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The Best Accounts for Heavy Savers

An HSA's tax benefits are hard to beat, but there are other options as well.

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Everyone has heard the advice to steer the maximum into their IRAs and company retirement plans if they can afford to do so. But where should heavy savers turn if they've maxed out those accounts and still have more to save? Joining me today to discuss that topic is Christine Benz. Christine is Morningstar's director of personal finance. 

Hi, Christine. Thank you for being here today. 

Christine Benz: Hi, Susan. Great to be here. 

Dziubinski: Clearly, this is a pretty high-class problem. Most people aren't in a position to invest beyond those basic retirement vehicles that I mentioned at the start. But let's assume someone does have extra funds to invest, what should be at the top of the list as the next investment? 

Benz: When we examine the tax benefits, the investment vehicle that would rise to the top would be a health savings account. These are available if you are covered by a qualifying high-deductible healthcare plan. And the reason they are so advantageous from a tax standpoint is that they allow you to put in pretax contributions. As long as the money stays within the HSA, it enjoys tax-free compounding. And then, if you use the money for qualified healthcare expenditures, the money coming out is also tax-free. So, for heavy savers, this can be a really nice ancillary retirement savings vehicle. You know you're likely to have healthcare expenses in retirement, so you'll be able to enjoy the tax benefits at each step of the way. So, I would take a look at this. Some tax experts might even say it should go above IRAs and 401(k)s. I wouldn't go quite that far because it's not as flexible in order to earn all three tax benefits you need to use the money on healthcare expenditures. And also, some HSAs are not that great. Our team has been taking a close look at them for the past several years. I think we've been shining the light on them, and I think they've gotten better. But some HSAs still do have heavy fees, which outweigh or potentially offset some of those great tax benefits.

Dziubinski: Let's say, you've checked out the HSA, what would be the next thing to be thinking about if you're in this situation? 

Benz: I would urge people to take a look at what are called aftertax 401(k) contributions. There is a lot of confusion about what these are and how they work. But one thing to know is that even though you see those sort of baseline 401(k) contribution limits, which is for people under 50 $19,500 in 2021 that you can make to a traditional or Roth 401(k). You'll notice that there's also this larger contribution limit. And that encompasses your employer matching contributions, your own traditional or Roth 401(k) contributions, and then what are called aftertax contributions. Not all plans allow them, but bigger plans typically do, or increasingly are, and the idea is that you're putting in aftertax dollars into the account. And many of these plans that offer this aftertax 401(k) feature also offer the opportunity to convert your contributions inside the plan. That means that you can convert them to Roth and that really reduces any taxes that you'll owe on making these aftertax contributions. It's a way for heavy savers to get more money into the 401(k), more money into the Roth column. And I would also call out, Susan, increasingly we're seeing not only is this conversion feature available, but it's automatic for plans that offer it. So, it's really a kind of frictionless way for people to save additional 401(k) assets and to have them be Roth. So, definitely worth checking out, but definitely fund your traditional or Roth 401(k) contributions before you look at this option. 

Dziubinski: What if aftertax contributions aren't allowed, or if someone still has additional funds to invest? 

Benz: Here I would look at a plain old taxable brokerage account where you're putting in money that has already been taxed. The thing I would note is that if you take care with that account, it's actually not that tax disadvantage to save within a taxable brokerage account. So, as long as the money stays within the account, you'll owe taxes on dividends, capital gains that are distributed along the way. But if you're careful and if you use low-cost broad market equity index funds or ETFs, if you use municipal bonds for your fixed-income exposure, you'll be able to really reduce the ongoing tax drag on your account. You'll be able to enjoy long-term capital gains treatment on your sales. And you'll also just have a ton of flexibility with this account type, where you can invest in anything, you can use the money for anything without any strictures. So, you have a lot more leeway with this type of account than you would with the other two account types that we already discussed. 

Dziubinski: And then, lastly, you have a couple of out-of-the-box ideas for some investors to think about, but you say they may not be for everyone.

Benz: Right. So, for people who have younger adults in their lives where college expenses are looming, consider 529 college savings accounts as an option potentially. The key thing I would flag here is that you just have a ton of flexibility in terms of who you can transfer the account to. So, if for whatever reason you oversave in a 529 account for your own child, well, the money could be held for your grandchild, for example, or for a niece or nephew. So, there's a lot of flexibility to help other loved ones who might have college plans down the road. Then another out-of-the-box idea I would call out is to consider prepaying your mortgage. And this is very controversial. A lot of people say, why would you ever do that, especially given how low interest rates are. And the key reason is that if you don't have any imminent needs for those funds, the mortgage paydown offers you a better return on your investment than you can have with other similarly guaranteed investments like investing in some sort of a money market account. So, this is kind of a piece of mind trade, but I think it's something well worth considering, especially for older adults who are getting closer to retirement and really want to try to reduce their total costs coming into retirement.

Dziubinski: Well, Christine, thank you so much for your time today and for these fresh ideas for super savers. We appreciate it. 

Benz: Thank you so much, Susan. 

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.