Dialing Back on a 401(k)

Question: I am currently contributing 15% of my salary to my 401(k). With the current crisis taking a toll on the stock market, would it be a good idea to reduce my contribution to 10% and place the additional 5% somewhere else? —Verona, Savannah, Georgia

Answer: Without a doubt, the last few weeks have ranked as the most tumultuous - and scariest - times that I’ve experienced in the more than 20 years I’ve been at Money magazine.

We’ve witnessed events that up to now had been almost unimaginable with the stock market fluctuating wildly up and down and governments around the globe taking stakes in or seizing control of major financial institutions in an attempt to unlock frozen credit markets. Yet, despite the extraordinary steps that have been taken, the questions of when we’ll hit bottom and how long a recovery will take still linger.

Given all this turmoil and uncertainty in the present, I can understand why you might be tempted to scale back a saving and investing plan that doesn’t have its payoff until sometime way off in the future.

But reducing your 401(k) contributions now would be a mistake for several reasons.

Keeping Uncle Sam at Bay

To begin with, you would be giving up some lucrative tax benefits. You pay no income tax on the money you contribute to your 401(k), nor on the investment gains your contributions generate, until you begin making withdrawals in retirement.

That tax deferral is a huge advantage, which means you’re much more likely to end up with a larger nest egg by contributing to your 401(k) than by saving in a taxable account.

So foregoing those tax breaks alone - even on a portion of your savings - means you will almost certainly reduce the amount of money you’ll have available to you when you retire.

Building a Bigger Nest Egg

Depending on your company’s policy on matching contributions, you may also be turning away the equivalent of free money if you shift funds outside your 401(k).

For example, if your employer kicks in 50 cents for each dollar you sock away, you’re effectively giving up an instant 50% return on your contribution. That’s a terrific deal at any time, but especially attractive today when losses have been the norm.

And let’s be honest, you’ve also got to ask yourself whether you’ll actually end up saving this 5% of salary you’re planning to divert from your 401(k). Without the convenience of a 401(k)’s automatic payroll deductions, good intentions to save can too often succumb to the temptation to spend. That’s an important consideration because when this crisis passes and the economy and markets recover - which they eventually will - you will still be counting on the balance in your 401(k) to finance a big part of your retirement.

Indeed, the additional debt that the U.S. government is taking on to deal with today’s financial crisis will place even greater strains on the federal budget in coming years, increasing the possibility of cutbacks in already stressed programs like Social Security and Medicare. Which means that more than ever before your security in retirement will likely depend on how successful you are in growing the size of your 401(k).

Saving for a Rainy Day

So while you’ll certainly want to make sure you’re investing your 401(k) money appropriately given current conditions now is not the time to cut back on your contributions.

With one possible exception.

We’ve already seen the unemployment rate climb from less than 5% earlier this year to just over 6% as of September. If economic conditions continue to deteriorate, companies may be forced to pare payrolls to cut costs, and the ranks of the unemployed could swell even more. So it’s especially important now that you have an emergency cushion of three to six months’ living expenses that you can tap should you lose your job.

This reserve should be tucked away in one or more highly secure stashes, such as federally insured bank accounts and short-term CDs or money-market funds run by large well-known fund companies.  (For an extra measure of safety, you can stick to money funds that participate in the Treasury Department’s money fund guarantee program.

If you don’t have such a cushion, you need to start building one pronto. Ideally, you would want to do this by tightening spending rather than contributing less to your 401(k). But if that’s not possible, you may have to resort to temporarily putting away less in your 401(k) or other retirement accounts.

I can’t stress enough, however, that such a move, if needed at all, should be temporary. Once you’ve created your emergency fund, be sure to bump your 401(k) contributions back to where they were before, if not a bit higher to make up for lost ground. To assure that the amount you’re setting aside will allow you to retire comfortably, you can check out our Retirement Planner.

That exception aside, don’t let anxiety about today’s financial crisis interfere with funding your 401(k). Otherwise, you may end up facing your own personal financial crisis when you’re ready to retire.