I’m maxing out my 401(k) or 403(b), now what?

“Okay Erik “I’m maxing out my 401(k) (or 403b!), where should I put my extra savings?” 

This question doesn’t have a straight answer since your specific goals will vary dramatically from one person to the next. Also, the ability to save beyond the typical 401k contribution limit brings about a lot of flexibility and opens up numerous planning opportunities for you.

So, it’s helpful to think of this in terms of setting up a framework for saving once you’ve reached the limit. 

I am going to order things in terms of general importance and also by tax efficiency. After all, when this question comes up, it’s usually because you want to save on taxes. Who likes paying more than they have to to Uncle Sam, anyway?

First, I’m going to assume you have a healthy emergency fund in place and you don’t have any credit card debt. If you do, then you really ought to stop maxing out your retirement plan ASAP and prioritize these two things.

So, now that you are maxing out your retirement plan at work, where does your next dollar go?

If you have an HSA available, you’ll want to max this out even before your 401k. (For 2020, the max contribution is $3,550 for those with individual health coverage, $7,100 for those with family coverage; with a $1,000 catch-up limit for those over age 55).

Why do you want to max out your HSA before your 401k? This account has more tax benefits than any savings vehicle currently out there. Your savings go in pre-tax, you can invest the balance and grow this tax-free, and withdrawals used to cover medical expenses are tax-free as well. There are ways to use this as a pseudo retirement account. 

One thing to note, is that you need a qualifying high-deductible health insurance plan (HDHP) to contribute to an HSA.

Next, let’s consider the Roth IRA. If you are already maxing out your 401k, chances are that your income is too high ($139,000 for single filers, $206,000 for joint filers in 2020) to make a direct contribution to a Roth IRA. If this is the case, you still might be able to get money into your Roth IRA. You’ll just have to take an indirect method to get there, also known as the back-door Roth IRA contribution. (Despite its name, this is a common practice, and congress has even acknowledged this as an accepted way to get money into your Roth IRA). Even though money goes in here after-tax, this represents up to $6,000 (2020 limits) per year that you can grow and eventually withdraw tax-free.

Are there any other retirement plans or savings options that your employer offers? After the Roth IRA, let’s go back to looking at your employer. Maybe it’s in the form of an ESPP, ESOP, other deferred compensation arrangement, or some form of purchasing stock in your employer. * Be careful here, as many of these secondary arrangements involve owning your company’s stock. This can represent a major risk to your finances when your earnings and your assets become tied to one company. However, when utilized properly, these arrangements can be good tools to boost savings and save on taxes.

Now, are you self-employed? 

You could set up either an Individual 401k or a SEP IRA if this applies to you. Using the individual 401k (or SEP IRA) is a great way to boost your retirement savings and lower your taxes. Again, the use of these requires ‘self-employed’ earnings. 

If using the individual 401k, you can’t make any more “employee” contributions (the same type you make at your current employer), but you can make “employER” contributions, also known as non-elective contributions.

In using your own 401k, you can contribute about 25% of your earnings from self-employment, after adjusting for the self-employment tax and contributions. Otherwise, total contributions can’t exceed $57,000 in 2020. If you are over age 50, it’s $63,500.

For updated contribution limits – click here

Do you work for a government institution or non-profit employer? 

Look into whether or not your employer offers a 457(b), sometimes just referred to as a deferred compensation plan. With a few exceptions, this essentially has the same contribution limits as a 401(k), and contributions can lower your taxes here as well. Between the 457 and 401(k) plans, that represents $39,000 (using 2020 limits) of potential retirement savings. That’s some hefty tax savings! 

The 457 plan has the added benefit of being able to take withdrawals before age 59 ½. So if you want to retire early, this may be a great savings vehicle to consider on its own!

If you’ve exhausted all the other options above, saving your money in an after-tax investment account is still a good idea. 

You will be taxed annually on the dividends and capital gains that accumulate in the account, but there are many ways to mitigate negative tax consequences. In fact, you can even use this account to your advantage when incorporating into your overall tax strategy. While this may not be the most tax efficient vehicle, it is the most flexible when it comes to withdrawing money from your investments.

The next grouping of savings options represent more tailored uses for saving, but they can be very useful nonetheless:

• Is college planning important to you (maybe for your kids or another loved one)? The use of a college savings plan, typically a 529 plan, could be a great idea. Money goes in after-tax, but earnings grow tax-free and withdrawals are tax-free if used to pay for *most* educational expenses.

• Is charitable giving important to you? You can always give your cash straight to a charity, or your church for example. But you can also start your own Donor-Advised Fund, or DAF. The money you contribute directly to a DAF is used as a one-time charitable deduction (if you itemize on your tax return). Then, from here, you can invest your money which will grow tax-free. And then you can use this to make contributions to charities and nonprofits that are important to you.

• Are you really into the idea of building a stream (or streams) of passive income? If you are also ok with the idea of being a landlord, then buying a rental property could be a good idea for you. This does have some tax advantages and tax complexities of its own, so you really want to get the help of a tax professional here as well. But this could be an effective way to capture a stream of income, grow your assets, and diversify if this really appeals to you.

• Lastly, the option of purchasing permanent life insurance or an annuity might come up. Generally, I dislike the use of these as savings vehicles. They are a really inefficient use of capital. However, they do make sense in some cases, so it can be appropriate to consider this as an option depending on your purpose.

Looking at the list above, you should feel free to move things up and down the list as your specific wants and situation commands. I have given you a starting point on where to prioritize your savings, but if you feel really strongly about giving, for instance, then maybe you move the donor-advised fund (or just plain, old-fashioned donations) up the list.

The bottom line is that you really need to nail down your “why” first. 

Why are you saving? What are your goals? The answers to these questions dictate where your savings should be directed. After that, you can start prioritizing which accounts and which avenues to pursue, even from a tax perspective.

And if this is feeling a little overwhelming to you and want help planning things out, I’m here to help.

P.S If you didn’t see a savings strategy you’re currently using above, what other savings vehicles have you used? Let me know, I’d love to hear from you!