This week, Gail answers a reader's question about frequent trading in a retirement savings account, and explains the rules governing Simplified Employee Pension (SEP) plans.

Dear Gail-

What can I say? I really screwed up my 401(k) in the past three years. First, when the market headed lower in 2000, I figured it was time to "buy low" so I loaded up on a mutual fund that invests in tech stocks. Then in 2001 it became apparent that they weren't going to bounce back any time soon, so I panicked and moved a lot of my money into cash.

That might have saved me from totally bailing at the bottom, but the problem was (probably like a lot of people), I stayed there too long. In late 2002 I shifted some of my money into a bond fund, only to have bonds pull back this summer. I figure I've lost $22,000. And now that tech stocks have recovered so much, I probably would have been better off just staying put.

Frankly, I wish it wasn't so easy to change the investments in my 401(k). Can I deduct my loss from my 2003 income?

Ruth

 

Dear Ruth-

The short answer is "No."

I spoke with according to April Caudill, the managing editor of "Tax Facts," the unofficial bible for tax professionals. She explains that before you can take a tax deduction for a loss, you must have first paid tax on the money to begin with. Since this was a contribution to your 401(k), you never paid income tax on the $22,000 you "lost."

(Think of it this way: if you were allowed to avoid paying tax on both your 401(k) contributions and take a loss against these same contributions, you'd be getting TWO tax breaks on the same amount of money.)

It probably won't make you feel much better, but you are not alone. Behavioral finance tells us that we tend to chase last year's winners. It's no surprise that, according to the Investment Company Institute, investors poured $310 billion into stock funds during 2000. The next year, $376 billion went into money market funds. Last year, bond funds got the lion's share of new investment dollars.

It's hard not to invest as if we're looking in the rear view mirror. Which is why perhaps the best approach to take is to make sure you are diversified, that is, own a wide variety of investments -- large company stocks, those of small and mid-sized firms, as well as bonds. And don't forget foreign investments, either.

So take a hard look at the investment choices in your retirement plan and diversify the money you have left. Resist the temptation to make frequent changes to your retirement mix. Instead, tell yourself that once a year, or maybe at the end of each quarter, you are going to re-balance your 401(k) portfolio so that your investments continue to make up the same percentages you started with. This will naturally involve selling funds that have done well up to then and re-investing the money into areas of the market which did not have stellar performance.

In other words, re-balancing forces you to "buy low and sell high." It's the smart way for individual investors to make money in the long run.

Best wishes-

Gail

 

Dear Gail-

After being laid off three years ago I started my own business as a consultant. It was a struggle for a couple of years and the most I could afford to set aside for retirement was an IRA contribution. But thankfully, business has picked up this year and I'm finally going to be able to put some significant dollars away for retirement. I opened a SEP plan with a mutual fund company because I read an article that said I could contribute up to 25% of my income to it. But my accountant tells me I can only contribute 20% to my personal SEP account. Who's right?

Thanks,

Rob

 

Dear Rob-

Both the article and your accountant are technically correct.

First, a bit of background. "SEP" stands for Simplified Employee Pension. It's a retirement plan specifically designed for small businesses like yours. As its name implies, a SEP involves much less red tape than a traditional retirement plan. For instance, the plan is not required to be "tested" each year to make sure it complies with federal regulations. In addition, instead of requiring a complex accounting system to keep track of each participant's benefit, company contributions are made to IRA accounts in the name of each eligible employee .

John Battaglia, of the accounting firm Deloitte Touche says the maximum contribution that can be made to a SEP account is 25% of each employee's income, up to a maximum contribution of $40,000 per person. The benefit to a company is that all money contributed to employee retirement accounts is tax-deductible and reduces its income tax bill. However, this calculation is more complex if you wear two hats -- one as the "owner" and the other an "employee."

As you are probably well-aware, all wages are subject to FICA tax, which pays for Social Security benefits. This 12.4% tax is split between the employer and the employee, with each paying half of the amount. However, as the owner/employee, you actually end up paying both parts of the FICA tax as well as the entire 2.9% tax that goes to Medicare. In addition, says Battaglia, since "your" income is equal to your "company" income, it includes your SEP contribution itself. Thus, making the SEP contribution will reduce the amount of income you can actually base the contribution amount on!

In order to adjust for these things, it's necessary to do a kind of "circular" calculation based on the amount of self-employment income you report on Schedule C of your income tax return. After you go through this exercise (reducing your self-employment earnings by half of the self-employment tax you paid), it turns out that the contribution for someone who is an owner-employee, ends up being 20% of your net income.

Unless you are really good at following instructions, you're smart to have your accountant do the math for you. But even smarter to contribute to your own retirement plan!

When you have the happy problem of needing to hire additional people because your business has really taken off, you can add these individuals to your company's existing SEP plan or consider opening a streamlined 401(k) designed just for small companies. It will potentially allow you to sock away even more than a SEP.

Best wishes,

Gail

 

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