If someone offered you free money, would you say no? Probably not. It may not seem like it now, but that's exactly what you're doing if you don't contribute to your 401k. There are several benefits to a 401k plan, which we will review, and every financial planner will tell you to invest in one. So, instead, let’s talk about something you are less likely to discuss—when you should stop contributing to your 401k. Before we get there, though, let’s take a look at why you’re participating in a 401k plan in the first place. Here are a few of the best perks.
- 401(k)s provide two separate tax breaks: You get a tax deduction for contributions, and your money grows untaxed until you take withdrawals.
- Many employers will match at least a portion of your 401(k) contributions, and that’s more or less “free” money.
- The tax-free growth and those extra employer contributions will stall when and if you stop contributing more money to your 401(k).
- Most experts recommend contributing to your 401(k) for at least as long as you’re working.
You get two tax breaks when you save in a 401k plan. First, the money you contribute is tax-deductible, meaning that what you contribute to a 401k this year will not be taxed as income this year. You will not pay taxes on the funds contributed until you withdraw the funds, typically in retirement. Your savings grow faster because they are tax-deferred. Your 401k enjoys compound growth untouched by the taxman until you retire and begin withdrawing the money.
Saving Made Easy
Investing in your 401k is “paying yourself first” because it ensures that you are supporting your future wealth. Steady saving is also one tactic that millionaires employ. It’s also an easy way to save since your employer deducts your 401k contributions automatically from your paycheck so you won’t need to remind yourself to write a check. After a while, it’s likely you won’t even notice the money missing from your paycheck. Without a 401k, you’d have to set up a retirement account and consciously take out your contribution every month, which, let’s be honest, won’t happen the month you take a spontaneous vacation, have to make an unexpected repair or purchase a big-ticket item. Plus, you are limited by the amount you are allowed to contribute to a retirement account, such as an IRA.
The 401k’s “forced savings” aspect also allows you to take advantage of dollar-cost averaging. Putting it simply, you consistently use the same amount of money to buy securities over time and this tends to lower the average cost of all of your shares. The market is consistently swinging, but putting money in on a regular basis via a 401k allows you to purchase shares when prices are low and will likely bounce back up later on. Since 401k investors are contributing to every paycheck, this is the default strategy.
To encourage participation, in many cases, an employer will match a portion of your 401k contributions. Let’s say your company matches 70% of your 401k contributions up to 6% of your salary. If you make $100,000 and contribute $6,000 (6%) the company will pitch in $4,200. Now that is a deal you don’t want to pass up!
Good Saving Habits
Saving today via a 401k gets you into the habit of living frugally. For example, if you make $80,000 and contribute 20% to your 401k, you’re actually living on $64,000. (Just be sure to watch out for the contribution limits.) That life-long practice will pay off in your later years by allowing you to actually enjoy your post-career life on less income, which can help make your retirement money last longer.
Now let’s talk about what happens when you stop contributing to your 401k. You guessed it—most of the above benefits go away.
- No more reduction in taxable income
- No more employer contribution
- No tax deferral on your additional retirement savings
- No more paying yourself first
Stopping your contribution dramatically slows the growth of your retirement money. It may feel good now to have that extra cash in your checking account, but when it's time to retire don’t you want to have saved as much as possible?
So when is the right time to stop contributing to your 401k? The answer is the day you stop working. Take full advantage of the 401k plan your employer offers. A program that lets you save tax-deferred and, possibly, collect free money through an employer match can put you on the path to your dream retirement.