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.

But now, because the federal government is running deep deficits, many experts worry that tax rates will go up. President Obama has promised not to raise taxes on households earning less than $250,000 a year, but there’s no telling what the government will do by the time you’re ready to make withdrawals 10, 20 or 30 years from now.

Normally, the tax deferral on 401(k) contributions and earnings is valuable because it allows the investor to avoid tax at the relatively high rates of the present to instead pay at lower rates in retirement. But if rates will rise, it might be better to pay at today’s rates instead of high rates in the future.

Investors who believe income tax rates will go substantially higher can consider forgoing their 401(k)s in favor of taxable accounts filled with holdings subject to long-term capital gains rates rather than income tax rates used for 401(k)s. While capital gains rates could change as well, they tend to be lower – a 15% maximum today compared to 35% in the top income-tax bracket.

Capital gains are profits from holdings like stocks, bonds or mutual funds, sold for more than they cost. Because the capital gains tax is not due until after the investment is sold, you can get the same tax deferral you would in a 401(k) by investing in things like stocks that appreciate over time.

Under today’s rules, profitable stocks like Google (Stock Quote: GOOG) and Green Mountain Coffee Roasters (Stock Quote: GMCR) would be taxed at the 15% long-term capital gains rate held in a taxable account, or at the income tax rate as high as 35% in a 401(k).
So, if your employer cuts or eliminates matching contributions, and you expect your tax rate to rise, the 401(k) has far less appeal than it would otherwise.

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