As you probably know by now, I’m a bit of a saver. In fact, over the past year I have turned into a turbo-saver by throwing every last dollar that I can into savings in preparation for the ever-sweet departure date at the end of 2016.
In October, I maxed out my 401k and Roth IRA contributions for the year. Now, my paychecks are larger because those automatic deductions are no longer happening. Talk about an awesome first world problem to have!
What in the hell do I do with all this extra cash?
For fun, I did quite a bit of research online to find out what the typical advice is, and I’ll be honest – it’s confusing even to me who has a fairly solid grip on investments and retirement savings. I can only imagine how confusing it might be to the casual investor looking for help on what to do with money after maxing out their 401k.
Here, I’m going to make it easy on you and give you my top three strategies for using that extra money wisely. Hint – what I am about to tell you is going to prioritize your future happiness.
What to do after maxing out your 401k and Roth IRA
1. Check your emergency savings – If you don’t have an easily-accessible emergency savings account with at least 6 months of living expenses, use the extra dough to build this pot of money up. While it is true that this money won’t grow at nearly the same rate as it would if fully invested, it may also be a life-saver if you need substantial cash down the road.
The two critical elements to an emergency fund are safety and accessibility – meaning, your money needs to be both safe as well as accessible at a moment’s notice.
This means storing $10,000 under your mattress is a bad idea because while the money is accessible (when you’re home), it’s definitely not safe. What happens if your home catches on fire while you’re at work, or your dog chews through your mattress (and money stash!) one day because he’s pissed that you didn’t fill up his food dish before you left for work? This violates the safe rule.
Storing your emergency fund in the stock market, while safe (not withstanding capital losses, of course!), does not offer the accessibility that we need out of our emergency funds. Stocks can be sold, but the process can take a couple of days before we actually see that cash in our hand. Emergency funds need to provide us with immediate cash, often necessary in an emergency.
My wife and I maintain an easily-accessible Ally high interest savings account to keep our emergency savings with an annual percentage yield of 1.00%, which isn’t bad for savings accounts. Capital One 360 is another online bank option. Emergency funds can be saved anywhere so long as the money is “liquid”, or in other words, easily withdrawn into spendable cash any time.
Do you really need 6-months of living expenses in your emergency fund? “Need” is such a strong word and there are no established rules in play here, but it comes down to the level of risk that you are comfortable with taking on. My wife and I prefer a larger emergency fund to account for job losses or any major expenses due to “shit happens”. Your level if risk may differ, and that’s okay.
The bottom line: Establish an emergency fund if you do not already have one, and if you do, ensure that you are comfortable with the amount that’s in it.
2. Open an HSA (Health Savings Account) – One of the better-known smart guys in this investment business, the “Mad FIentist”, calls the HSA the “Ultimate Retirement Account“, and for good reason. An HSA is a tax-advantaged (aka: pre-tax) account available for those who are enrolled in a high deductible health insurance plan. The idea is since your deductible is so high, the HSA will help provide an incentive to save for those potentially costly deductible payments.
The best part about the HSA is its tax advantaged status which, like your traditional 401k, reduces your taxable income by the amount contributed. Thus, if you contribute $3,000 in a year into an HSA, your taxable income gets reduced by $3,000 as well.
Even better, an HSA account can provide tax-free contributions, growth and withdrawals because there are no hard and fast rules that state HSA money needs to be used to pay for deductibles directly. This means that deductibles can be paid by using a regular credit card (instead of the HSA debit card), allowing us to keep that money within our HSA longer. We can then decide when to pay ourselves back – so long as we keep the deductible payment receipt. Check out the Mad FIentist article (linked above) for more detail on how this might work.
If HSA money is never used, it can be withdrawn from the account at age 65 without penalty, which essentially turns this account into another tax-advantaged 401k. This money will be subject to income tax at the time of withdrawal, but don’t forget that this money also enjoyed years of tax-free growth, all the while reducing your taxable income during your working years.
At the present time (2015), individuals can contribute $3,350 and families $6,650 into HSA accounts. The IRS said it will raise the amount of money that families can contribute by $100 in 2016.
3. Open a brokerage account – If your emergency savings is up to snuff and you’ve looked into an HSA as another pre-tax savings option, consider opening a taxable brokerage account. Brokerage accounts provide investors with another way to invest money in the stock market similar to a traditional 401k, except you’re investing after tax dollars. Any capital gains are taxed upon withdrawal. Investors pay a fee to the brokerage house with each transaction.
My wife and I have a brokerage account with Vanguard with holdings in stocks, bonds as well as mutual funds. Less experienced investors who wish to invest their money in something without needing a lot of knowledge might consider the Vanguard LifeStrategy Growth Fund, which is a broadly diversified 80/20 stocks to bonds collection of funds.
A wide variety of companies offer brokerage accounts, like Vanguard, Fidelity, Charles Schwab, T.Rowe Price, Scottrade and many others.
What say you? What would you do with your extra cash after maxing out your 401k and Roth IRA?