Where to Invest After Maxing Out Your 401k Contribution

For most people, there’s not much to think about when it comes to making contributions to their 401k plans. They enjoy reduced current taxes, deferred taxes on account earnings, and, for most, a matching contribution from their employer. That’s a huge incentive to contribute as much of their earnings as possible—up to $20,500 in 2022, and those over 50 can add $6,500 in annual catch-up contributions.

But what options are available if you are able to make the maximum contributions to your 401k and want to invest more towards retirement?

You can layer additional retirement investments on top of your 401k to boost your retirement fund while providing you with more flexibility and tax diversification in retirement.

Open a Traditional IRA

Even if you participate in 401k, you may still be eligible to contribute to a traditional IRA and receive a tax deduction for your contribution, depending on how much you earn. Single filers can get a full tax deduction on an IRA contribution, up to $6,000 in 2022 (plus $1,000 if you’re 50 over) if their income is $68,000 or less. The deduction is phased out between incomes of $68,000 and $78,000, with no deduction available above that amount. The income limit for married filers with only one spouse participating in a 401k starts at $204,000 to $214,000. If both spouses participate, the limits drop to $109,000 and $129,000.

Open a Roth IRA

The income limits for Roth IRA contributions are much more liberal. Single filers with an income of $129,000 or less can contribute the maximum amount ($6,000). If your income is over $129,000, the amount you may contribute is reduced, and if your income is over $144,000, you are not eligible to contribute. The income limits for married couples start at $204,000, with the cutoff at $214,000.

The advantage of investing in a Roth IRA is your withdrawals after age 59 ½ or tax-free. Since withdrawals from your 401k are taxable, the tax-free income from a Roth could boost your after-tax income in retirement.

In addition, Roth IRAs are not subject to required minimum distribution rules, as are 401k and traditional IRA plans requiring you to withdraw a minimum amount starting at age 72 so it can be taxed by the IRA, regardless of whether you need the income. Also, income from a Roth is not included in your Social Security tax calculation.

Invest in a Taxable Brokerage Account

You could also open an investment account with a brokerage firm. Investing after-tax dollars in a brokerage account has several advantages. First, you have much more flexibility in how much you can invest, when to access your funds, and where to invest your money.

Second, your funds are subject to required minimum distribution (RMD) rules as with a 401k or IRA (Roth IRAs are not subject to RMD rules either).

Third, if you hold your investments longer than a year, your withdrawals are taxed at the more favorable capital gains tax when you sell your securities—between zero and 20% depending on your adjusted gross income. This can provide more tax diversification since your 401k withdrawals are taxed at ordinary income rates.

You can lower your tax bill even further through tax-loss harvesting by selling securities for a loss to offset capital gains on securities you sell for a profit. You can buy back the securities you sold after 31 days to avoid the IRS’s wash-sale rule, which would deny you the loss deduction. That strategy is not available in a 401k or IRA.

The added benefit for those planning to leave assets to their heirs is that appreciated securities can be transferred at death on a stepped-up basis, meaning they can pass without any capital gains tax implications.

Alternative Retirement Funding Options is Smart Planning

Considering other retirement funding options other than your 401k (after you receive the maximum employer matching contribution) could be smart planning for tax purposes. If all your funds come from a 401k, you are paying taxes at ordinary income rates. By investing in accounts with lower tax consequences, you can lower your overall tax rate.