My husband and I are maxing out our 401(k) and IRA contributions. Are there other tax-advantaged places we could be putting more money away? What options do we have to save more for retirement? We are debt free, with the exception of the mortgage, which we refinanced to 15 years three years ago at less than 4 percent APR. All cars are paid for. We have no kids, so college savings is not required. — Pamela
Congratulations on being on track to a secure retirement! There are several tax-advantaged options you may want to consider, but none are as straightforward as 401(k)s and IRAs. There is no free lunch. Some high-income investors choose to invest in variable annuities, which offer the benefits of tax deferral but with disadvantages such as generally higher costs and reduced liquidity. For these reasons I usually don’t recommend this direction. Here are five other options you should consider.
1. Consider investing in Roth options. Hopefully your 401k provider offers a Roth option, which allows you to make after-tax contributions, but all earnings and withdrawals in retirement are tax free. This feature could be very valuable indeed if you believe that your income tax rate may be the same or higher when in retirement.
2. Contribute to a Health Savings Account. To qualify for an HSA, you need a high-deductible health insurance policy, whether it’s through an employer or on your own. The annual contribution in 2014 is $6,450 (for a family plan) plus an additional $1,000 if you are 55 or older. HSA contributions are tax deductible, and as long as funds are withdrawn to pay eligible medical expenses, no taxes are paid on withdrawals. HSA funds can be invested for long-term growth and held until you retire, at which point it can provide tax-free income by reimbursing you for past and current eligible medical expenses, including Medicare premiums.
3. Invest in low turnover, tax-sensitive strategies, such as index funds. Investing in a low-turnover strategy allows your capital to compound tax-free, although dividends would still be taxed annually. An S&P 500 Index fund, for example, distributes few, if any, capital gains on an annual basis. In retirement, the capital gain portion of the withdrawals will most likely be taxed at rates preferential to your 401(k) income. Many investment managers also employ tax overlays to invest portfolios in a tax-efficient manner.
4. Invest in master limited partnerships (MLPs) that pay tax-advantaged income. MLP dividends (called distributions) are comprised mostly of nontaxable “return of capital” due to depreciation deductions. After 10 to 20 years, this tax shelter will probably be diminished if not exhausted, but if you pass the shares on to your heirs, they get to start the process over again with a step-up basis. However, be careful to maintain diversification and invest only a small portion of your assets in such a focused segment of the market.
5. Ensure that your retirement assets are invested correctly for the long term. This is the most important thing you can do. For example, assuming you are at least 10 years from retirement, you may want to have your assets heavily weighted toward equities versus bonds (if they aren't 100 percent equities already). In the short term, you will likely have more volatility, but, while past performance is no guarantee of future results, stocks have historically outperformed bonds.