Maxing out your 401(k) and IRA has long been the de facto way to save for retirement. But it's not the only tax-smart way to build wealth to carry you through your golden years.
Wealthy savers also tend to focus on everything from investing in income-generating assets to implementing tax reduction strategies to grow their retirement nest eggs.
"When someone has been maxing out their traditional accounts most of their lives, it starts to hit them, 'I have most of my wealth in the stock market or bond market,'" says Nick Hamilton, national manager at Alliant Retirement and Investment Services. "I want to diversify more."
That’s not to say they blow off 401(k)s altogether. If a company offers a match, not contributing means you're leaving free money on the table. But it does mean they look for ways to save for retirement outside of the 401(k).
1. They invest in income-generating assets
Having enough cash flow in retirement is the name of the game. It means you don’t have to tap your retirement savings or worry about outliving your money, which is why many people look for investments that generate income.
One area that Hamilton says some of his clients focus on is residential real estate. It provides diversification, can generate income and has the potential to appreciate over time.
"You're not buying a ranch home in some small college town somewhere, you're buying a condo in Park City, Utah, where you can always rent it out," says Hamilton. The home doesn't have to be just for income. It can be for your enjoyment too. "You can use it for a little bit of both."
2. They look for tax-free withdrawals in retirement
This is a strategy Hamilton says is reserved for the wealthy, but in the end, enables them to access their money tax-free in retirement.
It works like this: You purchase a variable universal life insurance policy, or VUL. Premiums paid into the policy build the cash value. A portion of that cash value is invested in sub-accounts, which are like mutual funds, and grow on a tax-deferred basis. The remainder goes to the death benefit, which Hamilton says his clients try to keep as low as possible.
Once the cash value grows to a sufficient level and the account holder enters retirement, he or she can take tax-free loans against the cash value portion. Any loans that aren’t paid back reduce the death benefit that goes to heirs, but that’s not the point of this account. The idea is to have tax-free access to income in retirement.
There are no contribution limits with a VUL, unlike a 401(k) or an IRA, which makes it attractive to wealthy individuals.
But there are downsides.
For starters, fees associated with these types of policies can eat into returns. Additionally, your money is subject to market fluctuations. If things go south, the cash value of your account declines, which could lead to a policy lapse.
"A lot of wealthy clients turn to this strategy," says Hamilton. "You need a significant amount of wealth to ensure you can fund it over several years."
3. They use their HSA as a 'Stealth' IRA
A Health Savings Account (HSA) is more than a way to save for medical expenses; it’s a tax-advantaged powerhouse that the wealthy treat as a secondary retirement account.
That's because contributions are made pre-tax, the balance grows tax-free, and withdrawals are tax-free if used for medical costs.
The kicker: If you pay for medical expenses out of pocket now and save every receipt, you can reimburse yourself for decades of those old bills all at once in retirement. This creates a treasure trove of tax-free cash you can use for anything — from a new boat to a multi-generational family trip — guilt-free.
4. The wealthy look for greener pastures
You're missing out on free money if you don't contribute enough to get your company's full 401(k) match. If you're able, you should always try to invest the maximum amount allowable.
But after that, it's up for debate whether you should take advantage of 401(k) catch-up contributions or seek greener pastures elsewhere.
Wealthy investors don’t stay in money-losing propositions, and if their company’s 401(k) offerings are less than stellar, they will look to invest elsewhere instead of contributing more, and you should too.
You might find better choices investing in an IRA, funding a Health Savings Account (HSA), or opening a taxable brokerage account.
5. They make tax-smart moves
If a high-net-worth individual wants to cash out, they don't just sell a winning stock and walk away with the profits; they do so in a way that minimizes their tax liability, such as engaging in tax-loss harvesting. That occurs when you pair a winning stock with a losing stock and sell both. The losses offset the gains, reducing or eliminating the tax you owe.
Be mindful of the wash-sale rule with this strategy. With it, you can't buy the same or a substantially identical security within 30 days before or after the sale, or the loss deduction will be disallowed for that tax year. To circumvent the wash-sale rule, savvy investors will often reinvest in a correlated ETF or a stock in the same industry to maintain their market exposure without triggering the rule.
The 401(k) plus approach
The wealthy aren’t blowing off 401(k)s altogether. Nobody wants to leave free money on the table or miss out on a tax break. But they recognize that it's not the be-all and end-all. If opportunity comes knocking, they're taking advantage of it.
Whether they're investing in real estate or buying insurance to access tax-free withdrawals in retirement, they know there are additional ways to build a retirement nest egg beyond traditional retirement accounts.
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