If you’ve spent more than 32 seconds listening to any sort of retirement advice, you know we financial planners love us some 401k. We’re like a broken record on the awesomeness of this tax-deferred savings vehicle. If a financial planner had written The Princess Bride, the line would have been, “You fell victim to one the two classic blunders, the best known of which is, ‘Never miss a chance to grow your retirement by participating in your employer’s 401k plan.’”
So, we’re going to assume you got that message. Instead, let’s talk about when you should stop contributing to your 401k. Yes, stop contributing. That’s a real thing, worthy of discussion. Let’s start by looking at exactly why you are participating in a 401k.
Tax-savings: The money you contribute to a 401k this year will not be taxed until you withdraw it in 30 or 40 years. If you make $46,000 in 2016, and stash $4,600 (10%) in your 401k, your taxable income instantly drops to $41,400.
Tax-deferred growth: Similarly, your 401k enjoys compound growth unmolested by the taxman until you retire and begin withdrawing the money.
Forced Savings: Participating in a 401k is the perfect way to “pay yourself first,” to ensure that you are contributing to the future before the present takes its giant cut of your paycheck. Because the boss man deducts your 401k contribution from your paycheck, you never have a chance to spend it.
I’m not suggesting you lack discipline… but stop and think about the hassle of regular long-term investing without a 401k. You’d have to set up a retirement account and have your monthly contribution debited from your checking account every month… except that month when you are supposed to go to Cancun… and the one (TBA) when your car engine blows up.
The 401k’s “forced savings” aspect also allows you to take advantage of another thing that gets us financial geeks all revved up: dollar cost averaging. While the market has moved steadily upwards for decades, that progress is marked by both ups and downs. By putting money into the market on a regular basis via the 401k, you take advantage of those market dips by purchasing shares on the cheap that will likely bounce back and move higher.
Free money: In many cases your employer will match a portion of your 401k contribution. Let’s say your company matches 50% of your 410k contribution up to 6% of your salary. If you make $100,000 and contribute $6,000 (6%) the company will kick in $3,000. That’s right, the boss will make it rain just to see you save your own money!
Jedi Mind Trick: Saving today via a 401k gets you into the habit of living on less. If, for example, you make $75,000 and contribute 20% to your 401k, you’re actually living on $60,000. That life-long discipline will pay off in retirement by allowing you to enjoy your post-career life on less income, which will, in turn, help your retirement money last longer.
Now let’s talk about what happens when you stop contributing to your 401k. First off – duh -- most of the above goes away.
- No more reduction in taxable income.
- No more employer contribution.
- No tax deferral on your additional retirement savings.
- No more paying yourself first.
Worst of all, stopping your contribution dramatically slows the growth of your retirement nest egg. It may feel like you’ve saved enough for your ideal retirement. Maybe you have. And, yeah, it would be nice to have some extra money in your checking account today. But what if you live to be 98? Or face a personal or family crisis at 74? Don’t you want as much money stashed away as possible?
So, when should you stop contributing to your 401k? Here’s the exact date: The Day You Stop Working. Go ahead and mark it on your calendar.
Were you expecting another answer? Then you fell victim to that other classic blunder: “Never think a financial planner is going to tell you to drop a program that lets you save tax-deferred and often provides free money, too.”