401(k) flub: Turning down free money

(Money Magazine) -- Question: I'm 24 and my 401(k) plan matches $1.25 for every dollar I contribute up to 6% of salary. I currently contribute 3% of my salary and then put $75 a month into a Roth IRA. I do that because I don't want all my eggs in one basket. I'm wondering, though, whether I should stop the IRA contributions and take advantage of the company match instead? What do you think? --Matthew, Sacramento, Calif.

Answer: I think this is about as close to a no-brainer as you can get in retirement planning: You should take full advantage of the company match before putting money into any other retirement account.

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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)

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But don't just take my word for it. Let's run a few numbers.

Essentially, the choice you face now is whether to continue putting $75 a month into your Roth IRA or to put that money into your 401(k) instead and get the match.

But there's one important thing to keep in mind. The $75 you're contributing to the Roth is in after-tax dollars. You'll put pre-tax dollars into the 401(k).

So if we assume for argument's sake that you're in the 25% tax bracket, you're really deciding between putting $75 after-tax into the Roth or $100 pre-tax ($100 being the pre-tax equivalent to $75 after taxes for someone in the 25% bracket) plus the match into the 401(k).

If you do the Roth, you'll contribute $900 (12 x $75) after-tax over the course of a year. If you choose the 401(k), on the other hand, you'll put away $1,200 pre-tax (12 x $100) during the year. But you'll also get a $1,500 match (1,200 x $1.25) from your employer, bringing the total contribution to $2,700.

Question is, then, will you be better off come retirement time by putting away $900 after-tax or $2,700 pre-tax?

If you allow for a 7% annual return, at age 65 the $900 in your Roth account would grow to $14,420. Since you funded your Roth with after-tax dollars, you could withdraw that amount tax free (assuming you meet the criteria for tax-free withdrawals).

The $2,700 in your 401(k), on the other hand, would grow to a much larger sum, $43,261, but you would owe tax on that amount. Still, if you remain in the 25% tax bracket at retirement, you would deduct $10,815 in taxes, leaving you with $32,446 after taxes, clearly much more than the $14,420 after taxes in the Roth. If you drop to a lower bracket, you would pay even less in tax on the 401(k) money, making you even better off.

Of course, you would end up with less from the 401(k) if you were to move into a higher tax bracket. But to whittle down the $43,261 before taxes in your 401(k) to the $14,420 after taxes in the Roth IRA, you would need to face a 67% tax rate. Not impossible perhaps, given the way they're spending money down in D.C. these days, but not very likely.

Which means that, unless you expect to face a much, much higher tax rate in retirement, you're better off stopping the Roth IRA contributions and putting the equivalent amount of pre-tax dollars into your 401(k) to get your company match.

This analysis assumes that you make at least $40,000 a year. If you earn less than that, throwing an extra $1,200 into your 401(k) on top the 3% of salary you're already contributing would put you over the amount your employer will match. In other words, you would be contributing more than 6% of salary and not getting a match on the part that exceeds 6%.

But even in that case, it would still make sense to contribute whatever amount it takes to get the full match. You could then direct any extra money that wouldn't qualify for the match into the Roth.

This principle of taking full advantage of the match makes sense even if the employer match isn't as generous as your company's $1.25 for every $1 you contribute up to 6% of salary.

For example, if your employer were offering a match of 25 cents on the dollar instead of $1.25, the choice would be between putting $900 in the Roth or an extra $1,500 in the 401(k) ($1,200 plus a $300 match). In that case, you would still have the same $14,420 tax-free in the Roth at 65, while your $1,500 401(k) contribution would grow to $24,034 before taxes. So you would be ahead by $3,605 if you remain in the 25% tax bracket and your post-retirement tax rate would have to rise to 40% to knock down that $24,034 pre-tax to $14,420 after taxes, making it equal to the Roth.

As for your desire not to keep all your eggs in one basket, I'm sympathetic to that point of view. But in a case like yours I think the rationale for having different types of retirement accounts hinges not so much on safety (401(k) assets are held in trust) or access to more investment choices, but on diversifying your tax exposure in retirement.

So I don't want to discourage you from putting a portion of your savings into a Roth account. I think that's an option you should consider. But you're probably better off funding a Roth IRA only after you've contributed enough to your 401(k) to maximize the match.

Speaking of matches, I'll end with some good news on that front. According to a survey by Hewitt Associates, no employers planned on reducing or suspending their matching contributions this year, and 80% of those firms that cut or stopped their match in 2009 said they're likely to reinstate or increase the match in 2010.

So anyone out there who's pared 401(k) contributions for want of a match may want to check to see if it's been reinstated and, if so, boost contributions enough to grab that employer dough. If you don't, you're turning down free money.