How high earners can save thousands with these two tax strategies

Strategic investing isn't just about growing wealth—it's about preserving it in the most efficient way possible. For high-income individuals, optimizing tax advantages can significantly impact long-term financial success. Two standout methods in this domain are the Backdoor Roth IRA and Direct Indexing. These innovative strategies not only help high-income earners minimize tax burdens but also offer greater flexibility and control over financial planning.

This guide from Range covers how these strategies work and why they are invaluable for those looking to maximize their wealth-building potential.

The Backdoor Roth IRA: Unlocking Tax-Free Growth

Retirement planning can be tricky for high-income earners who are often excluded from contributing directly to a Roth IRA due to income limits. However, the Backdoor Roth IRA offers an effective way to bypass these restrictions and still enjoy Roth IRA benefits like tax-free growth and withdrawals.

What Is a Backdoor Roth IRA?

A Backdoor Roth IRA is a tax strategy that allows individuals to contribute to a Roth IRA indirectly by using this two-step process:

1. Contribute to a Traditional IRA: High-income earners can make after-tax contributions to a traditional IRA.
2. Convert to a Roth IRA: These contributions are then converted to a Roth IRA. Once converted, the funds can grow tax-free, and future withdrawals, if eligible, are also tax-free.

This strategy acts as a legal workaround to unlock Roth IRA advantages without being restricted by income limits.

Why Should High-Income Earners Consider It?

The Backdoor Roth IRA offers several key benefits that make it a compelling tax-planning tool for high-net-worth households:

• Tax-Free Growth: Contributions grow and compound without being taxed. This provides a significant financial advantage over traditional taxable accounts.
• Tax-Free Withdrawals: Once the funds are in a Roth IRA, eligible withdrawals in retirement are free of taxes.
• No RMDs: Unlike traditional IRAs, Roth IRAs do not require mandatory withdrawals starting at age 73, offering flexibility in how and when you access your funds.
• Bypass Income Limits: For 2024, high-income earners exceeding modified adjusted gross income (MAGI) thresholds—$165,000 for single filers or $236,000 for married filing jointly—can still contribute through this strategy.

The Pro-Rata Rule and Tax Efficiency

It's important to plan carefully to avoid complications with the pro-rata rule, which determines how much of your conversion is taxable if you have both pre-tax and after-tax IRA balances. One way to streamline this process is to transfer pre-tax IRA amounts to an employer-sponsored 401(k) plan, keeping the Backdoor Roth strategy focused on after-tax balances.

Direct Indexing: Tax-Efficient Portfolio Management

For high-net-worth investors, Direct Indexing is another innovative strategy that elevates tax-efficiency by offering a personalized way to manage index-based investments.

What Is Direct Indexing?

Direct indexing involves owning the individual stocks that make up an index, rather than buying an index fund or ETF. For example, instead of purchasing a fund that tracks the S&P 500, you buy shares of each constituent stock in the same proportions.

This approach provides unique opportunities for tax-loss harvesting and customized portfolio management, especially for those in higher tax brackets.

How Does It Work?

Building a direct indexing portfolio involves three main components:

1. Core Holdings: Purchase the largest stocks in the index individually, which typically include well-known large-cap companies.
2. Additional Investments: Add mid- or small-cap exposures to replicate the full performance of the index.
3. Ongoing Management: Regularly rebalance and monitor the portfolio to maintain tracking accuracy while seeking tax-saving opportunities.

Tax Advantages of Direct Indexing

The ability to focus on individual stocks enables direct indexing to deliver superior tax efficiency in comparison to ETFs or mutual funds. Benefits include:

• Daily Tax-Loss Harvesting: By monitoring individual stock performance daily, you can sell underperforming positions at a loss to offset gains elsewhere.
• Reduced Tax Burden: Harvested losses can reduce taxable gains across other investments, potentially lowering your ordinary income tax by up to $3,000 annually and carrying forward unused losses.
• Optimal Tax Flexibility: Gain more control over the tax impact of each stock transaction in your portfolio.

For example, if the market has a volatile quarter, a traditional ETF might show no tax advantages despite gains overall. However, with direct indexing, investors can strategically lock in losses on certain individual stocks for tax benefits without compromising overall portfolio performance.

Integrating Backdoor Roth IRA and Direct Indexing

These two strategies, while distinct, work harmoniously to complement each other in reducing taxes for affluent households:

• Backdoor Roth IRAs enable tax-free growth and eliminate future tax liabilities—essentially creating a retirement account immune to future rate changes.
• Direct Indexing actively manages investments with tax-loss harvesting, allowing for incremental tax savings that can amplify overall returns year over year.

When combined with proper planning, these approaches provide high-income earners with a powerful advantage in both retirement savings and active wealth management.

Final Thoughts—Strategic Planning for Lasting Wealth

High-income earners face unique challenges in retirement and portfolio management, but solutions like the Backdoor Roth IRA and Direct Indexing offer proven ways to optimize growth while minimizing taxes. By leveraging these strategies, you not only stay ahead of shifting tax policies but also ensure your wealth compounds with maximum efficiency over time.

If you're ready to integrate these advanced techniques into your financial plan, consult with an experienced advisor to ensure a smooth, compliant, and strategic implementation.

This story was produced by Range and reviewed and distributed by Stacker.