Q: I'm 50 and will be taking advantage of catch-up contributions in my 401(k). How should I allocate the 401(k) contributions, though?
A: Making catch-up contributions to a 401(k) is an excellent way for certain workers to take advantage of extra tax breaks to save for retirement.
For 2019, 401(k) plan participants who are aged 50 or older are allowed to contribute an extra $6,000 to their 401(k) plans, on top of the normal 401(k) contribution limit of $19,000.
That means you can put a total of $25,000 a year in your 401(k) plan without paying taxes on that money. Your 401(k) funds will eventually be taxed when you start taking distributions from the plan in retirement. In the meantime, though, your contributions have the opportunity to benefit from investment growth without being diminished by taxes. Also, since people are often in a lower tax bracket after retirement, you could have a lower tax burden when you eventually take distributions than you would if you paid tax on the money throughout your career.
So this leads to your question: With all this extra money going into your plan, how should you allocate your contributions among the different investment options available to you?
This actually breaks down into two questions -- one is a matter of how aggressive your 401(k) investments should be, and the other is a matter of who should manage the asset allocation of those investments.
How aggressive should your 401(k) investments be?
Generally speaking, younger people tend to be more aggressive with their 401(k) investments than older workers. According to the Employee Benefit Research Institute (EBRI), people in their 20s tend to have nearly 80 percent of their 401(k) assets in stocks. This tapers down with each subsequent age group, reaching a 55.4 percent average equity allocation for workers in their 60s.
The reasoning is that younger people have more time to wait out the ups and downs of the stock market and can afford to invest more aggressively. Older workers who have already built much of their nest eggs generally want to be more conservative so they do not risk a major downturn in investment values occurring just as they are getting ready to retire.
While your time frame until retirement is an important element, it's not the only factor in deciding how aggressive to be. If you are running behind schedule in saving for retirement, you could benefit from more growth and may want to be more aggressive with your 401(k) investments. Also in that case, making relatively large deferrals into the plan can help mitigate the negative effects of market volatility. Finally, people who are behind in their retirement saving may end up having to work longer, which lengthens the time frame for funds to be invested and suggests you can be more aggressive.
Since you are 50, a point of reference you may be interested in is that the Employee Benefit Research Institute (EBRI) found that people in their 50s have an average of 65.7 percent in equities. The extent to which you need to get your retirement savings caught up and how long you intend to work should influence whether you want to be more or less aggressive than your peers.
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Do you want to make the asset-allocation decision yourself?
Use your 401(k) investment menus to allocate your new contributions and plan balance among a range of investment options ranging from aggressive stock funds to conservative cash equivalents and stable value options. The decision of how to allocate among these alternatives has a huge impact on the investment results you will get.
If you don't feel comfortable making such a critical investment decision, see if your 401(k) plan menu offers target-date or life-cycle funds. These are options that represent a professionally managed mix of stocks, bonds and cash, with the aggressiveness of each mix depending on the plan participant's investment time frame.
The EBRI reports that about two-thirds of 401(k) plans now offer these options, and they are a useful tool for people who do not want to make detailed asset allocation choices themselves.
Making catch-up contributions is a great step toward building your retirement nest egg. That mission should also be helped when you allocate the money according to your needs, time frame and comfort level with making asset-allocation decisions.
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