Once you have a solid financial foundation and suddenly have extra income due to a pay increase, cash windfall, inheritance, or a reduction in expenses, what should you do with it?
Laura answers a listener’s question about how to invest extra cash after maxing out a retirement plan at work.
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I recently received a question from C.G., who said, "Hi, Laura. I enjoy your show and appreciate your delivery of information. I'm 55 years old and have a year of emergency savings and no debt except for two mortgages, one on my primary home and another on a condo near my work.
I used to contribute to a Roth IRA but recently exceeded the allowable annual income limit. However, I max out my Roth at work. Now that I cannot contribute to my Roth IRA, I have an extra $300 monthly. What should I do with it? Thanks for your advice."
Thank you for your question, C.G., and congratulations! Earning too much for a Roth IRA and having some extra money is an excellent problem. This show, episode 772, will answer your question by reviewing the best ways to invest excess cash and how to prioritize your options.
Hey, everyone, and welcome back to Money Girl—I'm so glad you're spending some time with me! If you're a new listener, my name is Laura Adams. I'm an award-winning author and financial expert who's been bringing money tips and advice weekly on this podcast since 2008, with over 40 million downloads.
I also work with select brands doing on-camera and writing work as a spokesperson, consumer advocate, and P.R. consultant. If your company is interested in collaborating for an upcoming campaign or ongoing marketing, please reach out!
On the show, you'll hear me talk about a wide range of topics, like building credit, dealing with debt, investing for retirement, owning real estate, paying taxes, having the right insurance, money management strategies, running a small business, and lots more. I also interview money experts and interesting people here from time to time.
If you want to request a show topic or have a money question, you can message me at 302-364-0308 or email me using my contact page at LauraDAdams.com. That's also where you can learn more about my work, award-winning personal finance books, and money courses.
For today's show, I'll assume you're like C.G., with enough emergency savings in the bank, no dangerous debt, and making regular retirement contributions. Once you have a solid financial foundation and suddenly have extra income due to a pay increase, cash windfall, inheritance, or a reduction in expenses, what should you do with it?
First, I recommend reviewing your financial goals and clarifying what you genuinely want to accomplish, like saving for retirement, starting a family, putting kids through college, buying a home, or launching a business.
In addition, what you should do with extra cash depends on many factors, like whether you or a spouse have a retirement plan, whether you're self-employed, how much you earn, any debt you owe, and your tax filing status. I'll explain more throughout the show.
If you have a workplace retirement account, such as a 401(k) or 403(b), it should always be the first place you invest because it has high annual contribution limits, and your employer may kick in free matching funds as an incentive. So, C.G. is wise to be maxing out a workplace Roth.
For 2023, the contribution limit for most workplace retirement plans is $22,500, or $30,000 if you're over 50. If you do that and still have more to invest, bravo! We'll review the next best places to invest, including what to do if you don't have a job with a retirement plan.
Here are the best ways to invest extra cash after exhausting your retirement options at work.
After a workplace retirement plan, maxing out a Roth IRA should be a top priority, and C.G. was doing that before becoming ineligible. For 2023, the IRA contribution limit is $6,500 or $7,500 if you're over 50.
With Roth accounts, you pay tax upfront on contributions and then can take tax-free withdrawals in retirement, which is a fantastic benefit. However, there is an income limit for contributing to a Roth IRA. Note there is no income limit to participate in a Roth at work.
For 2023, to qualify for a full Roth IRA contribution, single tax filers must have modified adjusted gross income (MAGI) below $138,000, and joint tax filers must be under $218,000. If your income is below that limit, you can fully fund a Roth IRA and a traditional or Roth workplace retirement plan.
But what if you're like C.G. and earn too much for a Roth IRA? Keep listening—I'll cover more excellent options to invest your extra cash.
C.G. didn't mention having any business income. But if you do freelance work on the side of your day job or are a full-time entrepreneur, you can contribute to a self-employed retirement plan, such as a solo 401(k) or SEP-IRA.
For 2023, you can contribute up to $66,000, depending on your business income. Plus, a solo 401(k) allows catch-up contributions, giving those over 50 a potential maximum contribution of $73,500 ($66,000 plus $7,500).
Note that those limits must include your workplace contributions if you have business income and a day job with a retirement plan. For instance, if you're under 50 and max out a 401(k) by contributing $22,500, you could put an additional $43,500 ($66,000 - $22,500) in a solo 401(k) if you have that much business income.
That's a fantastic way for entrepreneurs who max out a 401(k) at their day job to save even more for retirement with their extra cash.
Once you max out a workplace retirement plan, you may be able to make nondeductible or after-tax contributions, if your plan allows it, up to $66,000 for 2023.
Let's say you max out a 401(k) by contributing $22,500, and your employer adds $5,000 in matching for $27,500 in the account. You may be able to make additional after-tax contributions of $38,500 ($66,000 - $27,500) to get to the plan's overall annual limit.
The after-tax funds grow tax-deferred, and you can withdraw your contributions (but not earnings) without taxes or penalties. However, if you're younger than 59.5, withdrawing any earnings on nondeductible contributions would be subject to tax plus an additional 10% penalty.
Not every employer offers an after-tax contribution option, so check your plan summary document for more details or ask your benefits administrator. It may be a good option if you want your investments to grow tax-deferred for retirement. Just make sure to keep good records so you know the amount you previously paid tax on.
LISTEN ALSO: Can You Contribute to a 401(k) and an IRA in the Same Year?
A traditional IRA has no income limit, making it an excellent choice for high earners. With traditional retirement accounts, you make pre-tax contributions, giving you a tax deduction in the current year. That reduces your taxable income, even if you don't itemize deductions on your tax return.
However, there's a catch. If you or a spouse have a workplace retirement plan or one for the self-employed and also contribute to a traditional IRA, your IRA tax deduction gets reduced or eliminated when your income exceeds annual limits.
For 2023, single tax filers must have MAGI below $73,000, and joint tax filers must be under $116,000 to deduct a full traditional IRA contribution when they also participate in a workplace plan. If your MAGI is higher, your contributions will be partially deductible or nondeductible.
Additionally, if you're not covered by a workplace or self-employed retirement plan, but your spouse is, your MAGI must be under $218,000 for a full traditional IRA deduction. But if neither you nor a spouse have a retirement plan at work or one for the self-employed, your traditional IRA contributions are tax-deductible.
C.G. didn't mention income, but not qualifying for a Roth IRA likely means their contributions to a traditional IRA would be nondeductible. While you don't get an upfront tax deduction, nondeductible contributions to a traditional IRA still grow tax-deferred. That's a meaningful benefit to consider when investing extra cash.
You must file IRS Form 8606 for every year you contribute after-tax amounts to a traditional IRA.
LISTEN ALSO: Should You Have a Traditional or Roth IRA?
After exhausting your retirement account options, the next best place to invest is a health savings account or HSA. However, it's only available when you have a high deductible, HSA-eligible health plan. C.G. didn't mention having one, but it's worth mentioning because HSA tax benefits are so good, and there are no income restrictions.
If you qualify, the 2023 contribution limit is $3,850 when you have an individual health plan or $7,750 for a family plan. Plus, if you're over age 55, you can contribute an additional $1,000.
HSA contributions are tax-deductible, and your investment earnings grow tax-free if you use the funds for various qualified expenses, including medical, dental, vision, chiropractic, acupuncture, prescriptions, and many over-the-counter medicines and products.
Your HSA funds roll over from year to year with no penalty. And if you have a balance after age 65, you can spend it on non-medical expenses. Before age 65, if you spend HSA funds on non-qualified costs, you must pay taxes plus an additional 20% penalty.
C.G. didn't mention having a family or wanting to return to school. But if you're going to pay education expenses—such as tuition, books, computer equipment, internet, and room and board—for you or a family member, a 529 college saving plan comes with nice tax breaks. Plus, you can even use up to $10,000 per year for education expenses related to public or private school for students in kindergarten through high school.
Once a student is out of high school, you can use a 529 for any college, university, graduate school, or vocational school without an annual limit if the institution is eligible to participate in a federal student aid program.
While 529 contributions are not tax-deductible, your account grows tax-free if you use the funds for qualified education expenses. And there are no restrictions on annual income to participate.
Most states offer at least one 529; however, the fees and benefits vary, so comparing plans is wise. The good news is that you don't have to be a resident of a state to enroll in its plan. For example, you could live in Florida, participate in a California 529, and use the funds to pay for a school in Texas.
Also, note that some states offer residents a tax deduction or credit for choosing an in-state 529. Depending on where you live, that could add up to significant savings compared to an out-of-state plan.
The only downside of contributing to a 529 plan is that spending it on anything besides qualified education expenses comes with a penalty on the earnings portion of a distribution. You typically must pay income tax plus a 10% penalty on amounts that weren't previously taxed.
Once you've exhausted tax-advantaged ways to invest your extra money, it's time to look at taxable options, such as a brokerage account or other investing platform. The firm you choose should depend on the investments you want to purchase, such as mutual funds, exchange-traded funds, real estate funds, cryptocurrency, or precious metals.
While you don't get tax benefits with a brokerage, it's incredibly flexible because you can tap the account early for any reason without penalty. Remember that, in general, you must be over age 59.5 to avoid a 10% penalty on withdrawals from retirement accounts that weren't previously taxed.
When you have investment dividends or capital gains, you must report that income on your tax return. The brokerage sends you tax forms in January for the prior year so you know the types and amounts of income earned or lost. Your tax rate depends on your income and how long you own an investment.
For instance, when you profit from an asset owned for less than a year, it's a short-term capital gain. The tax rate is the same as "ordinary" income, which ranges from 10% to 37% for 2023. Tax on investments owned longer than a year is long-term capital gains, which range from 0% to 20%, depending on your income, which could be lower than the ordinary income tax rate you must pay for taxable retirement account withdrawals.
Choosing one or several of these options to invest your extra cash is an excellent way to achieve your goals and create more financial security.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.