How to Be Smart About Asset Allocation

How many times have you heard the following from Wall Street, the financial media, your CPA or your financial advisor, Max out your 401(k)? Almost every day there is another article on how and why you should Max out your 401(k).

The marketing powerhouses behind Wall Street programs tells us to contribute as much money as we can to our 401(k)’s. But why? Is this really the best way to save for your retirement? Who really benefits, you or banks and financial institutions?

There are two primary benefits to contributing to your 401(k):

1. Tax deferred growth – your 401(k) contributions are tax deductible and grow tax deferred. However, when you need the money the most during retirement, your withdrawals are 100% taxed.

2. Your employer provides a match on your contributions – typically a company matches your contributions up to a certain amount or percentage. This is a big benefit because it’s free money and there aren’t too many places where you can find free money.

Most people understand these benefits upfront but don’t really think about the consequences of over contributing until they’re retired and it’s too late.

How Most People Save for Retirement

Say you’re age 40, plan to retire at age 65 and you intend to max out your 401(k) contributions for 25 years. That maximum per year is $17,500. In addition, you will receive a $5,000 company match. So your total savings for the year will be $22,500, as illustrated below.

Assuming a modest 5.5% growth rate, over the 25 years your 401(k) account value will grow to roughly $1.1 million. That’s the good part. The challenge, what most people don’t realize is this money has been growing tax deferred, but when it comes time to withdraw, both your contributions and your gains will be taxed and taxed hard.

In our program, we teach students a concept called Power Ranking your Money and I want to share this with you here. The four different types of money, ranked best to least best, are:

• free money – a 401(k) company match is considered free money

• tax-free money – money you can access without paying taxes (i.e. Roth IRA)

• tax-deferred money – traditional monies from a 401(k) or IRA, where you get the upfront tax deduction, tax-deferred growth and pay taxes when you withdraw

• taxable money – every other kind of money falls in the taxable money category… we want to avoid this as much as possible. There is no tax advantage now or in the future.

Smart Saving For Retirement

Now take a look at why it’s so important to apply the power-ranking-your-money concept (this is what we teach our students). Let’s say an investor wants to save the same $22,500 a year. We know the company match is $5,000/year and so we’re only going to put that amount into the company 401(k); we want to take the free money. But, the remaining $12,500 will be saved utilizing another tax efficient strategy you may not be aware of. Basically, you’re still saving $22,500 per year but the money is allocated differently.

Still assuming the same 5.5% growth rate, over the 25 years your account value will grow to roughly the same $1.1 million. However, due to the benefits of power-ranking you earn and keep more money.

To demonstrate why max out your 401(k) is a bad idea, let’s say at retirement you want to withdraw the same amount every year for 20 years until the funds are depleted.

With the traditional approach (what most people do) you take out $81,031 each year from Tax-Deferred Money (401k + company match). Don’t forget you need to now pay taxes on this money… at a tax rate of 25% you’ll pay $20,258 in taxes and so you end up keeping $60,773.

With the Alternative Approach you’re going to take out $35,891 from your tax-deferred account. Since you’re taking out less money you get the benefit of a lower tax bracket and only pay 15% in taxes or $5,384. Now, here is where the real advantage comes in… Remember those other accounts you saved in over the 25 years? Those funds were growing in tax-free accounts. Now, at retirement you withdraw $28,298 and $58,250 from two different types of tax-free money accounts and pay zero taxes on that money (if designed properly). If you add those numbers up you’re actually keeping $114,055.

That’s a difference of over $53,000 that you’ll be putting in your pocket every year. And remember, you’re withdrawing for 20 years and over that 20 year period you’ll be putting in your pocket over $1.0 million.

You could argue, take the tax savings and invest it. If you run those numbers, you get a little more benefit but it still does not compare. Most folks don’t end up investing the tax savings anyway, they end up spending it.

While the example above is very simplified, the main point is to think about the max and understand that there is another strategy that may be a much better option for you. So why doesn’t Wall Street teach you about these concepts? Here’s a hint… mutual funds. What types of investment vehicles are mostly found in 401(k)s? That’s right, mutual funds. And what do most mutual funds have in common? If you said fees you are correct, and most are not cheap. Who benefits from these fees charged in your 401(k) mutual fund? Right again, Wall Street Banks and Financial Institutions.

Banks and institutions are simply using smart strategies to attain profits and are very smart with their money and the vehicles they save in. Learn to think and act like Wall Street. Utilize strategies that put more money in your accounts, not the accounts of banks and financial institutions.

 

---

 

Check now the Forex Foundation Course - Free videos

Learn to Trade Now