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Currently, I am contributing 15% to my 401(k). My company has decided to no longer match our 401(k) contributions. They contributed up to 6%. Many of my coworkers are no longer contributing to their 401(k)s because of the lack of matching. I am continuing to contribute inspite of no matching. The way I'm looking at is: I'm still ahead because all of the money I put in is pre-taxed, so, it's still free money in my pocket later on. My co-workers who have stopped contributing think I'm crazy. Am I right in my thinking or should I stop contributing and roll my money over to somewhere else?
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Am I right in my thinking or should I stop contributing and roll my money over to somewhere else?

It's going to depend on what your investment options are in your 401(k). If all of the choices available in your 401(k) perform poorly, it won't matter that the money invested was tax deferred.

If you have the same choices available to you in your 401(k) that you would choose in a self-managed account, the question then comes down to what your tax rate is now vs. when you retire and start withdrawing money from the 401(k). If your tax rate when you retire is the same as it is today, and you have the exact same investing options available to you, it won't matter whether the money is invested in the 401(k) or an IRA or a taxable account.

The problem with many 401(k)'s (like mine) is that the investment choices aren't that good. If that's the case, you're better off investing the money in your own taxable account and moving your existing 401(k) money to an IRA. Of course you have to decide for yourself whether the investment choices available in your 401(k) are "good" based on your investment goals.

Wot
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...My co-workers who have stopped contributing think I'm crazy. Am I right in my thinking or should I stop contributing and roll my money over to somewhere else?

I contribute eventhough my company rarely contributes. For every $1.00 I put in it cost me only~$.70 in pre-tax $$. It's my way of saving painlessly. You cannot roll over until you leave your current employer.

TB
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You're right.

But you mention that it's free money in your pocket later on.

The fact of the matter is that it's free money in your pocket right now. Because of your contributions you are paying out less in income taxes. Granted, the match is really nice, but you are still putting that money that was going to Uncle Sam in your pocket.

Also, you may benefit from a new tax credit this year for contributions to retirement plans, 401(k)s included. If your adjusted gross income (that amount at the bottom of the front page of the Form 1040) is below $50,000 you may be eligible for a credit on your tax return in addition to your normal tax break.

Also, many people forget that by virtue of contributing to a 401(k) plan they are making it more likely that they will be able to deduct contributions to an IRA account.

When my company started its 401(k) plan there was no match either. Now they have consented to match 25% of the first 6% of employee contributions. I've always contributed the max. I consider the match gravy.

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I am assuming that your 401K investment options and fees are reasonable. If there are problems with the 401K and your company does not match contributions then it would reasonable to stop contributing.

Most who have stopped contributing are probably spending the money plus paying additional income tax. Eventually, they will regret not continuing to contribute.

If your company does not match contributions then you might consider reducing your contribution and fund a ROTH IRA. Since you are convered by a 401K the income limits for a deductible IRA are low and therefore a 401K would be a better choice than a traditional IRA.

Debra
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The way I'm looking at is: I'm still ahead because all of the money I put in is pre-taxed, so, it's still free money in my pocket later on. My co-workers who have stopped contributing think I'm crazy. Am I right in my thinking or should I stop contributing and roll my money over to somewhere else?

The 401(k) contributions are usually pre-tax which, if you are close to the income limits for a Roth IRA, would help by lowering your income as far as the limits are concerned. However, the tradeoff for pre-tax contributions to your 403(b) or deductible contributions to a Traditional IRA is that distributions (withdrawals) in retirement will be taxed at ordinary income tax rates. So this isn't free money later on.

If you think your retirement tax rate will be higher than your current working tax rate, it may make sense to maximize Roth IRA contributions, even if you might have to reduce your 401(k) contributions. With the Roth IRA, you pay taxes now, when your tax rate is lower, before that money goes into the Roth so you can have the distributions from the Roth be tax free in retirement.

On the other hand, if you expect your retirement income tax to be lower than your current working tax rate, you may want to make use of pre-tax investments first, such as your 401(k) or, if your income levels allow for it, deductible contributions to a Traditional IRA. The 401(k) usually allows for much larger contributions. The idea is to defer taxes until you expect that your income tax rate will be lower.

If you expect your retirement tax rate to be pretty much the same as your current working tax rate, it is a wash after tax considerations between the after-tax/tax-free accounts (Roth IRA) and the pre-tax/taxed-withdrawals accounts (401(k), Traditional IRA funded with tax deductible contributions), other factors being equal. Roth allows withdrawal of regular contributions at any time without tax and without penalty (but it is a different story with the earnings), but the 401(k) enjoys ERISA protection from creditors (except IRS and divorce).

Taxable accounts (after tax money is used for investing, the gains then get taxed at either capital gains rates or at ordinary income tax rates, depending on the nature of the growth) don't work out as favorably as the above "tax favored" accounts over the long run, other factors being the same, but then there are no income limits, no withdrawal age limits, lots of flexability, but at the tax penalty, and also with potential on-going tax obligations (e.g., dividends and realized capital gains are taxable in the year they occur).

Other factors are often not equal. As mentioned by another poster, if the investment choices inside the 401(k) are poor (e.g., high expenses or lags the average for what that particular choice invests in), it may be better to skip the 401(k)--if the expenses are high enough or the returns are significantly below similar types investments, the tax-favored advantage might end up not being an advantage after all.

There are some other things one might consider:

1. Whether a 401(k), Roth IRA, taxable investments, or a combination of all these, they are investments (or at least savings). Treat them as serious business--learn your options, develop an investment strategy that you can stick with, and stick with it! (Counter example: I was in an expensive 403(b) plan for a couple years before I started seriously considering expenses, and then when I realized I could switch 403(b) providers for lower expenses and higher returns, I had missed about $1500 in the higher expenses and surrender charges that I wouldn't have had if I had started with my current 403(b) provider.)

2. Payroll deduction is a great way to save or invest. If one doesn't have the discipline to save or ivnest on one's own, having Payroll provide the mechanics to keep the money out of your hands really does help! (I have managed to save, maybe, $2K over the past 23 years. But you wouldn't know that if you look at my accounts--my credit union, my 403(b) provider through our Payroll department, and my taxable investments do my savings for me, that is, they get a good chunk of my money before I get a chance to foolishly sqander that cash!)

3. I am trying to recall if it were 75% of retired Americans are living below the poverty line. Whatever the number is, the vast majority of Americans are financially unprepared for retirement. By saving and investing now, you are taking steps to have a decent retirement instead of eating cat food or dumpster diving dinners in your cardboard lean-to.

4. Don't lock too much into retirement! It is recommended that one pays off all consumer debt (non-house, non-student loans), build up a fully-funded emergency fund (typically the equivalent of 3 to 6 months of living expenses), and save or invest for pre-retirement goals without forsaking the retirement goals.
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Of course the employer match is an advantage! But my message #15408 applies after contributing up to the matched amount.

I don't think you are foolish to contribute more than matched by your employer, but I don't know the details of your 401(k) plan. I contribute to my 403(b) and Roth IRA right up to their respective limits, and I don't get a cent of matching.

The usual recommendation (assuming decent 401(k) choices, retirement tax rate roughly same neighborhood as current working tax rate) is:

1. Contribute to the 401(k) at least up to the amount matched by your employer.

2. Contribute to the Roth IRA up to your legal limit. Not only can you withdraw your Roth IRA regular contributions at any time for any purpose, no tax nor penalties (though for investment purposes it is good to keep as much money invested as long as possible), but also since you can open a Roth IRA at just about any financial institution you wish, you have far more investment choices than in a typical 401(k). I often use the example that I have a great 403(b) provider but it is light on the small cap arena, so my Roth IRA is overweighted in small caps to help balance my overall portfolio.

3. If you still have money to invest for retirement, and if the expenses and returns in the 401(k) are reasonable in light of what other funds investing in similar investments are doing, contribute to the 401(k) up to your legal limit.

4. If you still have money to invest for retirement, taxable investments may make sense. Or it may make sense to pay down one's mortgage. Many people do some of both.

But as my previous message indicated, there can be tax considerations (and not mentioned: estate planning considerations, financial aid considerations) that one might want to do things in a different order than listed in #2-#4 above.
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MarleysGhost,

You wrote, The fact of the matter is that it's free money in your pocket right now. Because of your contributions you are paying out less in income taxes. Granted, the match is really nice, but you are still putting that money that was going to Uncle Sam in your pocket.

Actually, it's not free money at all. You just get to pay your taxes on the income later. And if you plan it you might get to pay less in taxes, relatively speaking.

And, Also, many people forget that by virtue of contributing to a 401(k) plan they are making it more likely that they will be able to deduct contributions to an IRA account.

How is that? You can't contribute to a conventional, tax-deductible IRA at all if you or your spouse contribute to a 401(k). Roth IRA contributions aren't tax deductible, so I assume you're not talking about them.

- Joel
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You can't contribute to a conventional, tax-deductible IRA at all if you or your spouse contribute to a 401(k).

Unless the rules have changed without my noticing (a possibility), one can make a deductible contribution to a traditional IRA, subject to a cap on the AGI. Relatively few people (a) have sufficiently low income to qualify and (b) max out their 401k contribtion and (c) have cash left over to put into an IRA, but it is possible within the tax code.


JDOyster
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Hi Joel:

On point #1, yes, you're quite correct. I should have said that the contributions represent additional money in your pocket right now. Not free money. However, I'd still rather have use of that money now than later.

On point #2, in fact you may contribute to a traditional IRA even though you contribute to a 401(k) plan. The issue is whether or not you may deduct the contribution.
Depending on your income, your 401(k)contributions may help you deduct all or part of your traditional IRA contributions.

A simple illustration: (single employee)

(sorry for the clumsy appearance)

Employee A (contributes 6%)

Gross Salary $29,000
401(k) contr (1,740)
Taxable Salary to line 7 Form 1040 $27,260


Employee B (contributes 15%)

Gross Salary $29,000
401(k) contr (4,350)
Taxable Salary to line 7 Form 1040 $24,650


Assuming no other income, and since the phaseout range for deductible contributions for a single taxpayer who is a member of an employer's plan is Adjusted Gross Income between $25,000 and $35,000 Employee B deducts all traditional IRA contributions up to $3,000 for 2002.
Employee A may only deduct 78% of any traditional IRA contributions ($7,750/$10,000). This may be a small amount, but it's the basis for my statement that your 401(k) contributions can help you max out any traditional IRA contributions.
The phaseout range is higher if your married filing a joint return.
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In addition, I forgot to mention that you may contribute to a traditional IRA even if you are a member of an employer's plan and your salary exceeds the phaseout ranges, but the contribution will be non-deductable, becoming part of the owner's basis in the IRA, and therefore non-taxable upon withdrawl.

Here's where it more advantageous to contribute to a ROTH, since it does not force the owner to draw down the balance upon the owner reaching the year in which he/she turns 70.5.

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In addition, I forgot to mention that you may contribute to a traditional IRA even if you are a member of an employer's plan and your salary exceeds the phaseout ranges, but the contribution will be non-deductable, becoming part of the owner's basis in the IRA, and therefore non-taxable upon withdrawl.

Here's where it more advantageous to contribute to a ROTH, since it does not force the owner to draw down the balance upon the owner reaching the year in which he/she turns 70.5.

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As far as I'm concerned, if you have any more than 10+ years and you DON'T NEED the deduction, the ROTH IRA is the way to go. I put as much as I can into my 401k (15% = @ $7k per year) and then max out the ROTH contribition on a weekly transfer basis. It's easier to pay myself this way than to find the $2k+ each eyar to fund the IRA. Plus, my ROTH is a brokerage account so I'm constantly adding cash to the trading account.

The 401k is diversified across all the major fund types (small-, large- and mid-caps, international, total bonds and total stock {aka index}) so that with DCA (dolar cost averaging) I'm picking up the shares at various discounts in relation to the markets preference.

Unfortunately my employeer does not match any funds going into the 401k. Damn. I used to work for a bank that match 100% for the first 6% deposit. 100% return!! I saved so much in 10 years there, it was real nice....

No matter what, put it away now, how ever you can. if you absolutely need the tax deduction, then I would fund your regular IRA first then the 401k. Calculate/estimate the amounts needed to deposit into each account type without going over the limits...And, remember, the 401k caps are going up...

cat
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