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I now contribute the maximum allowed to my 401(k), which is 20 percent of my salary. Would I be better off reducing my 401(k) contribution to 10 percent and putting the other 10 percent in a savings account? I'm 62 and plan on working three more years.
-- Name withheld
A recent report from consulting firm Buck Consultants revealed that after three years of a bear market many workers are shying away from their retirement plans. Indeed, the survey showed that the percentage of workers contributing to their 401(k)s dropped to its lowest level since the early 1990s (although that percentage is still a relatively high 73 percent).
But still, unless I'm missing something here, I can't think of any good reason why you should stop contributing to your 401(k) in favor of a savings account. Let's think about this.
Thems the tax breaks
When you contribute to your 401(k), you get an immediate tax break because you're investing pre-tax dollars. What's more, any earnings your contributions generate also compound tax-free. Yes, you'll pay tax on those dollars when you eventually withdraw them. But in the meantime, you have all of your money working for you, not just the earnings minus Uncle Sam's take.
Over the course of many years, that tax-deferral can be quite valuable. And though you're approaching retirement age, we probably are talking a very long time assuming you're going to pull money out of your 401(k) gradually after you retire.
But what happens if you put 10 percent of your salary into a savings account? Well, you'll have to pay taxes on that 10 percent of salary, which means you won't be stashing as much away to begin with.
Let's say, for example, you're in the 27.5 percent federal tax bracket. That would mean that, after taxes, you wouldn't have 10 percent of your salary to stick in a savings account. You'd have 7.25 percent (10 percent minus 27.5 percent for taxes). And any interest earnings your savings account generates would be taxed each year, as opposed to escaping taxes until withdrawal as is the case in a 401(k).
Roth IRA vs. 401(k)
I suppose you could make an argument for cutting back some of your 401(k) contributions and funneling the money into a Roth IRA. In that case, the money you contribute to the Roth wouldn't get an immediate tax break. You would be investing after-tax dollars. But you could eventually withdraw your contributions and earnings tax free.
A Roth would make sense if you figured you'll likely be in a higher tax bracket during retirement than you are now. The reason is that you would be, in effect, arbitraging tax rates, paying taxes now at a lower rate and escaping taxes later when your tax rate is higher.
Keep in mind, though, that you're limited to a $3,000 maximum contribution to a Roth for the 2002 and 2003 tax years, although since you're older than 50, you can also throw in an extra $500 "catch-up" contribution each year. For more on the 401(k) vs. Roth issue and a look at some other reasons you might want to consider a Roth, click here.
But maybe you're thinking of making this switch for safety reasons -- that is, you want to hunker down in a savings account rather than subject your savings to the vagaries of an uncertain stock market. But even then I don't see how the move makes sense.
Why? Well, virtually all 401(k) accounts offer some investing option that offers stability and capital preservation, usually a money market fund or a stable value fund (see more on these vehicles in "How safe is your safe haven?"). So if you want to protect a portion of your money from stock market volatility, I think you should still be able to do that within your 401(k).
And if your 401(k) doesn't offer such an option, then you're still better off opening a Roth IRA (or even a traditional IRA) and finding a secure option there rather than foregoing the tax benefits of a tax-sheltered account altogether.
One final thought: it's understandable that many investors are spooked by today's markets. I suspect that's why participation in 401(k)s is down and why many people are looking for safe havens. But I think it's also important for investors to consider the possibility that perhaps now is a good time to take some reasonable risks with money they'll be investing for the long term. (I include you in that long-term group since a man your age has a 50-50 chance of living into his 80s and pretty decent odds of living well into his 90s.)
You can argue about whether stock prices are at bargain levels now or not. But I think it's a given that they're more attractively priced than they were in the late 1990s when people couldn't get enough of stocks. And buying after major downturns has proven to be a good bet in the past for investors with long investing horizons.
So don't be too quick to abandon your 401(k), and don't get so obsessed with finding a short-term safe haven that you jeopardize your chances of getting long-term growth.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday afternoons at 4:30 pm on CNNfn.