How to Invest Pretax Withholdings

by Dale Bye, Demand Media

    Figuring out your pretax withholding investments – whether they're in a 401(k), a 403(b), thrift savings plan or some other employer-sponsored plan – boils down to two basic questions: How much do you withhold and where do you put it? For both questions, keep your approach simple by settling on a strategy and sticking to it.

    Basic Training

    The arithmetic might be a little complicated, but using your pretax dollars early and often carries two advantages: the value of tax deferral and the gift of compounding returns. For each pretax dollar you invest, it costs you only 70 cents or so in take-home pay, depending on state taxes. For example, if your take home pay is $1,000 per week, diverting $100 to your pretax retirement plan saves you roughly $25 in federal tax and another $5 or so in state and local taxes. You save $100, but your take-home pay drops only to $930. If you invest that $100 every week for 40 years, and you figure in a conservative 6 percent annual return, you'll retire with nearly $865,000 in your account through compound growth. Now let's say you wait 15 years before you start saving money for retirement. To get the same $865,000 in retirement funds with only 25 years of savings, you'd need to put away $288 a week.

    Make that Match

    If your employer matches a percentage of your pretax retirement plan contributions, don't turn down free money. Contribute enough to get all the company offers. If the company offers matching contributions up to 5 percent of your paycheck, divert at least that percentage to your pretax account. Any additional contributions beyond what you need to capture the match depends on your financial situation and budget.

    Easy Does It

    You're likely to have several investment options in your pretax retirement plan. If you don't believe you have the expertise or desire to be a stock or fund picker, there's often an easy choice: lifestyle mutual funds in which the mix of assets – stocks, bonds, cash – is pegged to your age or retirement year. As you get older, the fund gradually lowers the percentage of riskier, but higher growth-potential investments, such as stocks. A lifestyle fund's purpose becomes distorted if other funds are chosen at the same time because the asset allocation ratio gets out of whack.

    Roll Your Own

    If you're comfortable selecting your own investments, most experts recommend a diverse asset mix. One rule of thumb suggests a bond percentage equal to your age, but other advisers suggest a more aggressive allocation in which the percentage of stocks equals 120 minus your age. Whatever direction you choose, the selections should include some funds featuring large companies and some funds from small holding companies. Bond funds should be mixed between government- and corporate-issued securities.

    Plenty of Company

    Steer clear of buying company stock with pretax withholdings, especially if your employer's match comes as company stock. Your job gives you plenty of investment in the company's future. If the company does well, your chances for pay hikes go up, too, which gives you a chance to boost your savings. If the company fares poorly, you don't want your retirement savings to do down the drain along with your job.

    About the Author

    Dale Bye has spent more than 40 years in journalism, including 25 supervising reporters and editors at metropolitan newspapers and eight years as senior managing editor at a national sports magazine. He directed five newspaper-sponsored personal finance fairs. His fields of expertise include business and personal finance, sports, fitness and theater. Bye holds a Bachelor of Journalism from the University of Missouri.