Jane Young, CFP, EA
Many large employers have started offering employees the choice between a traditional 401(k) and a Roth 401(k). However, only a small percentage of employees have elected to contribute to a Roth 401(k). The primary difference between the two plans is when you pay income taxes. When you contribute to a traditional 401(k) your contribution is currently tax deductible, but you must pay regular income taxes on distributions taken in retirement. Contributions to a Roth 401(k) are not currently deductible, but you pay no income taxes on distributions in retirement. As with your traditional 401(k), your employer can match your Roth 401(k) contributions, but the match must go into a pre-tax account.
There are several differences between a Roth 401(k) and a Roth IRA. In 2014, annual contributions to a Roth IRA are limited to $5,500 plus a $1,000 catch-up contribution if you are 50 or over. Contribution limits on Roth 401(k) plans are much higher at $17,500 plus a $5,500 catch-up contribution, if you are 50 or over. Additionally, there are income limitations on your ability to contribute to a Roth IRA, and there no income restrictions on contributions to a Roth 401(k). Additionally, upon reaching 70 ½ you must take a required minimum distribution from a Roth 401(k). You are not required to take a distribution from a Roth IRA at 70 ½. However, you do have the option to transfer your Roth 401(k) to a Roth IRA prior to 70 ½ to avoid this requirement.
The decision on whether to invest in a Roth or traditional 401(k) depends primarily on when you want to pay taxes. If you are currently in a low tax bracket and believe you will be in a higher tax bracket in retirement, a Roth account may be your best option. On the other hand, if you are currently in a high tax bracket and you think you may be in a lower tax bracket in retirement, a traditional 401(k) could be your best option. A Roth 401(k) is generally most appropriate for younger investors who are just getting started in their careers or someone who is experiencing a low income year. People who are in their prime earning years may be better off taking the current tax deduction available with a traditional 401(k).
Unfortunately, it’s difficult for most of us to know if our tax bracket will increase or decrease in retirement. It is also hard to know if tax rates will increase before we reach retirement. From a historical perspective, tax rates are currently low and some believe future rates will be increased to help cover the rising federal debt. Amid this future uncertainty, your best option may be to split your contribution between a Roth and traditional 401(k). This will give you some tax relief today and some tax diversification in retirement.
Jane Young, CFP, EA
Managing your finances is a balancing act between spending for today and saving for the future. It’s important to plan and save for retirement but the demands of everyday life frequently get in the way. Here are some common pitfalls to avoid when planning for your retirement.
Living Beyond Your Means – Spending more than you earn, failing to save and going into debt can be huge threats to your financial security and retirement plans. Develop a spending plan that allows for an emergency fund and annual savings of 10-15% of your gross income. Make a conscious decision to spend less money, buy a less expensive house and buy less expensive cars to keep your expenses below your income. This can help you save for the future with a buffer for financial emergencies.
Failure to Participate – Participate in tax advantaged retirement plans for which you may be eligible. Contribute to your employers 401k or 403b to take advantage of any employer match and deduct the contributions from your current income. Additionally, if you are eligible, consider contributing to a Roth IRA. Generally, an after tax Roth IRA contribution can grow tax free, with no tax due upon distribution.
Failure to Diversify – Maximize the potential for growing your retirement nest egg by maintaining a well-diversified portfolio designed to meet your unique risk tolerance and investment timeframe. A common pitfall is the failure to monitor and rebalance your portfolio on an annual basis. A portfolio that is too conservative can be as detrimental to your retirement plan as an overly aggressive portfolio. Upon retirement, investors frequently make the mistake of changing their portfolio allocation to be extremely conservative, when they may live for another 30 to 40 years.
Market Timing and Trading on Emotion – Moving in and out of the stock market based on short term market fluctuations generally results in lower long term returns. There is a natural inclination to buy when the economy is booming and sell when the economy is in the doldrums. This usually results in buying high and selling low, which can be very detrimental to your portfolio. To maximize your retirement portfolio avoid the emotional temptation to react to short term events and fluctuations in the market.
Funding College and Living Expenses for Grown Children at the Expense of Retirement – Avoid the pitfall of sacrificing your retirement to fund college education for your children or to make significant contributions toward an adult child’s living expenses. Students have many options to finance or minimize college expenses but you can’t take out a loan to finance your retirement.
Cashing Out or Taking an Early Withdrawal – When you change jobs, transfer the money from your employer’s plan to another tax deferred plan such as a Rollover IRA. This allows you to avoid paying significant income tax and a 10% early distribution penalty, if you are under 59 ½.
Jane M. Young
Generally the typical investor is better off investing in stock mutual funds than in individual stocks. A mutual fund is an investment vehicle where money from a large number of investors is pooled together and invested by a professional manager or management team. Mutual fund managers invest this pool of money in accordance with a predefined set of goals and guidelines.
One of the primary benefits of investing in stock mutual funds is the ability to diversify across a large number of different stocks. With mutual funds, you don’t need a fortune to invest in a broad spectrum of stocks issued by large and small companies from a variety of different industries and geographies. Diversification with mutual funds reduces risk by providing a buffer against extreme swings in the prices of individual stocks. You are less likely to lose a lot of money if an individual stock plummets. Unfortunately, you are also less likely to experience a huge gain if an individual stock skyrockets.
Another benefit of stock mutual funds over individual stocks is that less time and knowledge is required to create and monitor a portfolio. Most individual investors do not have the time, expertise, or resources to select and monitor individual stocks. Mutual funds hire hundreds of analysts to research and monitor companies, industries and market trends. It is very difficult for an individual to achieve this level of knowledge and understanding across a broad spectrum of companies. Mutual fund managers have the resources to easily move in and out of companies and industries as investment factors change.
Most individual investors appreciate the convenience of selecting and monitoring a diversified portfolio of mutual funds over the arduous task of selecting a large number of individual stocks. Stock mutual funds are a good option for your serious money. However, if you really want to play the market and invest in individual stocks, use money that you can afford to lose.
For diehard stock investors, there are some advantages to investing in individual stocks. Many stock mutual funds charge an annual management fee of between .50% and 1% (.25% for index funds). With individual stocks, there is a cost to buy and sell the stock but there is no annual management fee associated with holding stock.
Another advantage of individual stocks is greater control over when capital gains are recognized within a non- retirement account. When you own an individual stock, capital gains are not recognized until the stock is sold. In a high income year, you can delay selling your stock, and recognizing the gain, to a year when it would be more tax efficient. On the other hand, when you invest in a stock mutual fund you have no control over capital gains on stock sold within the fund. Capital gains must be paid on sales within the mutual fund, before you actually sell the fund. Mutual funds are not taxable entities, therefore all gains flow through to the end investor.
Please mark your calendars for our next Pinnacle Financial “Fireside Chat”, to be held on Wednesday, September 7th from 7:30am – 9:00am.
Jane will discuss the characteristics of modern retirement and how to plan for it. She will explore different approaches to retirement and some of the factors to be considered. She will also explain the various plans available to help you save for retirement.
The Fireside Chat sessions are informational only (no sales!) and interactive — a great opportunity to learn new things and ask questions in a relaxed environment. These sessions are open to your family and friends, so please feel free to pass this email along to anyone that you think might be interested in attending.
Please call Judy (719-260-9800) if you would like to attend this session on September 7th, as space is limited.
We hope to see you on September 7th! Coffee and donuts will be served!