Rethink Retirement Plans for New 401(k) Laws

Last week, the Internal Revenue Service raised the annual contribution limits for IRAs, 401(k)s and similar retirement plans in 2012. That means now might be a good opportunity to build your holdings of cash to spend in retirement.

Maximum contributions to a 401(k) or similar plan will be $17,000 in 2012, up from $16,500 this year, while additional "catch-up" contributions for people over 50 will remain $5,500. Annual contributions to traditional and Roth IRAs will be limited to $6,000, the same as this year.
Changes in contribution rates for retirement plans mean that some people need to rethink their nest eggs.

Higher limits are good if you're an aggressive saver, but would you really want to use an IRA or 401(k) for cash? Don't most investors emphasize stocks and bonds in tax-favored retirement accounts?

Yes, many investors use these accounts for tax breaks on investment gains, and there aren't many gains with cash savings. Also, there's generally a 10% penalty for taking money out of these retirement accounts before age 59.5, so they're not a good place for an emergency fund or routine bills.

While all that's true, cash has other uses that can make it a sensible option for a portion of your long-term retirement savings. Cash is not subject to the big price drops that can hit stocks and bonds, so it can help even out the bumps, making your portfolio's performance more stable.

It can also pay to have a cash reserve for jumping on opportunities, like buying stocks when prices are down. Cash is a good choice for new contributions when stocks and bonds look too risky, especially in accounts that offer immediate tax deductions on contributions.

And, of course, as retirement nears it's good to have enough cash to fund spending needs for a year or two, so you won't have to sell stocks or bonds during a downturn. It can pay to build that gradually, to avoid having to liquidate large stock or bond holdings if prices are down when you retire.

Finally, interest earnings on cash in an IRA or 401(k) are sheltered from income tax. This isn't a big consideration right now because interest rates are so low, but it could matter when yields return to normal. Since there are annual limits on retirement plan contributions, it can pay to build your tax-favored cash reserves over time.

Interest in a 401(k) or traditional IRA is taxed as income, the same rate you'd face in a taxable account. But in a taxable account the tax is due the year the interest is earned, while in those retirement accounts tax is postponed until the money is withdrawn, which leaves more in the account to compound. There is no tax on interest earned in a Roth IRA or Roth 401(k), since all withdrawals are tax free.

The new contribution and income limits are not exactly earth-shaking, but every little bit helps.

And, as the new year approaches, it is a good time to reassess savings plans. Many employers, for example, send out notices in the fall reminding workers they can change their 401(k) contributions for the coming year. It's a convenient time to rethink your allocation to stocks, bonds and cash.

SOURCE: http://www.thestreet.com/story/11289551/1/rethink-retirement-plans-for-new-401k-laws.html