Why You Should Always Contribute to Your 401k Plan...

(June 27th, 2009)

Some financial advisors recommend that during times of economic uncertainty and recession, middle and low income class people should stop contributing to their 401k plans altogether. We think this is totally misinformed and the author of such articles do not know the tax advantages of contributing to 401k plans, as well as the long term building of wealth.

It seems illogical that someone could possibly be against any form of or the concept of savings accounts and retirement funds during the recession in favour of contributing to a system with lesser return. Here are some of the reasons why you should always contribute to a 401k plan, no matter what economic realm we are in. 

i) Contributions you make to your 401(k) plan are tax-deductible. For example, if your income is $50,000 for the year and you contribute to your 401(k) plan a sum of $4500 for the year 2008, then your total taxable income becomes ($50,000 - $4,500 = $45,500). If however you did not contribute to your 401k plan, then you would be taxed on a $50,000 income.

ii) Most medium to large sized organizations in the United States offer a 401k matching plan where they will match every $ you contribute to your 401k plan by 50% or dollar to dollar. Therefore, if you contribute $5000 to your 401k and if your employer matches by 50%, then the total contribution to your 401k will be $5000 + $2500 = $7,500. Think of this 50% matching contribution as a free return on investment with no risk whatsoever.

Other employers prefer to match 100% of the first 3% of your annual salary. For instance, if you earn $80,000 a year, then your employer will match 3% x $80,000 = $2,400 per year. What's more, this $2400 contribution that you received will be tax-deferred until upon retirement when you withdraw it.

iii) God forbid if you were to ever declare bankruptcy, most courts will put forward resolutions to protect your 401(k) retirement accounts while liquidating or selling off your other assets. Thus if you are to declare bankruptcy in the near future, it is advised to contribute towards your 401(k) plan to the maximum allowable limits so that more of your money remains with you, rather than being liquidated.

iv) If you were to invest in stocks or mutual funds rather than hold money in a 401(k), you would have to pay taxes on capitals gains that you make every year. However, if you hold money in a 401k retirement plan up till you stop working and withdraw this money, all taxes are deferred until you withdraw the cash. This provides a very competitive advantage versus investors who make capital gains every year and have to pay taxes on them.