DR 084: Where To Invest When You’ve Maxed Out Contributions To Retirement Accounts

It’s a good problem to have. You’ve maxed out your 401k and IRA contributions for the year and you still have some more cash to invest. What are your options?

That’s the situation a reader named Harout recently emailed me about:

I am a little obsessed with your podcasts. I listen to about one a day. It’s been a very helpful tool.

I’m still catching up on all the podcasts so I am a few behind, but I just heard podcast 25 and wanted to know how often should you re-balance your portfolio. Also on a different note. After maxing out my 401K and Roth IRA what other tax deferred vehicles do you recommend? A few I have heard of are a non-deductible IRA, a Health Savings account and an annuity. Or should I look to invest in a taxable Vanguard account? Any thoughts on those?

Thanks again for all your help and all that you do!

This is a great question and raises an issue that I confront. I still have more money to invest after maxing out all of my available retirement accounts. There are several options when it comes to tax efficient investing.

Podcast Episode of this Article

SEP IRA or i401(k)

If you happen to have self-employment income, a SEP IRA or i401(k) can significantly increase your contribution limits. This still leaves open the question of where to invest when you’ve maxed out these higher limits (see below). But it’s worth making sure you take advantage of these options if they are available to you.

Health Savings Account

For those with high deductible health insurance policies, a Health Savings Account can be a great way to save for retirement. HSAs are tax-advantaged accounts designed to help pay the high deductibles of health insurance policies. Money left in an HSA, however, can be carried over from year to year and ultimately used for retirement.

You can check out the details in this podcast about HSAs.

Annuities

Variable deferred annuities offer another way to save money for retirement. Contributions are on an after-tax basis, but earnings grow tax deferred until retirement. The biggest criticism of these types of annuities are the fees. It’s critical to examine the fees and to make sure the tax benefits are worth the fees. I this interview with Tim Holmes of Vanguard, we cover the basics of these types of annuities.

Taxable Account

The final option is the most simple–invest in a taxable account. There are many tax efficient investment options:

  • Individual Stocks: With individual stocks, you have complete control on capital gains. Simply put, there are no capital gains until you decide to sell some or all of your investment. For dividend paying stocks, these investments will generate taxable income each year. Even with taxable dividend income, however, stocks can be extremely tax efficient. And with some investments, such as Berkshire Hathaway that doesn’t pay a dividend, the investment is as tax efficient as a tax-deferred annuity.
  • ETFs: Exchange Traded Funds tend to be more tax efficient than mutual funds for several reasons. Two key reasons stand out. First, many ETFs track an index, and as a result, keep buying and selling to a minimum. Second, when investors flee an ETF during a down market, the ETF need to sell investments to buy out these shareholders. Unlike a mutual fund, ETFs are traded between investors. It is important to realize, however, that not all ETFs are tax-efficient.
  • Index Funds: For those that prefer mutual funds, index funds tend to be tax efficient. As with ETFs, index funds have a low turnover of investments from year to year. As a result, capital gains are generally minimal.

Finally, a very helpful tool to evaluate the tax efficiency of an ETF or mutual fund is Morningstar’s Tax Cost Ratio. Morningstar reports this ratio for each ETF and mutual fund (here is an example for Vanguard’s S&P 500 Value Index fund). It shows how much of a fund’s return would be lost to taxes. It’s an easy and quick way to evaluate and compare the tax efficiency of an investment.

Published or Updated: July 10, 2014
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Jon says:

    Thanks for explaining that the best place to open an account to buy mutual funds is with the fund company. Especially with Gen Y, I feel that most are familiar with the basic uses of discount brokerages, but that’s as far as it goes.

    I still never ceased to be amazed by how much people think about retirement though- after being abroad a number of times, I’ve gotten used to seeing people live day to day, month to month. Not bad or good- just an observation I guess…

  2. What are you thoughts on ETFs or index funds from a tax management perspective? Shouldn’t these enter the conversation, at the very least, for their low turnover rates.
    Most people don’t realize that sometimes the biggest taxes can be cause by mutual funds in down markets. People tend to act irrational and cash out of investments in a down market. The mutual fund needs to sell within the fund to meet redemptions and thus, taxes are usually created even though the fund might be down for the year.
    From stock perspective, how about DRIPs?
    Then you probably shouldn’t forget properly funded cash value life insurance. Tax deferred growth with tax free withdrawals, can’t complain about that. I should stress properly funded because this is where most people really mess up life insurance. Unfortunately, it’s usually the insurance guy that leads the charge for messing up the policy.

  3. Chris says:

    There’s always Health Savings Accounts and 529 plans. Employers who limit employee contributions are doing a HUGE disservice to them. When mine did that, I would contribute the rest to HSAs and 529s up to the aggregate total of what I could put into a 401(k) (16,500) and/or Roth IRA (5,000). You’ll probably need an HSA and 529 someday anyway!

  4. nate says:

    pay off any non-deductible debt. No better returns than that!

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