Maxing out your 401(k) and IRA contributions is certainly a good "problem" to have. But then you have to figure out what to do with the rest of your investable assets. Investing in a taxable account is the next logical step, but you need to do so in a way that minimizes your tax liability. Here are three tax-efficient investment options for after you've filled up your retirement accounts:
Health savings account. This option is available for those with high-deductible health insurance policies. When you have a high-deductible health plan, you can put pre-tax dollars in a health savings account. This account is designed to help you pay the high deductibles of your health insurance policy throughout the year, but certain features of HSAs also make them ideal for retirement savings.
Unlike a flexible spending account, HSAs are not "use it or lose it." Any money in the account at the end of the year rolls over to the next year. Money withdrawn for qualified medical expenses is tax-free. Withdrawals for other purposes are subject to income tax and may trigger a penalty. However, once an account owner reaches age 65 they can withdraw the money penalty-free for any purpose. For this reason, many people use HSAs as an alternative retirement savings vehicle.
Deferred variable annuity. Contributions to a variable annuity are on an after-tax basis, but the earnings from the investments grow tax-deferred. Taxes on the earnings are typically paid when a retiree begins to withdraw money from the annuity.
However, like most insurance and investment hybrid products, there are many issues to consider before buying a variable annuity. Chief among these issues is cost. Variable annuities have significantly higher expenses than the cost of the underlying mutual funds. In some cases, these costs are so great that they exceed any tax benefits. As a result, it's critical to evaluate the cost of a variable annuity closely.
Even with low cost annuities, it takes time for the tax benefits to justify the costs. Tim Holmes, a principal with Vanguard Annuity Insurance and Services, says that people should plan to invest in an annuity for a minimum of ten years (and sometimes longer) to ensure that the tax benefits outweigh the cost.
Taxable account. The easiest option is to invest in tax-efficient investments in a taxable account. Investors are often in complete control of when and whether to sell shares, and thus when to pay capital gains tax. For those more comfortable with mutual funds and ETFs, there are many options that are extremely tax efficient. As a general rule, index funds generate relatively few taxable gains from year to year. And some funds are specifically designed to minimize capital gains tax. Morningstar offers a tool called the tax cost ratio that measures how much a fund's return is reduced by the taxes investors pay on distributions and can help you evaluate the tax efficiency of an investment.
Once you are in the enviable position of having maxed out your retirement accounts, you need to find other places to save. While there are a variety of options to delay and minimize taxes on your investments, taxes cannot be avoided forever. However, the longer you can delay paying Uncle Sam, the more your money can work for you.
Rob Berger is an attorney and founder of the popular personal finance and investing blog, doughroller.net. He is also the editor of the Dough Roller Weekly Newsletter, a free newsletter covering all aspects of personal finance and investing, and the Dough Roller Money Podcast.
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