Investors are told every fall to add money to their individual retirement accounts and 401(k)s to get the biggest tax break possible and turbocharge growth. But doing it can be tricky. For investing, the timing might be wrong. And 401(k) participants may find their plan doesn’t welcome a lump sum year-end contribution.
What are the hurdles and best ways over them?
The first issue: does boosting your contribution really make sense? Most experts say yes, as maximizing retirement account contributions is pretty much gospel.
[See: 7 of the Best Stocks to Buy for 2018.]
If you have a 401(k) or are eligible for a tax deduction in a traditional IRA, big contributions reduce your taxable income, cutting your tax bill. Federal law allows a maximum 401(k) contribution of $18,000 this year, $24,000 for participants older than 50. For IRAs, its $5,500 and $6,500 if older than 50. IRA and 401(K) contributions can wait to as late as the next April 15, but employer 401(k) rules may make it difficult.
And it’s good investing practice to invest earlier rather than later, since waiting means missing any investment returns possible in the meantime.
Craig Bolanos, CEO of Wealth Management Group in Inverness, Illinois, illustrates the value of compounding for two investors. The first starts socking away $200 a month at age 20, earning 6 percent a year, while the second starts at age 40 and earns 8 percent. Despite the bigger return, the late starter will have only $190,205 at 65, while the younger will amass $550,000.
“The advantage of making the largest allowable contribution is that you benefit from compound interest,” Bolanos says. “The more money you have in the account and the longer it stays in the account the better opportunity you have to grow your capital.”
Participants in 401(k)s are also generally advised to contribute enough to get the maximum offered by any employer match.
A more long-lasting benefit comes from tax deferral on investment gains. You won’t pay income or capital gains tax as profits roll in over the years, just an income tax on withdrawals in retirement. Avoiding tax leaves more money in the account to compound.
And, of course, the more you put into your account, the bigger it will be at the end.
On the other hand, money put into these accounts is tied up, as tax and 10 percent penalty apply to most withdrawals before age 59.5. So you don’t want to put in next month’s grocery money.
Another concern: what if you pour money in when asset prices are high, as stocks are today, and the market tanks?
[See: 7 Reasons to Invest in an IRA.]
The risk of a pullback is always there, but can be addressed with your investment choices. The lump sum can go into a money market fund to be parceled out among other holdings over time. This is the same dollar-cost averaging technique used by investors who contribute a fixed amount every pay period. That sum will buy more shares when prices are down, fewer when they are up, reducing the average share cost over time.
“A dollar-cost averaging approach is often best from pure investment standpoint,” Bolanos says. “Therefore, boosting ordinary payroll deductions is the most efficient way to make sure that some of your contributions are taking advantage of market volatility.”
Making a large year-end contribution to an IRA is easy — write a check or transfer funds from another account. But in early December the pressure is on to leave time to consider how best to use the new funds.
Things can be trickier for 401(k) participants.
Typically, you cannot simply write a check, as with an IRA, but can contribute only out of your pay, says Melissa Fort, financial consultant at Fort Wealth Management in Austin, Texas.
You might be able to contribute from a year-end bonus, but most likely will be allowed to boost the year’s contributions only by increasing the withholding from your paycheck. Since it may take a pay period or two for the new amount to kick in, it’s best not to wait too long.
“Lump-sum contributions are usually allowed by employer plans and usually must come from another qualified account or qualified employer plan,” Fort says. “For example, a rollover from an existing IRA, Roth, 401(k), 403(b), 457, Simple, SEP and more may be accepted into the current employer plan.”
Making a lump-sum contribution could therefore take two steps — moving money to the 401(k) from an IRA of similar plan, and then putting fresh money into the IRA. Remember, though, that the IRA replacement must be within the annual limits, which apply to all your IRAs, not each one separately. To avoid tax and penalty, don’t route the funds through your bank account, but have them sent directly from one retirement account to another, Fort says.
For many investors who have skimped on their contributions during the year, the only real option this late is to do better next year by ordering a larger payroll deduction.
If you can afford it, you can make large contributions at the start of the year to get ahead of the game, leaving room to cut back if money is tight later. Check first with your employer on how often you can change the amount.
[See: How to Pay Less Tax on Retirement Account Withdrawals.]
Finally, how should you allocate new contributions to your retirement accounts? Most experts recommend against making dramatic changes with new money. Instead, stick with the asset allocation you’ve chosen previously, assuming it still fits your situation. If one class of your holdings has gone up more than others, consider putting the new money into the laggards, which in the future may beat the past year’s winners.
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Year-End Contributions Can Pay Off originally appeared on usnews.com
