Insights & Advice


Today’s 401 (K) Dilemma– Can I afford Not to Contribute

By now most companies have probably sent a memo or e-mail reminding us that it’s time to decide how much we plan to contribute to our 401(K), 403 (B) or 457 plan for this year. Most likely many of us will stall until the last day and then contribute as little as possible or nothing at all. What is it about saving that bothers us so much?

Consider my choices this year. My employer is offering to match me dollar for dollar on the first 3% of my paycheck I contribute and a further fifty cents per dollar on the next two percent of my income I put into the plan. Essentially, I’m being offered a raise for saving and yet I hesitate. Why would I turn down free money? Answer: because I can’t spend it right away, that’s why, and I have to put an equivalent amount away for what seems like a long time without touching it. Like so many other American workers, I tell myself I can’t afford it but maybe that’s not entirely true.

The maximum contribution this year for these tax-deferred contribution plans is $15,500 ($20,500 if you’re over fifty). Like an IRA, I will only pay ordinary income taxes on the money in my 401 (K) when I withdraw it at retirement. Any withdrawals prior to age 59 ½ are subject to a 10% penalty tax although there are some hardship exceptions. Unlike an IRA, automatic payroll deductions take money out of my pay before I even see it so I won’t be tempted to spend it.

So this year, before making my decision, I crunched some numbers. I immediately realized that the more money I put into my plan the less tax I’ll pay in 2008, which means my take home pay will go up. Let’s say you make $36,000 a year and pay 5 percent of that into your company’s retirement plan. You’ve just reduced your taxable income by $1,800. When tax time rolls around, you would use $32,200 as your starting point for computing the government’s annual cut and that means getting some “real” money out of this deal in the form of lower taxes.

I also found out that many plans allow you to dip into your savings in the event of a family emergency. Hardships like high unreimbursable medical expenses, educational fees and tuition, payments to prevent eviction or mortgage foreclosure and down payments on first time primary residences are allowed. Loans are another available option. You can actually borrow from yourself at a fixed rate and repay the loan with after tax payroll deductions. I compared that with the benefits of maintaining my taxable savings account yielding 4% in a local bank. No contest, my 401 (K) plan wins hands down especially when I consider the investment options.

Most plans offer a smorgasbord of investments, mostly mutual funds, which are professionally managed by portfolio managers. I can pick from a variety of stock, bond or money market funds that invest in thousands of companies, securities and other investment opportunities. In a savings account, I’m on my own and any gains I might make are immediately taxable as well.

Finally, I did a”what if” exercise. Assuming for a moment I was twenty-five again and making $40,000 a year. I contributed $10,000 a year to my 401(K) earning 10% annually. At age 65, there would be nearly $4,870,000 in my plan but if I put off participating by even five more years, that sum dropped to $2,990,000.

So here I am, pencil poised above the maximum contribution line on my 401 (K) application and still I hesitate. Sure, I recognize the benefits but how much can I really afford? And then I recalled a speech last year by the Chairman of the Federal Reserve before Congress. He warned that this nation was heading toward a retirement brick wall in social security benefits and he isn’t the first Fed chief to sound that alarm. I pictured myself with no Social Security, spending my golden years on welfare. Shuddering, I reconsidered my question. Maybe it isn’t how much I can afford to contribute but rather can I afford not to, given the state of the nation’s retirement dilemma?

Posted in Investment Styles, The Retired Advisor