Beware of higher tax bill before dropping 401(k)
DES MOINES -- With economic pressures mounting, you may think reducing your 401(k) contribution is an easy way to add money to your paycheck. But before you do, consider how it will increase your tax bill.
Many people have become so focused on the recent losses of 30% or more in their account balances that they've forgotten a primary benefit of contributing to a 401(k) or an IRA is a lower tax bill.
It's a mistake to let short-term market lapses deter you from planning for your future and saving on your tax bill now.
"There is a backlash against the market, and against investing, but there shouldn't be a backlash against saving," said Dennis Suckstorf, a financial planner with Financial Advantage Inc. in Columbia, Md.
Let's say, for example, you're single and make $60,000 a year. Let's also assume you're contributing 6% of your income in a state where the income tax rate is 7%. In the end, you're saving yourself about $96 a month or $1,152 a year in taxes.
If your employer matches a portion of your contribution, you gain even more benefit because you're not taxed on the contribution which can grow in your account.
But the recession has taken a toll. An increasing number of people are halting contributions. About 6% of participants stopped putting money in their accounts in 2008, said human resources consultant Hewitt Associates. That's about twice the normal rate in recent years, said Pam Hess, director of retirement research for Hewitt, which analyzes 1.5 million retirement accounts.
Those who hoped to see that money in their paycheck may be disappointed to see just a portion because they didn't figure in the tax advantage.
"It's not dollar for dollar. They're not going to turn their contribution off and magically get all this money back in their paychecks," she said. "Being tax free is a huge benefit."
Others have simply scaled back their contributions. Hess said the average savings rate dropped from 7.8% of pay to 7.4% in 2008.
"People want to panic but they don't know how," said Richard Thaler, professor of behavioral science and economics at the University of Chicago's business school. He said the relatively low number dropping out or reducing contributions shows that people are befuddled by the market and unsure what to do.
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