another opportunity to close your savings gap if you work for a publicly traded company. About half of the companies in the S&P 500 and 38% of the companies in the Russell 3000 offer ESPPs. This can be another way to meet your investment savings goal in an automated way. This also requires some additional financial planning to manage the timing of sales of your ESPP shares. Like your RSUs it is important to devise a strategy for these shares before you start blindly investing funds back into your company’s stock.
Bottom Line
Navigating the complexities of rising income requires more than just a set-it-and-forget-it approach to saving and investing. As we have explored, significant income growth, particularly during the pivotal years of your late 30s to early 50s, demands a strategic and intentional effort to manage your savings gap effectively. Our example along with the outlined strategies, underscore the necessity of being proactive in diversifying your investment avenues beyond 401(k) contributions. Each strategy offers a unique path to ensure your financial plan remains on track and responsive to your evolving financial life. Remember, the goal is not merely to save money, but to optimize your savings strategy to meet your current and future financial aspirations. Embracing this level of wealth management not only bridges the savings gap but also paves the way for a future rich in opportunities and financial security.
Andrew Comstock, CFA