Simone says, “I’ve maxed out my retirement accounts, but still have $14,000 that I want to invest this year. My husband and I have a six-month emergency fund and are not inclined to prepay our mortgage because the interest rate is 3.25%. Would it be better to use a non-deductible IRA or a brokerage account to invest this money in low-cost index funds?”
Congrats to Simone for blowing the lid off her retirement savings! Not knowing what to do with all your extra cash is a fantastic problem to have.
In this post, I’ll answer Simone’s question and give you tips to make the most of additional money when you’re a good saver, get a raise, or receive an unexpected cash windfall. No matter how much or how little extra savings you have, we’ll cover the right way to prioritize it.
How to Prioritize Extra Cash
Before I answer Simone’s specific question about which investing account to choose, I’ll back up and discuss how to prioritize your extra cash. I created a simple framework, called the PIP plan, that allows you to quickly take note of what you’re doing right and where you may be vulnerable.
PIP stands for:
- Prepare for the unexpected
- Invest for the future
- Pay off high-interest debt
Let’s review each one so you can apply it to your situation.
Free Resource: Retirement Account Comparison Chart.
1. Prepare for the Unexpected
Your first fundamental goal should be to prepare for the unexpected. As you know, life is full of surprises. Some of them bring happiness, but there are an infinite number of devastating events that could hurt you financially.
In an instant, you could get fired from your job, need to travel to see a loved-one, be the victim of theft, get an oversized tax bill, experience a natural disaster, get a serious illness, or lose a spouse.
Being prepared for what may be around the corner is a work in progress. It should change over time because it depends on factors like whether you have a family, your total amount of debt, and your income.
While no amount of money can reverse a tragedy, having safety nets—like an emergency fund and insurance—can protect your finances.
While no amount of money can reverse a tragedy, having safety nets—like an emergency fund and insurance—can protect your finances. They make coping with a tragedy much easier.
Be determined to accumulate an emergency fund equal to at least three to six months’ worth of your living expenses. For instance, if you spend $5,000 a month on essentials—like housing, utilities, food, and debt payments—make a goal to keep at least $15,000 in an FDIC-insured bank savings account.
While keeping that much in savings may sound boring, the goal for your emergency fund is safety, not growth. The idea is to have immediate access to your cash when you need it. That’s why I don’t recommend investing your emergency money, unless you have more than a six-month reserve.
If you don’t have enough saved, make a goal to bridge the gap over a reasonable amount of time. For instance, you could save one half of your target over two years, or one third over three years. Put it on autopilot by creating an automatic monthly transfer from your checking into your savings account.
If you’re like Simone and already have enough saved, consider moving it into a high-yield savings or money market account that pays slightly more interest for large balances. You can download the free Online Bank Comparison Chart (PDF) for a review of the best online banks.
As I mentioned, another important aspect of preparing for the unexpected is having enough of the right kinds of insurance.
To beat inflation and earn enough to accumulate one or more million dollars for long-term goals, such as retirement, you’ll need to take some amount of risk by investing.
If Simone and her husband are lacking any major insurance, such as disability, umbrella liability, or a life policy, I’d recommend that they use some of their extra cash to purchase them before investing.
2. Invest for the Future
Once you start building an emergency fund and have the right kinds of insurance, begin the second goal that I mentioned: invest for retirement. That’s the “I” in PIP, right behind prepare for the unexpected.
If you’re like most people you’ll need to work on both goals at the same time. But unlike your emergency fund, money in your retirement account should never be tapped until you retire.
Another huge distinction between saving and investing is safety. Remember to keep savings safe. However, safety comes at a cost because it gives you no or little return. To beat inflation and earn enough to accumulate one or more million dollars for long-term goals, such as retirement, you’ll need to take some amount of risk by investing.
Use qualified retirement accounts, like a workplace plan or an IRA, to get extra tax savings that work in your favor. Some employers match a certain percent of your contributions to a 401k or 403b, which turbo charges your account. So always invest enough to max out any free retirement plan matching at work.
Contributions to a retirement plan at work can only come from your paycheck. In other words, you can’t move money from your savings into a 401k or 403b. You must adjust your payroll deduction to increase or decrease the amount you invest.
Remember that when you pay off a credit card that charges 18%, that’s just like earning 18% on an investment after taxes—pretty impressive!
Simone says she and her husband have maxed out their retirement plans at work, which is fantastic.
3. Pay Off High-Interest Debt
Once you achieve the first two parts of my PIP plan by preparing for the unexpected and investing for the future, you’re in a perfect position to pay off high-interest debt, the final “P.”
Always tackle your high interest debts first because they’re costing you the most. They usually include credit cards, car loans, personal loans, and payday loans with double-digit interest rates.
Remember that when you pay off a credit card that charges 18%, that’s just like earning 18% on an investment after taxes—pretty impressive!
Common low-interest loans include student loans, mortgages, and home equity lines of credit. These three types of debt also come with tax breaks for some or all the interest you pay, which makes them cost even less on an after-tax basis.
Simone is thinking about her mortgage the right way because she mentions that the interest rate is too low to prepay. Yes, paying it down would give her a guaranteed return, but likely a much lower return than she could make by investing. So, I recommend that she turn to other investing options.
Also see: Should You Pay Down Debt Before Investing?
5 Places to Invest After You Max Out a Retirement Account
Here are five places to invest if you’ve maxed out a retirement account at work or don’t have a job with a retirement plan.
- Individual Retirement Arrangement or IRA.
- Retirement plan for the self-employed.
- Health Savings Account or HSA.
- Different types of annuity products.
- Taxable brokerage account.
Let's go deeper into each.
1. Individual Retirement Arrangement or IRA.
A major reason you should top off a workplace retirement plan first is because the contribution limits are much higher than with an IRA. For 2017, you can contribute up to $18,000 to a workplace account, or up to $24,000 if you’re over age 50. With a traditional or Roth IRA, you can only contribute up to $5,500, or $6,500 if you’re over 50.
An IRA is a personal account that has nothing to do with your work; you open it, fund it, and control it yourself. The only requirement to contribute to an IRA is that you have some amount of earned income or have a spouse with earned income.
No matter how much you contribute to a retirement plan at work. you can also max out an IRA in the same year. There are annual income limits to qualify for a Roth IRA, but there are no income restrictions for a traditional IRA.
Also, be aware that if you or a spouse participate in a retirement plan at work, the tax deduction on traditional IRA contributions may be reduced or eliminated, depending on your income. That doesn’t mean you can’t max out the account; however, only some or none of your contribution will be deductible. Read or listen to Can You Contribute to a 401k and an IRA in the Same Year? for more details.
Simone asked whether it’s better to use a non-deductible IRA or a brokerage account to invest when you’ve maxed out retirement options at work. Assuming she and her husband earn too much to qualify for a Roth IRA (which has no restrictions when you also contribute to a workplace plan), I’d encourage her to max out a non-deductible IRA before using a taxable brokerage account.
While you don’t get an income tax break on contributions to a non-deductible IRA, you still defer annual investment taxes as your money grows. That means you don’t pay any taxes on your earnings until you take withdrawals in retirement.
2. Retirement plan for the self-employed.
Simone didn’t mention if she has any other income sources. But if you’re self-employed or have your own company, there are more ways to save for retirement, in addition to an IRA, even if you already maxed out a retirement plan at work.
I’ll just cover my favorite plan here, which is a Simplified Employee Pension Plan, also known as a SEP-IRA. It allows employers to make pre-tax contributions to a traditional IRA for each of their eligible employees.
If you’re self-employed or have your own company, there are more ways to save for retirement, in addition to an IRA, even if you already maxed out a retirement plan at work.
SEPs don’t allow employees to contribute; they can only be funded by employer contributions. But it allows individuals who are self-employed to make contributions to their own retirement account.
The money you put into a SEP can go to various options you choose from a menu of available investments, such as mutual funds. Your contributions are tax-deductible and grow tax-deferred until retirement.
The SEP rules allow you to contribute any amount you like, up to 25% of your salary if you’re an employee of your own company, or up to 20% of your net self-employment income. These percentages are capped at a maximum contribution of $54,000 for 2017.
You can even have a SEP for your part- or full-time self-employment income even if you have another job where you participate in an employer’s retirement plan and max it out.
Related: 401k or IRA—Which One Should You Invest in First?
3. Health Savings Account or HSA.
An HSA is a special tax-exempt account you can open for the sole purpose of paying medical expenses for you or your dependents. To be eligible, there are no income restrictions, but you must already have a qualified, high-deductible health plan as an individual or an employer.
Contributions to an HSA are deductible on your tax return (even if you don’t itemize deductions) and when you withdraw funds to pay qualified expenses, your original contributions plus any earnings are completely tax-free. That makes it an even better tax deal than a retirement account.
Money in most HSAs can earn interest, or be invested for potential growth in a menu of available options, such as mutual funds. So, this account does double duty as a smart way to pay for medical expenses on a pre-tax basis and to invest your balance.
For 2017, you or your employer can contribute a total of up to $3,400 to an HSA when you have a self-only health plan, or $6,750 for a family plan. If you’re age 55 or older you can contribute an additional $1,000 to an HSA when you have either type of health plan.
No matter where you buy your health insurance, you own and manage an HSA as an individual. If you have an HSA-qualified plan, you don’t need permission from an employer or the IRS to set up the account. And it stays with you even if you change jobs, become unemployed, or self-employed.
And here’s another great benefit of an HSA: Unlike a flexible spending account (FSA), you can roll over HSA funds from year to year with no penalty. When you turn 65, any remaining balance can be used for non-medical expenses with no penalty. Prior to age 65, you’ll have to pay a 20% penalty, plus taxes, if you spend HSA funds on non-qualified expenses.
So, your HSA morphs into something that looks like a traditional retirement account if you keep it long enough. You can spend the funds on anything you like, but withdrawals are taxed at your ordinary income tax rate.
Your HSA morphs into something that looks like a traditional retirement account if you keep it long enough. You can spend the funds on anything you like, but withdrawals are taxed at your ordinary income tax rate.
4. Different types of annuity products.
An annuity is a contract between you and an insurance company that promises to pay you income. Annuities can be complex because there are many different types sold by insurance companies, banks, and financial advisors.
Think of an annuity as insurance or a guarantee that you’ll have a future income stream. You purchase one with a lump sum or by paying premiums over time. Then the insurance company invests your money and typically pays you over time, even for as long as you live, so you never run out of money in retirement.
Unlike with most tax-advantaged accounts, such as a 401k, IRA, or HSA, there are no annual contribution limits with an annuity. You can put in as much as you want. And the longer you wait to start receiving annuity payments, the larger they may be.
But like the way investment earnings are treated in a traditional 401k or traditional IRA, the growth in an annuity is tax-deferred. You make payments to an annuity on an after-tax basis and only pay tax on the earnings portions of your withdrawals.
Annuities may be a good option when you’ve maxed out all other tax-advantaged accounts, such as a retirement plan at work, one or more IRAs, an HSA (if you’re eligible) and are approaching retirement, say over age 50.
5, Taxable brokerage account.
If you’ve run out of ways to make tax-advantaged investments and are too young to consider annuities, put your extra cash in a regular brokerage account. You can’t skip paying taxes on earnings, so be sure to report the income when you file your tax return.
The brokerage will send you the appropriate tax forms in January for the prior year so you know the types and amounts of income earned or lost. Depending on the activity in the account you might receive:
- Form 1099-B, which reports capital gains and losses
- Form 1099-DIV, which reports dividend income and distributions
- Form 1099-INT, which reports interest income
Most investors pay 15% on long-term capital gains and investment dividends, but those in a low-income tax bracket (10% or 15%) are exempt from tax. Patience is rewarded in investing because if you own one for a year or less, you’re subject to short-term capital gains, which are the same as your ordinary income tax rate, which is higher.
While paying tax on growth in a brokerage account is a downer, the upside is that you can take withdrawals at any time without penalty. Taking early or non-qualified distributions from a retirement account, HSA, or annuity comes with costly penalties.
Use This Retirement Investing Strategy
After you max out a workplace retirement plan, there are many good options to keep investing. The best retirement investing strategy is to use tax-advantaged accounts first and taxable accounts later, in this order:
- Workplace retirement plans, such as 401k, 403b, 457 (traditional or Roth options)
- IRA, such as traditional, Roth, or SEP (if self-employed)
- HSA (when you have an eligible health plan)
- Annuities (when you’re approaching retirement age)
- Brokerage accounts
Review your situation at least once a year to make sure you’re still on track. As your life changes, you may need more or less emergency money in the bank or different insurance coverage.
When your income increases, take the opportunity to bump up your retirement contribution—even increasing it one percent per year can make a huge difference.
And here’s another important tip: when you earn more don’t let your expenses increase as well. If you earn more, but maintain or even decrease your expenses, you’ll be able to reach any financial goal you dream about much faster.
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