What to Do After Maxing out Your 401(k) Plan

If you’ve already reached your 401(k) contributions limit for the year—or soon will—that’s a problem. You can’t afford to fall behind in the funding-retirement game. Also, losing the contribution’s reduction in your gross income isn’t going to help your tax bill next April, either. These pointers will help you decide how to handle maxing out your contributions and hopefully avoid a large tax burden in April.

Maximum Limits

Maxing out a retirement account contribution means that you’ve contributed or deposited the maximum amount that’s allowed to an individual retirement account (IRA) or a defined contribution plan, such as a 401(k). If you’re under the age of 50, the maximum amount that you can contribute is $19,500—for both 2020 and 2021. If you are 50 or older, you can add more money, called a catch-up contribution, which amounts to $6,500 for 2020 and 2021. In other words, if you’re 50 or older, your maximum, annual limit for total 401(k) contributions is $26,000. 

First Place to Look: IRAs

Contributing to an IRA in addition to your 401(k) is one option. Whether you contribute to a Roth IRA or a traditional IRA, your money will grow tax-free until you retire just as it does in your 401k. Once you start making withdrawals, you’ll pay income taxes on the money you withdraw from your traditional IRA or 401k, but not on withdrawals from your Roth IRA. However, a Roth doesn’t give you a tax deduction or tax savings in the year in which you make the contribution unlike a traditional IRA or 401(k). Please note that you can make a contribution to an IRA for the 2020 tax year through April 15, 2021.

Traditional IRA

How much of a tax-advantage you’ll receive when contributing to an IRA will depend on how much you earn. In other words, the tax deduction may be reduced, or phased out, until it’s eliminated, depending on your filing status (i.e. single or married) and income.

Since you are covered by a workplace retirement plan, for 2020 filing, once you reach $65,000 to $75,000 of income as a single person, you will either be entitled to deduct only part of your traditional IRA contribution or not entitled to a deduction at all. For 2021 contributions, the income limit range is $66,000 to $76,000.

The 2020 income limit range is $104,000 to $124,000 if married, filing jointly, or a qualified widow(er). For 2021, the income limit range is $105,000 to $125,000. However, if an IRA contributor is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $198,000 and $208,000 in 2021, up from $196,000 and $206,000 in 2020. 

Roth IRA

You might still be able to contribute to a Roth IRA. However, as a reminder, your contribution will not be tax-deductible. On the upside, when you start taking distributions at retirement, all the money contributed after-tax will be tax-free when it is withdrawn as long as the person is over the age of 59½.

However, for the 2020 tax year, the income phase-out range for singles is $124,000 to $139,000. For 2021, the income phase-out range is $125,000 to $140,000. For married couples filing jointly, the Roth income phase-out range for 2020 is $196,000 to $206,000, and for 2021, it’s $198,000 to $208,000. 

Next Steps: Strategic Investments

Let’s say you have also maxed out your IRA options—or have decided you’d rather invest your extra savings in a different way.

Although there is no magic formula that is guaranteed to achieve both goals, careful planning can come close. “Look at the options in terms of investment products and investment strategies,” says Keith Klein, CFP and principal at Turning Pointe Wealth Management in Tempe, Ariz. Here are some non-IRA options to consider as well.

Low-Risk Options

The options below are for those investors who need a reliable stream of income from their retirement accounts. These options will never show outstanding growth, but they are classic choices due to their predictable nature.

1. Municipal Bonds

A municipal bond (or muni) is a security sold by a town, city, state, county, or other local authority to finance projects for the public good (public schools, highways, hospitals, etc.).The purchaser essentially lends the purchase price to the government entity in return for a specified amount of interest. The principal is returned to the purchaser on the bond’s maturity date. “The nice thing about municipal bonds,” Klein explains, “is that they are liquid. You always have the opportunity to sell them, or to hold them to maturity and collect your principal back.”

Another advantage to municipal bonds for retirement-planning purposes is that the interest income earned along the way is exempt from federal taxes, and in some cases, from state and local taxes as well. Taxable-income munis do exist, however, so check that aspect out before you invest. If you sell the bonds for a profit before they mature, you may pay capital gains tax as well.

Also, check out the bond’s rating; it should be BBB or above to be considered a conservative option (which is what you want in a retirement vehicle). 

2. Fixed Index Annuities

A fixed index annuity (also called an indexed annuity) is issued by an insurance company. The purchaser invests a given amount of money to be paid back in designated amounts at regular intervals later. The annuity’s performance is linked to an equity index (such as the S&P 500), hence the name. The insurance company guarantees that original investment against downward market fluctuations while also offering the potential for growth (earnings). “They offer returns that are a little bit better than non-indexed annuities,” says Klein.

Fixed index annuities are a conservative investment option, often compared to certificates of deposit (CDs) in terms of risk. Best of all, the annuity’s earnings are tax-deferred until the owner reaches retirement age.

The downside is that annuities are rather illiquid. “You sometimes have to pay a [tax] penalty if you withdraw the funds prior to age 59½ or if you don’t take them as an income stream [after retirement],” cautions Klein. Even if you avoid the penalty, by moving the funds directly to another annuity product, you still probably will be subject to the insurance company’s surrender charges.

3. Universal Life Insurance

A universal life insurance policy, a type of permanent life insurance, is both an insurance policy and an investment. The insurer will pay a predetermined amount upon the death of the policyholder, and, in the meantime, the policy accumulates cash value. The policyholder can withdraw or borrow from the account while alive, and in some cases, earn dividends.

Not everyone is a fan of using life insurance as a means to build up cash value. If structured and used correctly, however, this type of policy offers tax advantages to the insured. Contributions grow at a tax-deferred rate, and the policyholder has access to the capital in the meantime.

“The good news is that you do have access to the funds prior to age 59½ without penalty if you use it correctly,” says Klein. “Through the use of policy loans, you may be able to take money out without paying taxes and put the money back in without paying taxes, as long as the life insurance policy is kept in force.”

The owner must pay tax on gains if the policy is canceled.

Riskier Options

There are some directions you can take if you still have a solid income or are expecting a windfall in the near future. Although these are not the most traditional options, they are worth discussing with your retirement planning professional.

1. Variable Annuities

A variable annuity is a contract between the purchaser and an insurance company. The purchaser makes either a single payment or a series of payments, and the insurer agrees to make periodic payments to the purchaser. The periodic payments can start immediately or in the future. A variable annuity allows the investor to allocate portions of the funds to different asset options, such as stocks, bonds, and mutual funds. So, while a minimum return is usually guaranteed, the payments fluctuate, depending on the portfolio’s performance.

Variable annuities offer several advantages. Tax payments on income and gains are deferred to age 59½. The periodic payments can be set up to last for the rest of the investor’s life, offering protection against the possibility that the investor will outlive their retirement savings. These annuities also come with a death benefit, guaranteeing the purchaser’s beneficiary payment equal to the guaranteed minimum or the amount in the account, whichever is greater. Contributions are tax-deferred until withdrawn as income. 

Early withdrawals are subject to surrender charges. Variable annuities also come with various other fees and charges that can eat into the potential earnings. In retirement, gains will be taxed at the income tax rate, not the lower capital gains rate.

2. Variable Universal Life

Yes, we know this sounds similar to item three in the preceding section. Variable universal life insurance is indeed similar; it’s a hybrid of universal life and variable life insurance, which allows you to participate in various types of investment options while not being taxed on your earnings. The cash value of your policy is invested in separate accounts (similar to mutual funds, money market funds, and bond funds), whose performance fluctuates. More gain, possibly—but more pain, too.

If the stock market falls, “those assets can fall to a value of zero, and you do risk the possibility of losing the insurance in that case,” warns Klein. “But if you need life insurance and have the ability to take on the risk of investing in the stock market, that may be an option.”

Variable universal life insurance is a complex instrument, so it is wise to study up before proceeding.

Other Strategic Moves

Alternative Investment Products

Some alternative products are highly sought after because of the low-interest rate climate and the potential for higher distributions. They include oil and gas investments “because of the tax deductions you’ll get for participating,” says Klein.

Also, certain types of non-traded real estate investment trusts (REITs) or other types of real estate investment trusts are desirable because only a portion of distributions are taxable. However, “non-traded products often carry some complexity and can be very illiquid,” Klein cautions.

Real Estate

Some investors like to invest in individual real estate holdings. “One of the great things about owning individual real estate is the ability to do Section 1031 exchanges,” says Klein. In other words, you can sell the property and roll the money into new real estate without having to recognize the gains for tax purposes (until you liquidate all of the property).

Individual Holdings

Another strategy is to buy individual holdings—stocks, bonds, and in some cases, exchange-traded fund (ETFs). “As you hold those investments, you do not have to pay tax on the gains until you actually liquidate or sell those holdings,” explains Klein. Mutual funds, by contrast, are subject to taxes on the gains as you earn them.

A useful strategy for some investors who buy individual assets or short-term investments that have fallen out of favor and created a loss is to employ tax-loss harvesting. The investor can offset gains by harvesting the loss and transferring the assets to a similar type of investment (without making a wash-sale transaction). “People that use tax-loss harvesting in their portfolios can actually increase their returns over the long run by as much as 1%,” says Klein.

Investing in a Business

“An employee who has maxed out their 401(k) might want to consider investing in a business,” says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Mass. “Many businesses, such as real estate, have generous tax benefits. On top of these tax benefits, business owners can decide what type of retirement plan they want to create. If, for example, they wanted to set up a 401(k) plan for their company, they would be able to expand their 401(k) contributions beyond what they may have at their employer.”

Pensions

Building on the previous idea, some business owners will want to consider creating a pension plan or defined-benefit plan beyond any 401(k) their company may offer. Large companies have moved away from pension plans because of the high cost, but these plans can work well for some smaller business owners, especially those who are successful and over the age of 40.

“These business owners can defer additional money from taxes into their retirement by using a pension plan for themselves or key employees in addition to a 401(k) plan,” Klein notes.

The new Setting Every Community Up for Retirement Enhancement (SECURE) Act was signed in Dec. 2019 by former President Donald Trump. A component of this act is designed to make it easier and less expensive for small business owners to set up retirement plans for employees. The new rule will let more small businesses band together to offer what are called Multiple Employer Plans or MEPs, though this provision will not be in effect until 2021.

The requirements for some workers are to put in at least 500 hours a year for three consecutive years in order to be eligible. 

HSAs

Another option for those willing to risk a high-deductible health plan is to fund a health savings account (HSA). “One option we have been exploring lately with our clients is the availability of HSAs,” says David S. Hunter, CFP of Horizons Wealth Management in Asheville, N.C. “If they qualify, there are potentially more tax benefits for those contributions than a 401(k) might have. Also, there is no earned-income phase-out for contributions. HSAs have many benefits, such as deductibility, income deferral, and tax-free distributions, which for an increasing number of savers equals a very handy retirement savings tool.”

After-Tax 401(k) Contributions

You can also see whether your company’s 401(k) allows you to make after-tax contributions to your 401(k) up to the legal limit of combined employer/employee contributions ($57,000 for 2020 and $58,000 for 2021).  

“Most employers don’t allow after-tax contributions, but if your plan allows it, it can be very beneficial,” says Damon Gonzalez, CFP, RICP, of Domestique Capital LLC in Plano, Texas. “Earnings on your after-tax savings grow tax-deferred and, once you separate from service, you can roll what you contributed on an after-tax basis to your 401(k) into a Roth IRA. The growth on those after-tax dollars would need to be rolled to a traditional IRA.”

Roths

Finally, those who can afford to play both sides of the tax game should consider using Roth IRAs or Roth 401(k)s. Deferring taxes to a later date, as with the regular 401(k), is not always guaranteed to offer the greatest advantage. Investors who hold both can take future withdrawals from the account that makes the most sense. If tax rates go up, withdraw from the Roth, because the taxes were already paid on the funds in there. If tax rates go down, the investor can take money from the traditional 401(k) account and pay taxes at the lower rate.

The Bottom Line

All of these investment options come with varying degrees of complexity, liquidity or illiquidity, and risk. But they prove that yes, there are tax-advantaged ways to save for retirement after the 401(k). There are many ways to max out your savings, so careful planners would be wise to consider as many methods as it makes sense to achieve their goals.

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