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The Perks and Pitfalls of Managing Your 401(k)
Financial Planning
April 2016
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The Perks and Pitfalls of Managing Your 401(k)
If you have turned 50, by all means take advantage of the catch-up contribution to 401(k) plans, where you may defer an extra $6,000 for a total of $24,000 in tax-deferred dollars each year until you retire. Even if you don’t turn 50 until Dec. 31, you may add the extra $6,000 to your contributions for 2016. If your employer matches your contribution up to a certain percentage, imagine how much more money you can accumulate by retirement. And that extra catch-up amount further helps reduce your income tax bill. For example, if you’re in the 25 percent tax bracket and contribute the full $24,000 to a 401(k), you would pay $6,000 less in income taxes each year.
However, not everyone can contribute $24,000 of their income and still make ends meet. One strategy is to divvy up the paychecks of a two-income household unevenly. For example, if one spouse is 50 or older but the other is not, you could allocate a higher percentage of the 50+ earner’s salary to his 401(k) and more of the younger earner’s salary to living expenses. If one spouse doesn’t have access to a 401(k) plan, max out the 401(k) first and then contribute whatever discretionary income is left between the two salaries to separate traditional IRAs to maximize your tax deductions.
Auto Escalation
In recent years, many employers have launched new programs designed to improve worker participation in 401(k) plans. The first is auto-enrollment, in which new employees are automatically enrolled when they start working at a company. A minimum deferral percentage is automatically deducted from their wages.
The second program is auto escalation, in which the employer automatically increases the amount each participant defers to the 401(k) on an annual basis. Both of the plans allow workers to opt out of the automatic deferrals or increases, but they must actively do so. Since nearly 50 percent of large employers currently auto escalate worker contributions to their 401(k) plans by 1 percent or more each year, there’s a good chance this is happening under your radar. In fact, since deferrals are taken out of your paycheck before taxes, you might not even notice the offset. This isn’t necessarily a bad thing, but you should be aware of what money is taken out of your paycheck and where it goes.
Another 401(k) management tactic that is often overlooked is rebalancing. When you first signed up for your 401(k), you probably selected a mix of funds based on how long you have until retirement and how much market risk you want to take. Bear in mind though, that the stock market has outperformed for several years now, and the financial markets experienced a fair amount of volatility in just the first quarter of this year. Now might be a good time to review your 401(k) account to see if it is weighed too heavily in one asset over others. By rebalancing, you can reinvest your gains from recent years into securities with more growth potential, while at the same time restore your original allocation and potentially reduce your overall portfolio risk.
Many investors take an “invest and ignore” attitude toward their 401(k) plan. Even though it may not be as actively managed as a taxable investment portfolio, it should be reviewed periodically to ensure investments are performing to your satisfaction. Furthermore, your plan’s asset allocation is more likely to help meet your long-term goals than the short-term performance of any one holding or asset class.
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These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.
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