Wealthy people often use the most commonly available banking and investment accounts to compound their wealth and avoid tax liabilities on future withdrawals. They love liquidity and tax benefits and generally maintain a frugal lifestyle. For these reasons, high-net-worth individuals often gravitate towards tax-advantaged accounts like 401(k), Roth IRAs, and brokerage accounts that offer them access to low-cost funds with high liquidity.
The Wealthy Leverage Backdoor Roth IRAs To Avoid Future Taxes
Tax liabilities grow as your wealth multiplies. The rich employ a host of tax-saving strategies to avoid paying to the Internal Revenue Service, evidenced by the US Treasury's estimate that over $150 billion in taxes owed by the top 1% goes unpaid annually. One strategy they use is a backdoor Roth IRA that grows post-tax money for tax-free withdrawals in retirement. PayPal founder Peter Thiel grew his $1,700 Roth IRA account to $5 billion, which he will withdraw completely tax-free.
Traditional IRA accounts are popular retirement instruments. Many choose them for more personalised investment options and to lower their annual tax liability while growing their pre-tax contributions tax-free. The maximum contribution limit for 2024 is $7,000. However, withdrawals from traditional IRA funds are taxed as regular income. Meanwhile, a Roth IRA takes in your post-tax contributions, and all withdrawals in retirement are tax-free. A Roth IRA also doesn't mandate you to take required minimum distributions after a certain age like most 401(k) accounts impose. There's a catch.
Roth IRA accounts can be opened by individuals with a modified adjusted gross income under $161,000 for the current financial year or $240,000 for those filing jointly. While these income limits prevent many high-earners from opening Roth IRA accounts, they often bypass these constraints by creating a backdoor Roth IRA. It involves converting your traditional IRA into a Roth IRA, where you pay taxes on pre-tax traditional IRA contributions and capital gains only once and never again on Roth IRA withdrawals. The wealthy prefer this tax strategy, given that there's no income limit for opening a traditional IRA or conditions on who can roll over IRAs.
Wealthy people Love Free Money From Their 401(k) Plans
A Ramsey Solutions survey of 10,000 millionaires revealed that 401(k)s were the most common accounts they used, with 80% having this employer-sponsored account in their portfolios. 401(k) accounts might not be the most flexible or cost-effective avenue to grow your net worth. Still, the employer-sponsored account offers several benefits, like a high annual contributions limit of $23,000 for 2024, growing your contributions tax-free while allowing you to deduct them from your annual taxable income, and employer-matching options, which offer essentially free money.
Research shows that most workers feel utilising 401(k) employer-matching is vital to reaching retirement goals. Employers matching your 401(k) contributions with their own money sometimes contribute up to 6.99% of your annual pay. Let's say you earn $60,000 annually, and your employer offers a 5% match on your contributions. So, if you contribute 5% or $3,000 towards your 401(k) account annually, your employer will boost that with a $3,000 contribution from their own pocket, which is free money that grows tax-free until withdrawn.
The Rich Avoid High-Cost Investments Through Brokerage Accounts
Retirement accounts like traditional 401(k) and IRAs offer many perks but not the flexibility to withdraw money before age 59½ without attracting taxes and penalties. These limitations of reaching a certain age or citing hardships before you can withdraw from your retirement accounts can pose problems for people planning to retire early. However, they mitigate these risks by opening taxable brokerage accounts, which lack tax benefits but offer access to diverse investment options.
According to Business Insider, wealthy people love to invest in index funds via brokerage accounts to avoid high fees. While a brokerage account can ensure you can cash out whenever required without pre-conditions, remember that realised earnings and capital gains from brokerage accounts are taxable in the applicable financial year.
