The Super Retirement Saver

Here's a piece from Money that starts with a question you don't hear every day:

I contribute the max to my 401(k) and my IRA, but want to invest more for retirement. What should I do?

Hold on, I'm feeling faint. Is there a person out there who's actually in this situation? I guess there is hope!!! Money has a similar reaction:

You, sir, are a bright and shining example for retirement savers everywhere. The fact that you're taking full advantage of government tax breaks by maxing out your 401(k) and IRA shows you already have good basic instincts when it comes to accumulating retirement wealth. And now you're ready to do even more. I salute you.

So, now that we've heaped accolades on this guy, what's the advice for him? Money suggests the following:

There are a couple of things people in your position typically consider. One is to contribute after-tax dollars to a 401(k) plan (assuming your plan allows it) or a non-deductible IRA (or both). Neither of these moves would give you an immediate tax break for the contribution itself. But the earnings on your contributions would enjoy tax-deferred growth.

Another route many people go is investing in a variable annuity, which is basically a mutual fund with some tax advantages. Again, you wouldn't get an immediate tax break in the form of a tax-deduction for the money you invest. But your money would grow free of the drag of taxes until you withdraw it.

I don't know. None of these sound too great to me. Luckily, Money agrees:

But, to tell you the truth, I'm not crazy about any of these options. What bothers me about the 401(k) and IRA options I mentioned is that the earnings you withdraw are taxed at ordinary income tax rates (the after-tax dollars you contributed aren't taxed again, of course).

So this means if you invest primarily in, say, stock mutual funds that deliver a good portion of their gains in the form of long-term capital gains, you end up paying ordinary income tax rates (which can be as high as 35 percent) on your profits instead of the maximum 15 percent long-term capital gains rate such profits would normally face. That's a big disadvantage.

As for variable annuities, well, you have the same tax drawback -- that is, effectively converting long-term gains to short-term gains taxed at a higher rate-plus you can face some stiff ongoing investment fees that can seriously erode their returns.

All I know about variable annuities is that they seem overly complicated in an attempt to mask very high fees. I try to avoid this type of investment at all costs.

So, what's this guy to do? Here's Money's suggestion:

Basically, I recommend that you now turn your attention to investing in regular old taxable accounts, but in a way that mitigates the tax bite. Fortunately, this is fairly easy to do become of some investor-friendly changes in the tax laws in recent years.

If you're a stock investor, for example, you'll face a maximum rate of 15 percent on appreciation in the value of the shares you sell as long as you hold them more than a year. Even stock dividends are now taxed no higher than 15 percent. (Technically, they've got to be "qualified" dividends to get that advantageous rate, but most stock dividends fall into this category.)

Either way, that's a pretty good deal compared with the top tax rate of 35 percent you'll eventually pay on gains from after-tax 401(k) and non-deductible IRA contributions.

Not a stock investor? No problemo. Many mutual funds also offer some significant tax benefits as well. The key is to find "tax efficient" funds -- that is, ones that minimize taxable distributions and instead deliver their gains in share-price appreciation, which means you pay tax only when you sell (and then at lower long-term capital gains rates provided you hold the fund more than 12 months).

Many index funds are inherently tax efficient because they don't do a lot of trading that generates short-term gains taxable at higher rates. Many exchange-traded funds are also tax efficient because of the unique way they create and redeem shares.

And, finally, there's a breed of funds known as tax-managed funds, whose managers use a variety of techniques, such as offsetting gains in some shares by taking losses in others, to keep the tax bite to a minimum.

To sum up, you should have no problem expanding your already admirable saving and investment efforts beyond 401(k)s and IRAs -- and doing so in a way that allows you to share as little of your gains as possible with the IRS.

I'm putting this on my to-do list to talk to my tax advisor about. I'm maxing out my 401k and then going to taxable accounts -- but I'm leaving out the IRA. I may be missing something here and I want to remedy this asap.

Comments

[JWM]

This person's situation is a breath of fresh air.

[Stephen]

Wow, how can you bypass the Roth IRA? Unless you make too much, of course.

I've been researching this issue for a couple of years. Due to serious cost cutting and a love of investing, I'm able to max the 401k and the Roth, and now my wife's Roth.

When you get down to it, I always revert back to my Sharebuilder account.

Variable annuities have many fees associated with them and can be hard to understand, unless you go with someone like Vanguard.

Variable Universal Life Insurance plans are tempting, but have tons of fees and only make sense if you have a LOT of money to put into them. Planning also becomes an issue - certain monies MUST be spent before you die.

The easiest route is probably to start a Vanguard account and invest in municipal bonds. Frankly, however, I'd like to have the chance at higher returns.

I always come back to Sharebuilder. It has low fees and I can do automatic investments. I can invest basically in whatever I want (for instance, I could purchase municial bond funds). Sharebuilder will automatically re-invest all dividends if I tell it to.

[Brian]

Also curious as to why you're not contributing to an IRA.

The wife and I are maxing out all of our retirement accounts while paying down some debt at the same time. In a couple of years we look to start a taxable account as suggested by this article after we get the debts paid off.

[Caitlin]

Huh...not even a mention of the forthcoming Roth 401(k)?

[FMF]

Stephen --

Yes, there are income limits on the Roth IRA -- unfortunately.

Brian --

If you're asking about the Roth, see my note above. If you're asking about a regular IRA, that's what I need to ask my tax person about -- the issues associated with record keeping, etc. when you contribute to an IRA you can't deduct.

Caitlin --

Do you mean from me or the article? If from me, my company isn't planning on offering them. If from the article, I'm assuming it's because the question is being answered for now -- not for the future -- and the Roth 401ks are not yet available.

FMF

[hedged]

seems to me like the nondeductible contribution to IRA or 401k is a good option if you are planning to invest at all in some sort of tax disadvantaged fixed income products. That way you can leave tax advantaged investments (like equity index funds, muni bond funds, etc.) in your taxable account and use the nondeductible IRA as well as your regular IRA and 401k for tax disadvantaged products (high yield, TIPS, general bond funds), if you are planning to have a fixed income component of your portfolio.

of course if you are in 100% stocks then your logic holds and the nondeductible IRA is a bad idea. another reason to hold the nondeductible IRA is that if your income is going to possibly be low in a future year you can convert it into a ROTH IRA at that time, which is a very valuable option (especially if one is young).