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Making up your employer's match

If your employer has cut back on matching 401(k) contributions, think about making up the slack.

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By Walter Updegrave, Money Magazine senior editor

Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

NEW YORK (Money) -- Question: My company currently matches my 401(k) contributions dollar-for-dollar up to 5% of salary. But starting in January my employer plans to do away with the match due to the poor economic conditions. I'm still early in my career and don't want to cut back on my retirement savings, so I plan on picking up the slack. I wonder, though, whether I should contribute an additional 5% of salary to my 401(k) or put the extra savings into a Roth IRA. What do you think? --Wes, Conshohocken, Pennsylvania

Answer: If it's any consolation, you're not the only one facing this sort of cutback. Many companies have resorted to eliminating or reducing matching contributions in this recession, shifting more of the burden of building a nest egg to individuals.

But there is also a bit of good news on this front: A recent Watson Wyatt survey found that 35% of companies plan to reverse reductions to their 401(k) match in the next six months. This is up from just 5% as recently as June, which suggests more companies are restoring their match as the economy improves. So with a bit of luck -- and more progress on the economic front -- perhaps your company will also begin kicking in matching funds again before too long.

In the meantime, though, I think you're absolutely right to ratchet up your own savings effort to compensate for the missing match. Indeed, responding that way is especially important when you're young, since failing to do so means you'll not only be short the amount of the employer match itself, but the investment earnings that money would have racked up over the years.

If you think that won't add up, consider this: Failing to replace $5,000 in matching funds for just one year would leave you with a nest egg 30 years from now that's about $38,000 smaller, assuming a 7% annual return.

As for whether you direct your extra savings to your 401(k) or a Roth IRA, I don't think there's a definite right or wrong answer. As I've noted before a Roth is usually a better choice if you think you'll face the same or higher tax rate in retirement than you do now. That's because you would be paying tax at a lower rate today on the money you contribute to a Roth and avoiding a higher tax rate when you withdraw your contributions and earnings tax-free later on (assuming you meet the criteria for tax-free withdrawals).

Of course, it's tough to know what tax rate you'll pay many years in the future. (Hell, we can't really even be sure what tax rates will be a year or two from now.)

Generally, though, if you're a young person with decent earning prospects, I think it's reasonable to expect that you'll face the same or higher tax rates later in life. For that reason -- the fact that it's a good idea to hedge your bets by having money in tax-deferred accounts like 401(k)s as well as tax-free accounts like a Roth -- I can see the case for contributing to a Roth IRA as a complement to the 401(k) stash you already have.

That said, putting your extra savings into a Roth IRA makes sense only if you put your extra savings into a Roth IRA. I'm not trying to come up with one of those wacky Yogi Berra quotes. I just mean that getting the cash into a Roth IRA requires a little more effort than with a 401(K), which automatically deducts the money from your paycheck. You've got to open the Roth IRA account and then fund it. If you think you might not follow through with your plan to throw the extra savings into the Roth, then I'd say you're better off just boosting your contribution to your 401(k). At least that way the extra money is being saved.

There are a couple of other things you'll want to consider if you're leaning toward the Roth.

You'll want to see if your income falls within the eligibility limits for contributing to a Roth IRA. If your income exceeds the threshold next year, you can still do an end run around the rules by contributing to a nondeductible IRA and then converting to a Roth IRA (although calculating the taxes due when you convert can get tricky if you have money in other non-Roth IRA accounts).

Remember too that you contribute after-tax dollars to a Roth IRA as opposed to pre-tax dollars with a 401(k). That means that contributing the same amount to a Roth IRA as to a 401(k) will leave you with less after-tax income.

For example, if you're in the 25% tax bracket and contribute $5,000 to a 401(k), you're effectively giving up $3,750 in after-tax dollars -- the $5,000 you would have had if you hadn't done the 401(k) minus the 25% you would have paid in income tax on that $5,000. Contribute $5,000 to a Roth IRA, on the other hand, and you'll have $5,000 less in after-tax income since your Roth contribution is made with dollars you've already paid tax on.

So as a practical matter, you would be giving up an extra $1,250 in current after-tax income ($5,000 vs. $3,750) by doing the Roth IRA in this scenario. Whether or not that's a worthwhile tradeoff -- less after-tax income today vs. tax-free withdrawals in the future -- comes down mostly (though not exclusively) to what tax rate you think you'll face in the future. But if your budget is already tight, you may want to take the Roth's effect on your current income into consideration in figuring how much to contribute to a Roth IRA or in deciding whether to do one at all (although, if push comes to shove, Roth distribution rules do allow you to withdraw your original annual Roth IRA contributions at any time without tax or penalty).

Bottom line: Because I'm a big fan of diversifying one's future exposure, I'd probably be more inclined to go with the Roth IRA if I were in your situation. But it's not as if I think you'll be doing yourself in if you decide to just go with your 401(k). The most important thing is that you save the extra bucks somewhere to make up for the lost match. Do that, and you'll be improving your chances of a secure retirement no matter which option you choose. To top of page

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