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.

"Taking all your money and putting in the bank even sounds scary now," Thaler said. "So freezing in place is the gut reaction people are having."

The long-term implications aren't clear. Trade groups and organizations tracking 401(k) trends are keeping a close eye on another trend they find equally disturbing. Specifically, they're concerned about how many of the nation's 5 million unemployed workers are handling their retirement savings.

"If you lose your job nobody would blame you for stopping contributions until you find another job," Thaler said, "but I think people would be ill advised to pull the money out if there's any way to avoid it."

When a worker loses a job the 401(k) balance can be rolled over to an individual retirement account, which offers many of the same benefits of an employer sponsored plan.

Cashing out a 401(k), however, before age 59½ is costly. You'll have to pay a 10% penalty and the taxes due on the money. You basically give up more than a third of your money to the government in most cases.

Hess of Hewitt Associates shares that concern. Statistics show nearly 80% of workers with less than $10,000 in their 401(k) cash out the account when they leave a job rather than roll the money into another retirement account. Those workers could end up with little or no retirement savings if they keep doing that, she said.

"It has long-term implications and should only be done as a last resort," Hess said.

Suckstorf, the Maryland financial planner, said many workers today have little choice but to continue putting money aside for the future. Most workers don't have pensions and the Social Security system will likely not provide the level of support for future retirees as it does today since current projections show the fund will begin to fall short in 2017.

"It may sound cliché, but somewhere down the road you're going to end up being a ward of the family or the government if you don't do something," Suckstorf said.

Follow the advice of financial planners and contribute at least at the level of your company's match if you can. Don't lose sight of the primary reasons for putting money into your 401(k) account — a comfortable retirement income and the tax benefits you're getting now.