We had a recent influx of cash, and our income has increased dramatically in the last two years. We have $20,000 in the bank – half of which is in an interest-bearing account (earning 5 percent), and we will earn about $170,000 this year. We are about 40 years old, married, two kids (no college fund yet), and have a mortgage. I have a 401(k) account with less than $10,000. We fear the possibility of alternative minimum tax (AMT). How should we structure our portfolio for growth in the time we have before retirement, and what strategies do you recommend to lower our taxable income? Also, any ideas on college funds?
M.M., via e-mail
A: Tom Vautin, a certified financial planner in Salem, Mass., would use these changes as an opportunity to kick your savings program into gear.
One good method of saving in a tax-efficient manner would be to further contribute to your employer-sponsored 401(k) plans because those contributions are deductible from your gross wages.
The maximum contribution per person for 401(k) accounts in 2007 is $15,500 (plus $5,000 if over age 50). So if both of you have 401(k)s, you could save $30,000 and defer that income from taxes this year.
To some degree, you need to make up for lost time, so Mr. Vautin suggests contributing the maximum. And if your employer matches a portion of your contributions, make every effort to pay in at least enough to get the full match – it's free money!
Based on assumptions he used regarding your income and deductions, Vautin believes that $15,000 in total contributions to your 401(k) accounts would save you roughly $3,500 to $4,000 in federal taxes this year. At the $30,000 level, the savings is twice as much, and if your state has an income tax, these retirement contributions may reduce your state tax liability as well.
Depending on the types and amounts of itemized deductions you have, you may be subject to the AMT. In many cases, however, the greater your retirement contributions, the lower your chances of having to pay AMT.
If your retirement time horizon is relatively long, your retirement investments should be weighted mostly toward stocks with a smaller amount allocated toward bonds to help dampen large fluctuations in your portfolio. For the stock exposure, your investments should be made across a wide spectrum of small-, mid-, and large-cap stocks in both domestic and international markets.
As for college savings, 529 plans can be a great way to accumulate money. Earnings from your investments will grow tax-deferred, and withdrawals are tax-free if the funds are used for qualifying education expenses.
Because loans, financial aid, and/or grants may be available to help fund college expenses, your best bet is probably to ensure that you adequately save for retirement before saving for college. When you begin exploring 529 plan options, consider those plans that have a combination of low expenses and a wide variety of investment options.
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