Are you unsure whether you’re maximizing your W-2 income? Do you need a quick quality control check to ensure you’re making the right decisions with your income and cash flow? Look no further. This guide will break down actionable steps for ensuring your income is managed tax efficiently toward your specific and unique financial goals. This is the high-income earners’ guide to maximizing W-2 income!
Step 1: Build a Cash Flow Spreadsheet
A great financial plan is always driven by cash flow and how it’s managed. Naturally, the first step to maximizing W-2 income is visually preparing a personal cash flow spreadsheet. Start with an annual representation of cash flow. Collect information on all income sources such as base salary, bonuses, equity compensation, or any other relevant income.
In this example, we’ll use a base salary of $250,000, a 15% base salary bonus, and $100,000 in restricted stock unit (RSU) income throughout the year. A mortgage payment of $54,000, living expenses of $80,004, insurance payments of $3996, and an auto loan of $3966.
The annual cash flow outline is built out below, which includes estimated taxes (through payroll withholding). If you need help determining estimated taxes, you can use an online calculator such as this one or or project out income and tax withholding using a paystub for the rest of the year.
This simple breakdown of annual cash flow helps you understand the amount of “excess cash flow” that is available to automate toward your specific financial goals. Roughly $151,762 is available for goals or 39% of gross income.
The next step is to identify and align your money with your goals. The vast majority of people hope to reach financial independence someday and have the ability to “retire” from their W-2 work. In this example, that’s important to the individual, so they want to align their money with that goal.
Their employer offers a 401(k) plan with a 100% up to 6% match along with an “after-tax 401(k)” and “in-plan Roth conversion.” Therefore, they’ve elected to max out their 401(k) AND after-tax 401(k). This will allow up to $69,000 in tax-advantaged funds toward long-term financial independence!
The in-plan Roth conversion also allows a large chunk of those contributions to grow tax-free after the contribution is made into the after-tax 401(k). It should be utilized rather than allowed to grow the funds in the after-tax 401(k) for better tax treatment in the future. This strategy is often called the “mega backdoor Roth.”
However, it’s also important for this individual to grow a taxable brokerage account for more flexibility on withdrawals and tax efficiency in the future. Since they “only” have $151,762 to allocate towards their financial goals, they don’t want to completely max out the $69,000 into the 401(k) and after-tax 401(k), so they’ve opted to max out the 401(k) at $23,000 and the after-tax 401(k) at $28,000 from their bonus income (once per year). Since $100,000 of their income is from RSUs that vest quarterly, they plan on using those vests to sell their company stock immediately after vest and diversify it into a taxable brokerage account.
If they can accomplish all these savings throughout the year, their savings rate will be 39% of their gross income, which in most cases is a very high savings rate and will lead to eventual financial independence. Building a cash flow spreadsheet is a great starting point to determine how to allocate the best “excess cash flow” towards financial goals.
Step 2: Optimize Other Employer Benefits
Ignoring the prior example, there are many other benefits that your employer may provide to help maximize your W-2 income. Benefits such as an employee stock purchase plan (ESPP), health savings account (HSA), dependant care FSA (DCFSA), group term life insurance, group disability insurance, legal benefits, or pre-tax commuting account, to name a few.
ESPP
The employer stock purchase plan can be an extremely beneficial benefit. Generally, they allow employees to use post-tax money from W-2 income to purchase the company stock at a discount using the lower stock price at the beginning or end of the purchase period, whichever is lower. It may be stated that an employee can allocate up to 15% of their income, with a 15% discount on the purchase price, purchased every six months, with the “lookback provision,” which allows the discount to be applied to the lower of the stock price at the beginning or end of the purchase period. Suppose the stock price grows in value during the purchase period. In that case, the purchase price becomes significantly more valuable since the discount is applied to the lower price at the beginning of the period. If the stock tanks in value during the purchase period, the employee can still gross a 15% gain over six months. Either way, it’s a fairly surefire way to gross a 15% gain over a relatively short time, with an upside of much greater.
HSA
Employees often overlook the health savings account as an option for their health insurance plan. The prerequisite to an HSA is that you must be enrolled in a high-deductible health insurance plan. While it’s true these plans have higher deductibles until insurance kicks in, which results in the plan feeling more expensive than a non-high deductible plan, the premiums are typically lower, and they include access to the HSA. When you factor in the pre-tax contributions to the HSA, it’s oftentimes a cheaper plan than their counterparts. Not to mention the true magic of the HSA, it allows you to contribute pre-tax and use the funds at any point in the future tax-free towards health-related expenses. It is the only “triple tax-advantaged” account available since the funds can also be invested over the long term and grow tax-free.
Dependant Care FSA
If you have kids and you pay for childcare, the dependant care FSA allows you to contribute up to $5,000 pre-tax annually, as a family, towards childcare-related expenses. While not a huge benefit for reducing taxable income, it does help, especially with your higher income. The key is to ensure you’re keeping tabs on childcare-related costs and initiate the reimbursement from the dependant care FSA annually when expenses exceed $5,000 if required.
Group Term Life and Disability Insurance
Employers often provide their employees with group-term life and disability insurance policies. It could be stated that the employer provides free life insurance for up to two times their base salary and long-term disability coverage for up to 60% of their monthly income. These are no-brainer options, especially if your employer pays the premiums. Remember that the long-term disability policy may be taxable if the employer pays the premiums and you go on disability. Employer-provided insurance should be viewed as a supplement to your private insurance policies for this reason, as the future is unpredictable, and the policies don’t necessarily leave with you if you take another job at a new employer. Bulletproofing your financial plan requires purchasing adequate insurance policies privately in most cases. Be sure not to rely solely upon employer-provided group life and disability, as it may not be enough.
Legal & Pr-Tax Commuting Benefits
Finally, your employer may provide benefits for legal representation and commuting. The legal benefits are typically provided through some group plan that allows employees to gain access to various attorneys with various legal services such as estate planning, real estate, or taxes. If you know you’ll need the services of an attorney in any given year, it’s a relatively cheap way to get legal services rather than finding an attorney out of the network. The qualify of work or advice, however, obviously depends on the attorney you work with, so there can be a give and take when utilizing this benefit.
The pre-tax commuting account is another tax-efficient way to pay for commuting costs to work. Typically, they allow a pre-tax contribution each month that can help reduce taxable income. If you’re already commuting to work, this one also makes sense to utilize if you’re trying to maximize all benefits and tax deductions.
Step 3: Backdoor Roth IRA
The backdoor Roth IRA doesn’t provide any immediate tax benefits, but the benefits can be substantial over the long term.
For high-income earners who cannot receive a deduction for contributions to an IRA or make a direct Roth IRA contribution, you can still make a “non-deductible IRA” contribution. Once the contribution is completed, a Roth conversion is initiated to get the funds into the Roth IRA. This essentially completes the process of the backdoor Roth IRA.
However, there are a few key items to be aware of, primarily that there aren’t any pre-tax IRA monies within any IRAs before completing the Roth conversion.
If funds are within an IRA or rollover IRA, the Roth conversion will cause income tax to be realized. To avoid this, roll any pre-tax IRA funds into your current employer 401(k), and the backdoor Roth IRA can be completed every year moving forward without causing any issues with realizing income on the Roth conversion.
Secondly, you’ll want to make sure you file form 8606 when filing taxes in the year that a nondeductible IRA contribution and Roth conversion is completed to ensure that the IRS is aware of the transactions and you remain in tax compliance.
Contributing to this account for decades can build another nest egg of tax-free income in retirement that is much more tax-efficient than had you avoided completing this process for the entirety of your career.
High-Income Earners, Maximize Your W-2 Income Today
High-income earners looking to maximize their W-2 income should carefully analyze cash flow and employer-provided benefits and ensure their money aligns with their goals. Start with a deeper understanding of your cash flow, then optimize employer-provided benefits. If there is additional cash flow to automate towards goals after employer benefits, consider the backdoor Roth IRA, brokerage account(s), and/or other investment opportunities.
If you need assistance reviewing any of the above or completing a full financial plan, don’t hesitate to schedule a free consultation today!
