Saving Outside Your 401(k)

Among the various tax-advantaged investing accounts out there, 401(k)s are many people's first choice for their retirement savings. Contributions lower your taxable income for the current year and can potentially grow tax free until you withdraw them. Plus, many employers offer matching funds to help boost your savings. 

But they aren't the only option for accumulating tax-advantaged savings. Health savings accounts (HSAs), individual retirement accounts (IRAs), brokerage accounts, and even annuities can also offer tax-smart routes to saving. Each account type has distinct benefits—and limitations. 

The question, then, is which ones to use and when. After all, we all have expenses and the amount of savable dollars is finite. 

We believe the first step to saving for retirement is to contribute enough to your workplace retirement plan to get the full company match, if one is available. Then, pay off nondeductible, high-interest rate debt like credit cards, and fill up an emergency fund with at least three months of essential living expenses. 

Once you've built a strong financial foundation and saved for any other goals—such as a home purchase or a child's college education—it's time to consider other tax-advantaged accounts. 

Here we discuss when you might consider using each type of account to help you maximize your savings, with an eye on tax efficiency.

If you have a high-deductible health plan and have otherwise met the conditions listed above, consider saving the maximum within your HSA.

These accounts offer a triple tax benefit. You get a tax deduction for contributions, the investments can grow tax-free, and you can use the money for qualified medical expenses at any time penalty and tax-free. If you're fortunate enough to not need the money for medical expenses, an HSA can be used like a traditional IRA once you reach age 65. Any distributions for non-medical purposes will be taxable, but they won't be subject to a penalty. 

You can learn more here.

Maximizing contributions to your employer-sponsored 401(k) plan—or Roth 401(k), 403(b), or 457(b)—can give you more assets to help create tax-free compound growth. Plus, employer-sponsored plans offer higher contribution limits than IRAs, without the income limitations. You also may have the ability to borrow against your balances or even take distributions in cases of financial hardship. 

Plus, if you're considering an early retirement, you may also be able to take distributions without penalty if you retire from your current employer at age 55. However, these plans can have a few downsides, such as limited investment options or the potential for higher fees. 

Almost anyone can save in an IRA, so long as they have earned income. With a Traditional IRA, you contribute pre- or after-tax dollars, your money can grow tax-deferred, and after age 59½, withdrawals of after-tax contributions and any growth are taxed as ordinary income.With a Roth IRA, you contribute after-tax dollars, your money can grow tax-free, and you can generally make tax- and penalty-free withdrawals after age 59½.

IRAs can offer some benefits not found in employer-sponsored plans, including more investment options and, in some cases, lower fees. However, if you or your spouse also participates in an employer-sponsored plan, your tax deduction for contributions to a traditional IRA could be limited. And if your income is over certain limits, you may not be able to directly contribute to a Roth IRA.

After you've maxed out the normal contributions to your tax-deferred or Roth accounts, you may still be able to make contributions to tax-deferred IRA and/or employer-sponsored accounts. However, those contributions will have to be with after-tax dollars. 

As implied, you don't get an up-front tax deduction for such contributions, but once the assets are in a tax-advantaged account, they have the potential to grow tax-free. Once you are in retirement, the portion of a withdrawal related to the after-tax contributions (i.e., the original principal) is tax-free, while any appreciation or income on the after-tax assets is taxable.

The benefits of tax-free growth can offset the loss of the up-front tax break, but to make these contributions even more tax efficient, consider rolling over these assets to a Roth account. Doing a Roth conversion means any appreciation or income from the after-tax contributions could be taken out tax-free in retirement. Although there is no tax on the after-tax portion of a conversion, any appreciation or income rolled over would be taxable.

The rules that govern after-tax contributions and Roth conversions are complex and can result in significant tax labilities, which is why we recommend working with a wealth advisor and tax professional before attempting these strategies.

The three main options for after-tax contributions along with a Roth conversion are:

• Backdoor Roth in an IRA: This strategy is available to anyone who has earned income and a traditional and a Roth IRA. It works like this: First, make after-tax contributions to a traditional IRA, then convert those assets to a Roth IRA. Be aware that the pro-rata rule applies here, which means any IRAs in your name are taken into account when determining the taxable versus non-taxable portion of a Roth conversion. You can learn more about this strategy here.
• In-plan Roth conversion in an employer-sponsored plan: For this strategy to work, your employer-sponsored plan must allow after-tax contributions, in-plan rollovers, and have a designated Roth account option. It works like this: First, you max out your normal contributions (either to a tax-deferred or a Roth account), then you make after-tax contributions to the plan up to the maximum limit of $69,000 in 2024, including contributions by you and your employer. Finally, you take the after-tax contributions and roll them over to a designated Roth account.
• Mega-backdoor Roth conversion in an employer-sponsored plan: If your plan doesn't allow in-plan rollovers, you could consider a mega-backdoor Roth. For this to work, your plan must allow after-tax contributions and in-service withdrawals (or you must have a "distributable event" occur). It works like this: First, you max out your normal contributions either to a tax-deferred or Roth account, then you make after-tax contributions to the plan up to the maximum limit of $69,000 in 2024. Finally, you roll over those assets to an IRA (known as an in-service withdrawal). During the rollover to the IRA, the IRS allows all the pre-tax assets to be moved to a traditional IRA and all after-tax assets to be moved to a Roth IRA. Any income or appreciation on the after-tax assets rolled over to a Roth IRA will be taxable. However, there is no tax on the pre-tax assets rolled over to a traditional IRA, nor is there tax on the Roth assets that are rolled over to a Roth IRA.

There are three primary options to save and invest after-tax dollars:

• After-tax savings in an employer-sponsored plan or traditional IRA: If you're able to make after-tax contributions to your employer-sponsored plan, but can't do in-plan Roth conversions or in-service withdrawals, you may still benefit by sheltering the after-tax contributions from taxes on earnings. If your plan doesn't permit after-tax contributions, you could also consider after-tax contributions to a traditional IRA. (Be aware that you have to file IRS Form 8606 in the year you make such a contribution.) The earnings will be taxed as ordinary income when a withdrawal is taken, but the initial contribution can be taken out tax-free. Be aware, you may not be able to access the money without penalty until you meet the withdrawal requirements for these accounts.
• Annuities: Annuities may fit your retirement strategy if you're looking for tax-deferred growth and guaranteed income. With an annuity, you're allowed to contribute as much as you like but only with after-tax dollars. Once the annuity if funded, earnings are tax-deferred during the accumulation phase, which means you don't pay taxes on earnings, but you will pay taxes on earnings when you withdraw. The tradeoff is that annuities may charge higher fees and can be less flexible than some other saving options. To learn more about annuities, check out this podcast. 
• Save after-tax dollars in a taxable account: Standard taxable brokerage accounts may not offer tax benefits, but you can still use them tax efficiently. Plus, these accounts offer flexibility that other accounts lack. There are no savings limits, almost no restrictions on the assets you can own, and you can sell assets at any time to meet your spending needs. The downside is that taxable accounts are subject to annual taxation, which can act as a drag on returns. However, by implementing strategies such as tax-loss harvesting and asset location, and holding municipal bonds, your brokerage account can be quite tax efficient.

Remember, there's no shame in getting help. Investing and tax planning can be complicated. We recommend meeting with a wealth advisor and tax professional to help you target the most tax-efficient ways to save and invest for your situation and goals.