401(k) Plans Save Taxes and Build Wealth401(k) Plans Save Taxes and Build Wealth
Today it’s imperative to take charge of your retirement plans. With fewer and fewer employers funding retirement plans and the future of Social Security in doubt it is up to you, the individual to take charge of 401(k) plan opportunities.
The benefits of a 401(k) plan are hard to beat. Your contributions are tax-deductible, you typically get a matching contribution from your employer, and both your contributions and earnings grow tax-deferred until they are withdrawn. A maximum 401(k) contribution of $15,500, ($20,500 if age 50 or older) may save up to $9,081of tax (Federal and California).
To maximize your pre-tax wealth accumulation we suggest the following timely strategies:
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Know Your Plan
The past few years have brought about many improvements to 401(k) plans —more investment choices, enhanced employer contributions, and better reporting, to name a few. To maximize the benefits of your 401(k), you need to know and understand your plan and its features. Take the time to read the material your employer provides.
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Contribute the Maximum
To get the most out of your 401(k), you have to put the most into it. Your company sets the maximum contribution as percentage of your salary up to the IRS limit (currently $15,500). Keep in mind that each dollar you contribute to your 401(k) is deducted from your taxable income so you avoid paying income taxes on that money until you withdraw it, typically at retirement. And since all the interest, dividends and capital gains earned in your 401(k) grow tax-free until withdrawn, your money grows at a much faster rate than it would as a taxable investment.
Most companies that offer 401(k) plans match all or part of your contribution, which significantly raises your rate of return. If you cannot contribute the maximum the law allows, at the very least try to contribute enough to earn the full employer match.
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Invest for the Long-Term
Most company plans provide a broad range of investment options. Typically a plan will offer one or more stock mutual funds, a bond fund or fixed-income contracts, a balanced fund, a money market mutual fund, and perhaps, international fund. Oftentimes investment in the company’s stock is another option.
Strive for a diversified mix of investments. A soundly allocated portfolio will grow and preserve your money over the long-term. Many academic studies have shown that a long-term soundly allocated portfolio will produce rates of return of from 10.5 % to 12.5%, and that allocation of the portfolio plays a very significant role in the rate of return. Your allocation between stocks and fixed-income assets is a function of your time frame and risk tolerance. Generally when you are younger you can have a heavier allocation in stocks.
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Monitor Your Investments
It’s your responsibility to keep a close watch on the performance of your 401(k) investments. Most plans provide quarterly reports and some even have a toll-free number or a web site for up-to-date balance figures. At the very least, the law requires that you receive an annual statement. Review your reports carefully and compare your fund’s performance to those in the Standard & Poor’s 500-Stock Index or to other performance averages for the different types of funds you hold. It is important that you regularly rebalance your 401(k) holdings to reflect your long-term goals. How often you can change your investments and your allocations depends on your plan’s rules. Some have fixed dates, some permit daily adjustments and some permit only a certain number of transfers per year. Just don’t get carried away trying to time the market. Again, many academic studies have shown that the odds are against successfully timing the markets, by a factor over nine to one. A good rule of thumb is to re-balance once or twice a year.
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Keep an Eye on Expenses
The do-it-yourself nature of 401(k) plans extends to paying investment expenses and administrative costs. Your are responsible for paying these expenses, which are typically deducted from your plan and reduce your earnings. If you feel these expenses are too high, don’t be shy about bringing your concerns to your employer’s attention.
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Keep All of Your Funds in Your Plan Until Retirement
Do not withdraw your funds from your 401(k) plan prematurely. Premature withdrawals do two very serious damages to your retirement financial independence: (1) The combination of income taxes and income penalties can wipe out over half of your account’s value and (2) You lose the accumulated compounding leverage of those funds. Alternatively if borrowing is available from your 401(k) do not do it, short of the most dire of financial crises. While you do earn the interest that you pay back into your account, you lose any of the long-term growth of that money, and if you should change jobs the unpaid balance is deemed to be a taxable (…and, maybe premature) distribution.
Putney Klein Associates, Inc.
Financial Advisory | Tax Service | Estate Planning
1243 Alpine Road, Suite 219|
Walnut Creek, CA 94596
(925) 932-2612
Fax (925) 932-2118
chuck@putneyfa.com
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