So You've Maxed Out. Now What?

Got a plan at the office? Is there employer matching? Are you contributing the maximum amount you're allowed each month? Then all this should add up to a very comfortable retirement, one that you'd be hard-pressed to match without the tax-deferred compounding a 401(k) offers.

Think of it this way: What other investment gives you the equivalent of a 25% or 50% return on the first day? But, there's only one problem. The federal government puts a lid on the tax-advantaged salary reduction amount you can contribute to your 401(k). In 2005, employees max out at $14,000 ($18,000 if you are 50 or older). So, if you still have money you want to save after filling up your 401(k), our research shows that you should follow this pattern:

Roth IRAs
After you've maxed out the company match, then turn to a Roth IRA — if you qualify. (Your modified adjusted gross income must be less than $110,000 if you're single or less than $160,000 if you're married, although the amount you can contribute begins phasing out at $95,000 and $150,000, respectively.) That's a better option than putting it in the 401(k) without the match. It's true that you won't get a tax deduction on Roth contributions, but the eventual tax-free status of your Roth returns outweighs any immediate gain you'd get from a tax deduction.

Unmatched 401(k)
Keep putting your excess savings into the Roth until you've used up the $4,000 limit ($4,500 if you are 50 or older) that you're allowed to contribute to it in 2005. Then, if you want to save even more than that, make whatever unmatched contributions you are allowed to your 401(k). In 2005 the government caps tax-advantaged salary reduction contributions at $14,000 ($18,000 if you are 50 or older).

Taxable Investments
If you plan to invest in equities, a taxable investment account with a brokerage firm is probably the next best thing given the current 15% maximum federal rate on long-term capital gains and qualified dividends. The key to choosing taxable investments for your retirement savings, however, is to keep your expenses down and get the most benefit from that 15% rate. That entails holding your stocks for more than 12 months — longer, if possible — and choosing mutual funds with a low annual turnover (the rate at which the fund manager buys and sells holdings). Since the law requires that gains from selling stocks be distributed to mutual fund investors, the higher the turnover rate, the greater the amount of your return each year that will be subject to taxation — and that amount may be taxed at higher rates.

Nondeductable IRA
Here the contribution limit for 2005 is $4,000 ($4,500 if you are 50 or older). Unlike a deductible IRA, anyone with earned income from a job or self-employment can open one. And since these accounts grow tax deferred, if you have a long investment horizon, the tax-savings can be significant. That said, withdrawals are taxed as ordinary income, rather than at the lower long-term capital gains rates applied to taxable accounts. Given the current 15% maximum federal rate on long-term capital gains and qualified dividends, these accounts aren't as attractive for those with a relatively short investment horizon.

Variable Annuities
Forget them. Their exceptionally high expenses often counteract the tax-deferred aspects of those contracts. Variable annuities make sense only for a fixed-income asset such as bonds or cash, and only if you are saving for many years. In that case, the gains from compounding your interest free of income tax may eventually outweigh the drag created by higher fees. The exact number of years necessary to come out ahead depends on your tax bracket and the income yield of your investments.