Mid twenties, no debt, maxed out all contributions to "common sense" stuff, what can I do to maximize the value of my money now?

Question

I'm in my mid twenties living in the US, in a relatively inexpensive city (my rent is 930 a month).

I max out 401(k), 80% going to Roth 401(k), 20% traditional 401k (I expect I'm going to have to pay more taxes in retirement than right now).

I max out my Roth IRA, 6000 a year

I max out my HSA, I'm young and I don't use the money from it at all, set it to invest automatically. 3550 maxed out

My gross income is $86,000 about.

I have no debt, no loans.

The 40k I have in my savings account is purely from saving over time, none of it is from windfall or anything.

My best guess is I should take $20,000 and put it into index funds. I'm worried about tax implications and what happens with dividends (like are some funds automatically withheld? I know I'll make more overall but will I end up having to pay if I make enough in dividends come tax season, and then possibly not have enough out of pocket money to pay that?). I would probably be using Vanguard. I have no goal to "use" this money for anything, maybe bolster retirement income or something.

I'm not married, I don't own a home and don't have kids, the advice here is either not really relevant to my demographic and doesn't help me make a decision on what to do with my money.

Answer 1

To quote another answer:

You can't max out your retirement savings.

There is no limit to what you are allowed to save/invest for retirement. There are specific tax-advantaged ways to invest money (IRA, 401(k), HSA, 529, etc.) that have various rules constraining amount and manner of contributions, distributions, etc.; it is possible to max out these vehicles. You can continue to save and invest the rest of your money elsewhere, but you won't get the preferential tax treatment (and relevant restrictions) that come with the special account types.

Yes, investing (whether in index funds or otherwise) outside these accounts can introduce some tax liability. However, this is hardly a problem. To oversimplify, taxes on investments broadly fall into two categories:

Dividends: If you receive $2000 in dividends from your investments in a year, this money will be taxed as ordinary income, and you will owe some amount based on your tax bracket. However, you now have an additional $2000 on hand to pay this tax. You still come out ahead. Even if you are in the highest tax bracket and pay 37% on this money, you have more than $1400 cash more than you did before. This is in addition to the fund shares themselves.

Capital Gains: If the value of your investments go up, and you sell some of the investment at a gain, you will owe taxes (on the gain, not the whole sale amount). If you do not sell, you don't owe anything (yet). If these gains are short-term (you held the asset for less than 1 year), the gain is taxed as ordinary income; if the gains are long-term (you held the asset for more than 1 year), the tax rate is more favorable. If you sell any investments for a loss, you can deduct that from your gains and potentially not owe any capital gains tax.

In either situation, a tax liability only happens when additional money comes to you, and since the tax is some percentage of that money, it is always less than the money that came to you, and you would therefore have the means to pay what you owe. Generally, the amount owed would not be automatically withheld. If you are worried about IRS penalties for under-withholding, you can increase your withholdings from other sources (file an updated form W4 with your employer), or make estimated payments to the IRS throughout the year.

Answer 2

Assuming the 40k you mention is in a regular savings account, I think your idea of putting some of that into index funds is perfectly reasonable. Then again, it's pretty reasonable to leave it where it is too.

• You need to keep enough money in cash, in a regular bank account, to weather 3-6 months of expenses during an 'emergency' — whatever that means.
• Above that, putting money into index funds is a good idea, but doesn't matter that much for $20k. You might expect that to yield 3%=$600/yr for you, but with thousands of dollars in fluctuation.
• You owe taxes when you earn money outside of a retirement account, including dividends and capital gains when you sell. That's okay though — it's part of growing your wealth. As you accumulate more wealth and earn more money from that, you will find many more issues like this. Embrace it! It's a good problem to have!
• Funds don't withhold taxes for you. If you have money to pay the taxes elsewhere, then re-invest the dividends and pay the tax on them separately. Otherwise just take the dividends and use part to pay their taxes.

Answer 3

If your Emergency Fund, 401k, IRA, and HSA are all taken care of, the next obvious choice is a regular Brokerage account. Get whatever money you have left, put it in a Brokerage account and invest it in cheap, broad index funds.

I personally recommend the money be evenly invested across a Large-Cap Index Fund, Mid-Cap Index Fund, Small-Cap Index Fund, International (Ex-US) Index Fund, and U.S Government Bonds Fund (Preferably Municipal Bonds since interest payments on those are tax free). Adjust accordingly from there, depending on your risk tolerance.

As far as your concern about taxes goes, they will never leave you worse off than if you had not invested at all: any taxes you may owe, will always be a percentage of your earnings.

Answer 4

The core of your question:

My best guess is I should take $20,000 and put it into index funds. I'm worried about tax implications and what happens with dividends (like are some funds automatically withheld? I know I'll make more overall but will I end up having to pay if I make enough in dividends come tax season, and then possibly not have enough out of pocket money to pay that?).

The dividends and capital gains from a mutual fund or ETF in a non-retirement account will trigger taxes. The general advice is to re-invest these payments to increase the number of shares you own. That advice is rock solid within a retirement account, because the quarterly/annual dividends and capital gains will not trigger taxes until you are retired or never depending on the Roth status. If you are concerned about being able to afford the taxes on the capital gains and dividends then don't automatically reinvest them, keep them in cash in the account and pull out what you need when it is time to pay the taxes.

Now with $20,000 as an initial investment these gains and dividends should be small enough to handle, but over time if the plan is to keep purchasing shares then the gains and taxes will increase.

One thing you should try and factor into your tax planning is that the gains and dividends will increase the amount of income that isn't addressed in the numbers on your W-4/W-2. If you generally get either a small tax refund, or only pay a small amount of taxes when you file in April; that additional income could cause other tax issues related to under withholding. This can be hard to estimate because these funds tend to make their largest capital gains and dividends in December when it is hard to make adjustments before the tax year ends. You might want to check the gains and dividends payment history.

The general advice is to keep 3-6 months of money in an emergency fund, plus additional money for a life happens fund to handle those unexpected expenses such as something breaking or a major repair. You do have some medical expense coverage due to the amount in your HSA. Make sure that you aren't putting the emergency money at risk.