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.
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.
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.