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When You Should Opt Out of a 401(k)

Should you invest in a 401(k)?

Sure. Absolutely. All the experts say so.

That’s probably true for most people most of the time, but not always. These days, investors are wise to focus on a couple of factors that have changed (or might soon), making 401(k)s less appealing: tax rates and the availability of matching contributions from employers.

A survey done late in the winter found that about a third of employers that offered 401(k)s had either cut back or eliminated matching contributions in 2008, and that more than a quarter planned to do so during the following 12 months.

Financial advisors have long urged investors to put at least enough into their 401(k)s to get the maximum match offered by the employer. Otherwise, you’re just leaving money on the table.

While formulas vary, many companies contribute 50 cents for every dollar put in by the employee, up to a maximum of 3% of pay. An employee earning $50,000 could thus put in $3,000 and get $1,500 from the boss, supercharging gains over the decades.

But what of there is no match?

The 401(k) still offers benefits. First is the tax deduction on contributions. Put $3,000 in and you’ll save $600 in taxes, assuming a 20% tax bracket. You get this deduction even if you take the standard deduction rather than claiming itemized deductions. That’s a good deal, because many itemized deductions, such as the one for mortgage insurance, can’t be taken if you opt for the standard deduction.

But 401(k) contributions are really just tax-deferred, not tax-free. They are taxed at ordinary income tax rates when you make withdrawals in retirement.

Which raises the second issue, taxes. Investors and financial planners have generally assumed that most people will find themselves in lower tax brackets after they retire, since their income from investments, pensions and other sources is likely to be smaller than in the prime working years.

Read More:   401k, retirement, your nest egg
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