Some financial experts advise pausing contributions to retirement plans when money is tight or during a debt-reduction plan. However, here's why you should always contribute to your 401(k), even if you are falling behind on your bills: To do anything else is to leave money on the table.
Thanks to the magic of compound returns, contributions to your retirement accounts become worth far more over time than they were when you invested them. Beyond that, there are other considerations that make money added to your 401(k) worth more than you might have reckoned.
The bottom line is that you should never stop contributing to your 401(k) if there is any way you can possibly help it, no matter how bad the financial crisis may be.
- Many Americans are not saving enough for retirement, and many turn to their 401(k) accounts too early.
- Contributing to a 401(k) account can help grow money through favorable tax treatment, compound returns, and employer match.
- Funds in your 401(k) account may be protected from creditors or in bankruptcy proceedings.
Tapping Into 401(k) Balances
The American retirement system is in crisis. Social Security typically covers only a portion of a retiree's financial needs. In 2021, the maximum payout for an applicant who retires at 70 is $3,895, but the average amount is far less at $1,543. Most retirees will need additional income to get by.
However, few American workers are saving enough for retirement. According to a survey from TD Ameritrade, nearly two-thirds of 40-year-olds have less than $100,000 saved for retirement. A fifth of respondents in their 70s reported having less than $50,000 in retirement savings.
Savers may also be tempted to dip into their 401(k) accounts when times get tough. If they do so before age 59 1/2, most will pay a 10% penalty tax. In the old days, you couldn't raid your pension fund, no matter how dire things became. Now, people turn to their accounts, always banking on being able to replenish the funds at some point in the future.
Above all, avoid taking an early withdrawal from your 401(k). If you do so, you may pay a penalty as well as taxes on the withdrawal.
Here is why to keep contributing to your 401(k) plan, even if you are experiencing financial hardship:
Contributions Are Often Tax-Deductible
In other words, your taxable income is reduced, so you end up paying less in tax. If you instead choose not to put those dollars aside, the federal and state governments will take a bigger chunk of your pay in income taxes. Not only will you end up with less money in your retirement account, but you'll also have less cash in your hand today. It's sort of like killing the chicken for meat now when you could live off the eggs for a much longer time.
Many Employers Match Contributions
If your firm were to give, say, a dollar-for-dollar match on the first 3% of salary, and you make $40,000 per year, you could get an extra $1,200 in pay—tax-deferred—simply by making contributions to your 401(k). If you stop, not only would you pay the higher taxes we discussed just a moment ago, but you also would forfeit that money forever.
Protection Under the Law
If you are unfortunate enough to have to declare bankruptcy, most courts will protect your retirement accounts, including your 401(k). That means the money that has been put aside will stay there while the rest of your assets are liquidated or reorganized.
If you are really in trouble, you should want to put as much as possible away in this relatively safe place, beyond the reach of many creditors.
One of the benefits of keeping money safe from creditors is that if you are financially wiped out for any reason, you would have a chance at starting over ahead of the game, with investments pumping out passive income for you.
Long-Term Tax Advantages
Over long periods of time, the tax advantages brought by a 401(k) can result in far more wealth than if you had held your stocks or mutual funds in a taxable brokerage account. If you stop contributing to your 401(k) plan, you lose all of the time value of money compounding that would have gone to you.
The Balance does not provide tax, investment, or financial services or advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk, including the possible loss of principal.