honoluluadvertiser.com

Sponsored by:

Comment, blog & share photos

Log in | Become a member
The Honolulu Advertiser
Posted on: Thursday, October 30, 2003

401(k)s still great way to save despite cuts in taxes

By Jeff Brown
Knight Ridder Newspapers

 •  401(k) still solid

What $6,945 invested now will pay* out after 28 years at 10 percent a year:

In a 401(k): $671,000

In taxable account: $575,600

*This assumes no employer match. Both totals are after taxes.

Source: Vanguard Group

If you work for a company that offers a 401(k), sometime over the next month or so you'll be asked whether you want to put money into the retirement plan next year.

Given the tax cuts enacted last spring, do these tax-deferred retirement plans still make sense?

The tax cut reduced the federal capital gains tax to 15 percent from 20 percent. Also, dividends are now taxed at that 15 percent rate rather than at income-tax rates, which run as high as 35 percent.

The new law did not change the rules for 401(k)s. All withdrawals, which can start after age 59 1/2, will continue to be subject to income taxes, which for most investors are 25 percent to 35 percent.

So here's the dilemma: Profits on the same investment could be taxed at a 35 percent rate if it is held in a 401(k) but only 15 percent if held in an ordinary taxable account.

In addition, taxable accounts give you many more investment choices than 401(k)s, which typically offer only about a dozen options. Also, you can take money out of a taxable account at any time without the 10 percent penalty that generally applies if you take money from a 401(k) before you're 59 1/2.

Despite all this, the 401(k) still makes sense for most people.

There's no doubt at all if your employer matches all or part of your contribution. Without a 401(k), you simply won't get that money, which for many people is thousands of dollars a year.

But should you contribute more than that? Or should you contribute at all if you get no employer match?

In most cases, yes, you should contribute all you can afford.

This is because your contributions are subtracted from your taxable income, reducing the tax you have to pay for the year the contribution was made. You don't get that tax saving if you invest in a taxable account.

Although that 401(k) contribution will be taxed as income when you withdraw it in retirement, you could benefit from many years of compounding investment gains in the meantime.

In addition, money you would have used to pay taxes now can instead be invested.

The Vanguard Group looked at a hypothetical investor saving $6,945 a year and choosing between a 401(k) that did not provide an employer match and an ordinary taxable stock fund. See the results in the box below.

Bottom line: Put every cent you can afford into your 401(k).